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SPECIAL REPORT

Infrastructure Projects

Latin American Water: Opportunities and Challengesfor Private Investment

by Richard j. Cooper, Chantal E. Kordula and Manisha Desai

Opportunities for private sector investment in theLatin American water industry have never been greater.The reasons for this are numerous. According to WorldBank estimates, more than a quarter of the populationin Latin America does not have access to safe drinkingwater and half of the population does not have accessto adequate sanitation facilities. This situation, com-bined with the shortage of public funds, weak opera-tional performance of existing water systems, successof public/private partnerships in other sectors of theeconomy (e.g., power and telecommunications), andpressures from multilateral agencies, has prompted. many governments and municipalities in LatinAmerica to open their water systems to private sec-tor participation. Over the next 10 years, the invest-ment needs in Latin America for drinking water andwastewater treatment are expected to be between $50billion and $75 billion.

The desire of Latin American governments to attractprivate investment to their water industries comes at atime when the large, primarily U.S. and European pri-vate water companies, having invested heavily in theirown markets, are looking to the developing world foradditional investment opportunities. Many of the big in-dustry players are scrambling to get footholds in LatinAmerica, where water is the last infrastructure frontierfor private investors. Suez Lyonnaise des Eaux, one ofthe oldest and largest private water companies in theworld, created a $300 million investment fund, LyonnaiseLatin American Water Corporation, to support the ex-pansion of Suez Lyonnaise into Latin America. Azurix,the U.S. water company created in 1998 as a division ofU.S. energy giant Enron, recently completed acquisitions

Richard J. Cooper and Chantal E. Kordula are members ofCleary Gottlieb's Project Finance and Infrastructure Group.Manisha Desai was a summer associate in both the NewYork and Paris offices of Cleary Gottlieb during the sum-mer of 2000. The firm has been involved in a number ofwater and wastewater projects in Latin America, includ-ing the sale of a strategic interest in Esval, the first of 1 3Chilean water companies to be privatized.

of water and wastewater companies in Argentina, Braziland Mexico. The United Kingdom water companies havebeen similarly active.

This article surveys recently completed and pend-ing water privatizationsl in Latin America and then ana-lyzes the primary challenges that need to be overcometo attract additional private investment to this market.

Recent Latin American Water ProjectsThe last decade has seen a significant growth in

private investment in the Latin American water sec-tor. Set forth below is a brief description of a few ofthe more notable transactions in some of the largermarkets in the region.

ArgentinaArgentina set the stage for private sector participa-

tion in the Latin American water industry in 1993, withits successful privati~zation of the water and seweragesystems for the Buenos Aires metropolitan area, one ofthe largest systems in the world in terms of population.The privatization, part of an overall economidc restruc-turing and liberalization program announced by the Ar-gentine government in 1989, was accomplished throughthe award of a 30-year concession to Aguas Argentinas

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LATIN AMERICAN LAW AND BUSINESS REPORT(ISSN 1065-7428) is published monthly by WorldTradeExecutive Inc., 2250 Main St., Suite 100, P.O. Box 761,Concord, MA 01742 USA.Tel: 978/287-0301 Fax: 978/287-0302Internet Home Page: http: I / www~wtexec.com

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S.A. ('Aguas Argentinas"), an international consortiumcomprised of, among others, Suez Lyonnaise, Aguas deBarcelona and the International Finance Corporation(IFC). When Aguas Argentinas assumed control over theoperation and maintenance of the water facilities pursu-ant to the concession, the system was near collapse dueto a lack of investment and poor maintenance. The firstobjectives were to restore and improve service, expandwater and sewerage treatment coverage and then beginproviding sewerage treatment, in each case within a timeframe established by the concession for accomplishingthese goals. Since 1993, Aguas Argentinas has investedapproximately $1.2 billion in the Buenos Aires systemand has incurred $600 million to $700 million in medium-term and long-term debt.

Following the award of the Buenos Aires concession,the government embarked on a series of provincial wa-ter and wastewater systems privatizations. A consortiumled by the French water company Vivendi (then knownas Compagnie G~sndrale des Eaux) was awarded a 30-year concession to run Tucumnin's water and sewage sys-tem in July, 1995. The concession for the province of SanteFe was awarded to Suez Lyonnaise in September, 1995.In May, 1998, Azurix, together with SAUR, anotherFrench utility company, led a consortium that paid $150

The Colombian government says itwill grant concessions for 17 urban

water facilities, three regionalservices and 47 small municipalities,

requiring total investments of $1billion over the next 20 years.

million for a 7 0-percent equity stake in the water andsewage company of the province of Mendoza. Althoughmost of Mendoza's 1.4 million residents receive serviceunder the existing system, the consortium plans to in-vest over $300 million over the first 25 years of the 95-year contract on network improvement and increasedconnections to deal with expected population growth.In May, 1999, Azurix was awarded a 30-year water andwastewater concession for the province of BuenosAires for which the company bid $438.6 million. Mostrecently, in April, 2000, the Spanish consortium Asea,led by Spain's Fomnento de Construcciones y Contratos,was awarded a 30-year, $332 million concession tooperate the water utilities in three areas of theCatamarca province. Asea is expected to invest $43million in order to expand both water and sewerageservices in the three areas.

"Done Deals" in BrazilAlthough a great deal of public attention has been

focused on the failed transactions in Brazil, somesmaller privatizations have been completed. In Sep-tember, 1999 seeking to establish a Brazilian base forits investment activities in Latin America,, Azurix ac-quired three 'Brazilian companies providing waterdrililg, Water suppl and water and wastewatertreatment services in Brazil from AMX Acqua Man-agement Inc., for $55.6 million.

The government of the state of Sao Paulo suc-cessfully awarded a concession for the Limeria:water and wastewater system to Suez L~yonnaise.The 30-yea concession calls for ~Suez Lyonnaise to~invest ~$124 mi'llion in the system over the life ofthe: concession with the goal ~of: increasing potablewater output annually by,25 percent and ensurnthat ~95 percent of Limeria's 2.50,000 residents haveclean water within five years.

Folowing the Limeriaconcession:Suez Lyonnaisehas recently made two additional investmnents in Bra-zil. ~In a partnership with the Universit of Sao Pauloand the local government; Suez Lyonnaise is devel-opingaprogram to collect and treat wastewater whichflows from a low-income community into the border-ing Guarapiranga ~reseIrvoir, which is-the principalsource of :drinking water for Nthe city ~of Sao Paulo.Representatives of Suez Lyonnaise noted ~othattein-vestment', whichi was only expected to involve$20,00 to $300,000, will prepare the company forupcomniing projects in Brazil that will present more

In June, 2000 Suez Lyonnaise Purchased for $107million a 90 percent stake in Manaus Saneamento, asubsidiary of the sanitary services of the state ofAmazonas. Sabesp, SAO Paulo's state water utility~ isseeking private investors to implement its $800 mjl-lion, three-ear investment plan. The plan, which in-cludes the construction of two wastewater facilities,is aimed at providing 100 percent of the drinkingwater, 90 percent of the sewage collection, and 75 per-cent of the wastewater treatment coverage to Sa-oPaulo's 24 million residents.

The privatizations of Compesa ~(in Pernambuco)and Embasa (in Bahia) are expected to occur by theend of the year, and there are indications that theprivatization of Rio de Janeiro's Cedae may be re-scheduled in the near future as well.

BrazilWith the largest territory, population, and economy

in Latin America, Brazil presents the greatest number ofopportunities for water and wastewater systemprivatizations, not only in Latin America but worldwide.

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Second Report and Order, CC Docket No. 98-146 (adopted, August3, 2000).3 Ex port IT Latin America: Internet, E-Commerce, and Telecommunica-tions Market.4 The distinction was introduced by the List of Conditions for theprivatization approved by Decree 62/90."Rule CNT 1083/95 (ruling issued by the National CommunicationsCommidssion in Argentina defining value added services).6 1d. The categories of telephony and VAS are comparable to the divi-sion between telecommunications and information services developedby the Federal Communications Comm-ission (FCC) in the UnitedStates. In the so-called "Computer I Inquiry" in 1966, the FCC createda mutually exclusive classification between telecommunications andinformation services. The Telecommunications Act of 1996 continuedto differentiate between basic services, now called "telecommunica-tions services," and enhanced services, now called "information ser-vices." For a comparison between Internet regulations in Argentinaand in the United States, see Kenneth Carter and Ivana Kriznic, NewRegulations for Internet Services in Argentina Comparative Perspec-tive with the U.S. Regulatory Framework, available from the Argen-tina Telecommunications Law Association's website at <http://wwwV.aadt.org.ar />7 Section 9.2 of Decree 62.90 (Decree 62.90 approved the list of con-ditions of the privatization of the state-owned monopoly ENTel).8 Decree 264 /98 (Decree 264 /98 approved the liberalization plan per-mitting limited competition between Telecom Argentina, Telefonicade Argentina, and the consortia lead by Movicorn and CTT).9 Rule CNT 1083/95 and Rule SC 97/96 (considering the Internet aVAS within Rule CNT 1083 /95).1 0 Rule CNT 2373 /93.

11Rule SC 16.200/99 (approving the licensing regime).12 But compare the European Union's ruling that Internet telephonydoes not currently meet all the criteria for voice services. The Euro-pean Union distinguished VoIP from voice telephony based on thelevel of development of each service. Directive 90/388/CEE classi-fied VaIl' as a VAS. According to Article 1 of Directive 90 /388 /EEC"voice telephony" means the commercial provision for the public ofthe direct transport and switching of speech in real-time between pub-lic switched network termidnation points, enabling any user to useequipment connected to such a network termination point in order tocommunicate with another termination point. See <http:/Iwvww.europa.eu.int /comm /dgO4/Ilawliber/en /voice.htm>.13 Rule SC 170/00. English translation available at <http:/ /www.secom.gov.ar>.1 4 Decree 465/00. Industry's comments submitted to the proposedrulemaking proceeding of Rule SC 170 /00 are posted at the site of theSecretary of Communications at <http: / / www~secom.gov~ar>.15 Decree 465/00. Translation by the authors. This new investmentrequirement applies to all players, including previous licensees of te-lephony services, with the exception of LSBs. Therefore, licensees un-der Section 5 Decree 264 /98 must comply with the obligations set forthin that rule until November 8,2000, and, then, from November 8,2000,and to June 30, 2001, may elect between their original commitmentsor make the $2 investment. Similarly. licensees under Rule SC 16.200 /99 are permitted to elect between the coverage requirements for thefirst year as set forth by said rule or invest the $2.16 Former Rule SC 16.200 /99 required the applicant to declare the pro-posed investment for the first three years in order to (1) show that theapplicant's corporate capital was not lower than ten percent of thatamount, and (2) post a compliance guarantee valid for three years inthe amount of ten percent of that amount.1 7 The regulation does not clarify this figure. U


The Brazilian govermnment estimates that approximately$20 billion will be invested in the sector during the next15 years. Despite these indicators, the privatization pro-cess in Brazil has been slow to gain momentum.

From late 1995 through the beginning of 1996, Brazilannounced the privatization of 100 water projects, how-ever many of these privatizations have been either can-celed or postponed, for a variety of reasons. The sale ofCedae, the Rio de Janeiro water company, made head-lines in the water industry when it was first announcedin 1997. Serving 12 million people, it was to become thelargest concession for water and wastewater services inthe world. BNDES, the Brazilian development bank, hadfixed a minimum price of $4.07 billion for the award ofthe concession. However, since the announcement, thesale has been postponed numerous times because of dis-putes over the sale's legality. The "on again-off again"nature of the bidding process has resulted in both of theconsortiums initially pursuing the project, Azurix and aconsortium among Suez Lyonnaise, Vivendi and ThamesWater, withdrawing from the process. The March, 1998attempt by the State of Santa Catarina to sell a 49.9 per-cent interest in its water company to a private investorwas similarly plagued with political and legal challengeswhen the auction was abruptly canceled.

ChileBetween 1988 and 1990, Chile undertook a major re-

structuring of its water and wastewater industry, whichuntil such time had been administered by ServicioNacional de Obras Sanitarias (SENDOS). The restructur-ing was aimed at providing all Chileans with access topotable drinking water and at least 70 percent of Chil-eans with adequate sewerage systems by 2008. In con-nection with this restructuring, a General Law of Sani-

The greatest challenge to attractingadditional private investment to the

water sector is overcoming the lingeringpolitical and social bias against private

participation in the water sector.

tary Services, which contained the regulatory frameworkfor industry-granted concessions for sanitation projects,was enacted. SENDOS was separated into 13 new inde-pendent state-owned companies which together provideapproximately 85 percent of the water service and over90 percent of the wastewater service to 13 regionsthroughout Chile. In order to attract additional manage-


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ment and financing expertise to the companies, changethe role of the state from administrator to regulatorand reduce the state's holding to less than 50 percentto avoid being subject to the legal constraints appli-cable to state-owned companies, the Chilean govern-ment slated each of the 13 newly-created companiesfor privatization by 2002.

Esval, the second largest water and wastewatercompany in Chile servicing the cities of Valparafso andVifia del Mar, was the first of the 13 companies to beprivatized. In December, 1998, Chilean electricity dis-tributor Enersis and British Anglian Water paid $138.4

Depending upon the terms andconditions of a particular concession,

the differences between an outright saleand continued governmental control of

the system can be minimal.

million for a 40 percent interest in the company. Thejoint venture, Aguas Puerto, was expected to imple-ment a $230 million four-year investment program.This first auction was followed in July, 1999, by thesale of a 51 percent interest in Essal, the company serv-ing a region in southern Chile, to Iberdrola, a Spanishwater company, for $94 million.

In September, 1999, Suez Lyonnaise and SpanishAguas de Barcelona paid $1.08 billion for a 51 percentinterest in Emos, the company servicing the metropoli-tan region of Santiago. In November, 1999, AguasChile, a consortium between Thames Water andElectricidade de Portugal, purchased 45 percent ofEssel, which services the region south of Santiago, for$112.5 million. Despite the success of theseprivatizations, private investors in Chile are now en-countering "overlap" problems. Emos was first barredfrom the Essel auction and is prohibited from partici-pating in the sale of Essbio, the country's third largestcompany, which is scheduled for the end of 2000, be-cause Emos is nearing a 50 percent holding limit whichhas been established by the Chilean government.

MexicoMexico first attempted to attract private financing

to the water industry in the early 1990s. The first pro-gram that was established for such private investmentincluded tariff structures that were seen by many in theindustry as too aggressive, because consumers were ex-pected to pay high tariffs in instances where they hadpreviously paid little or nothing for water prior to the

program. In Aguascalientes, for example, in 1996 themayor terminated a concession that had been awardedto Empresas ICA, the Mexican construction company, inresponse to increases in water prices linked to inflation.2

California-based company U.S. Filter, which in the early1990s built two wastewater treatment plants in the stateof Morelos and invested $20 million in two 15-year con-cessions, found customers unwilling to pay their waterbills following increases in the tariff.

In response to these problems, the Mexican govern-ment has developed less stringent regulations and es-tablished a government partnership program throughBanespa that investors have responded to favorably. Thefederal and state partnership involves the federal gov-ernment providing funds to pay a portion of construc-tion costs, thereby reducing the capital expenditures re-quired by private investors, and the state providing in-vestors and their lenders with a backstop guarantee.

In March, 1999, Azurix: acquired a 49.9 percent inter-est in and the right to operate and manage the water andwastewater treatment concessions for Cancun and IslaMujeres for $13.5 million. Azurix estimates that 65 per-cent of the concession's operating revenues are derivedfrom the supply of drinking water to tourist hotels whoseoperating revenues are primarily U.S.-dollar based. Theconcession requires investment estimated at $44 millionover five years. In September, 1999, Azurix acquired a49-percent interest in IASA Holdings S.A. de C.V., a com-pany that provides metering, billing, collections, opera-tions and maintenance for an area covering approxi-mately one quarter of Mexico City. Darby Overseas In-vestments Ltd. made its first investment in the LatinAmerican water industry in December, 1999, when itsDarby Latin American Mezzanine Fund made a $10 mil-lion investment in Tratamiento de Agua de Puebla S.A.sponsored by Suez Lyonnaise and Tribasa, a Mexicanconstruction company. The capital invested is being uti-lized to fund a portion of the $60 million required forconstruction and operation of four wastewater treatmentplants in Puebla, Mexico.

ColombiaFrom a private investor's perspective, the water

industry in Colombia does not present the same po-litical and security issues that other infrastructureprojects in Colombia have experienced, particularly inthe oil and gas sector.

In 1997, Suez Lyonnaise des Eaux acted as the spon-sor for the $130 million Salitre water and wastewatertreatment project in Bogota. It was one of the first waste-water plants in the world to be financed in the interna-tional capital markets and the first project financing toincorporate a partial risk guarantee from a multilateraldevelopment bank (in this case, the Inter-American De-velopment Bank (IDB)) without a sovereign counter-


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guarantee. In November, 1999, Colombia awarded oneof its first 20-year water concessions for the city ofMonteria to a consortium led by Vivendi. The conces-sion requires the concessionaire to invest $70 millionover the term of the contract to expand and operatewater and sewerage services.

The Colombian government recently announcedthat it plans to continue privatization of sanitary ser-vices throughout the country by granting concessionsfor 17 urban water facilities, three regional services and47 small municipalities that will require aggregate in-vestments of $1 billion over the next 20 years. Althoughauctions for concessions in lbague, San Andres, Neivaand Popayana were postponed for political reasons, a20-year $220 million concession for the water utilityin Cucuta as well as concessions for the Sincelejo andCorozal are planned for the near future. The WorldBank is helping the government of Colombia with fi-nancing for its investment plan and has committed toprovide $895 million between now and 2010.

PeruIn the early 1990s, the administration of President

Alberto Fujimori embarked on a privatization programO aimed at modernizing the Peruvian economy. DecreeLaw Number 674 was enacted in September, 1991, creat-ing a state agency to oversee the privatization processand establishing the rules for carrying out the process.

Initial public reaction to the privatizations was fa-vorable and approval ratings for the program averagedaround 60 percent until 1993. Popularity declined, how-ever, in the second half of the 1990s in response to tariffincreases and the elimination of government subsidies.As a result, in recent years, privatizations have slowedand many previously announced privatizations havebeen either canceled or postponed.

The privatization of Sedapal, Lima's water and sew-erage company, was announced in the early 1990s andwas even promoted during an international road showin 1994. In November, 1997, however, Fujimori an-nounced that Sedapal would not be privatized as longas he was in power. The government justified its deci-sion by arguing that the privatization was not necessaryas the state company was being run efficiently and hadaccess to financing for modernization and expansion (cit-ing, for example, that investment had increased from$1.10 per inhabitant served by Sedapal in 1990 to $14.70in 1996). More recently, there has been some indicationthat the government may seek limited private investmentin its water industry. In January, 2000, the goverrnment. awarded a 25-year concession for the construction, op-eration, maintenance and transfer of a $80-100 milliondrinking water system on the Chillon River to a consor-tium of Italian companies. The government is also pur-

suing a public auction for the $150 million Olmos reser-voir and irrigation concession.

BoliviaBolivia has had limited private investment in its

water and wastewater systems. In 1997, Suez Lyonnaiseled a consortium that won a 30-year concession for thewater and wastewater system of La Paz. In 1999, the Bo-livian government sold the public water system ofCochabamba, Bolivia's third largest city, to a group ofinvestors led by International Water Limited, an affiliateof U.S. Bechtel. As more fully described below, protestsin response to increases in the tariff resulted in the ter-mination of the concession.

PanamaThe national water company of Panama, Instituto de

Acueductos y Alcantarillados Nacionales (IDAAN), is asemi-autonomous government entity under the auspicesof the Ministry of Health. Panama faces serious watershortages due to a growing urban population, increaseddemand from industries and commerce and deteriora-tion of existing water production and distribution sys-tems. As a result, IDAAN is faced with the need to imple-ment a major investment program in both the urban andrural areas of Panama.

With the advice of the World Bank and the IDB,Panama decided in 1996 to seek the participation of the

Issues of regulatory discretion,incentives, penalties, reporting andoversight need to be fully resolved

before privatization.

private sector in the rehabilitation and development ofits water industry. In December, 1997, the governmentawarded a 30-year concession for the Lake Gatun po-table water service to a consortium led by British Biwater.Recently, IDAAN has announced its intention to auctiona $ 18-20 m-illion contract to build the Linea de Orienteaqueduct to service 300,000 residents in the central andeastern zones of Panama City.

EcuadorThe government of Ecuador is planning the auction

of a 30-year concession to operate Ecapag, the water util-ity for Ecuador's largest city, Guayaquil. The project,funded by a $40 million IDB, loan, involves an invest-ment of approximately $72.5 million to implement a re-habilitation program for potable water, sanitary sewageand rainwater sewage in the first five years of the con-cession. The concessionaire is also expected to make a


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capital investment of $520 million over the next five-yearperiod to expand the services, with the goal of increas-ing drinking water coverage to 95 percent and sewagecoverage to 90 percent by the end of the concession.

Challenges Facing the Latin AmericanWater Market

Despite the successful closing of a number of impor-tant Latin American water projects over the last decade,there remain significant challenges facing the industry ifthe transition from public ownership and control to pri-vate operation and management is to continue. Under-standing and meeting these challenges is critical if theconsiderable investment needs of the region are to be met.In an era of fierce global competition for capital, LatinAmerica is still widely viewed as a region prone to po-litical upheaval and risk, and water projects, perhaps likeno other infrastructure projects, tend to galvanize theforces that generate such risk.

The Political ChallengeThe first, and perhaps the foremost, challenge to at-

tracting additional private investment to the water sec-tor is overcoming the lingering political and social biasagainst private participation in the water sector. Water,unlike electricity or telecommunications, is w idely

If significant additional investment in theLatin American water sector is to occur,

there will need to be a greatergovernment commitment to raising

tariffs to permit private investors to meettheir contractual commitments and

realize reasonable returns.

viewed as a basic life staple, and in Latin America priorto 1990, there was virtually no precedent for private par-ticipation. In addition, because of the obvious health andenvironmental considerations, providing safe drinkingwater and proper sanitation services is considered notonly a proper government function but an essential pub-lic service. Recognizing these perceptions and under-standing the challenges that they present is crucial to thefurther deployment of private capital to this sector.

Host Country's ConcernsIn practical terms, what does this mean? From a host

country's perspective, the transition from public owner-ship to private sector management has to be carefully

planned. First, the appropriate form of private sectorparticipation has to be used, whether it involves a lim-ited service contract, a concession or an outright sale. InLatin America, the most widely used method of intro-ducing private sector investment into the water sectorhas been the concession model, where ownership of theassets remains in the hands of the public sector but pri-vate companies are contracted to operate, expand andenhance the system. Concessions have been used in Ar-gentina, Brazil and Mexico because, in each of these coun-tries, there has been strong opposition to outright sales.Depending upon the terms and conditions of a particu-lar concession, however, the differences between an out-right sale of the system and continued governmentalcontrol of the system can be minimal.

For example, the privatization of the Mendoza wa-ter system in Argentina involved a 95-year concessionwhich provided the concessionaire with significant re-sponsibility and control over the system. Chile, by con-trast, has structured its water privatizations differently;each privatization has been structured as a sale of an in-terest in the water company rather than as a concession.Two of such sales have been sales of a strategic interestwhere the investor purchases 35 percent to 45 percent ofthe equity of the company but gains effective control ofthe company through shareholder arrangements with thegovernment retaining veto power over certain key deci-sions. For the host government, the key is to select theform of private sector participation that will be accept-able to consumers and other interested parties.

Second, the public has to be educated as to the ben-efits that will flow from private participation and madeto understand the link between improvement in servicesand increased tariffs. Many governments that have suc-cessfully privatized their water systems have precededthe privatization with a series of rate increases to lessenthe need for and diminish the political fallout that mayresult from any subsequent rate increases by the newoperator. Others have structured the concession so thatwater charges are increased gradually and there is noup-front payment by the concessionaire to the govern-ment for the concession, the inclusion of which almostcertainly requires an increase in rates. Still others havetied rate increases to service improvements hoping thatpublic reaction to such increases will be muted by rec-ognizable improvements in the quality of service.

Private Sector's Evaluation of RisksFrom the private sector participant's perspective, a

careful assessment of the applicable political and socialenvironment must be undertaken to determine whetherprivate sector involvement in the water sector presentsacceptable risks given the expected economic returns thatwill be generated. Undoubtedly, this will require the par-ticipant to analyze the stability of the host government,


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its experience with other privatization projects, the stand-ing and experience of the local water company, the de-gree of local support for the transaction, the willingnessof the population to pay for water, and the demograph-ics of the community. The private sector participant willalso want to ensure that the bidding process has beenconducted in a transparent manner to avoid subsequentchallenges and criticisms. Finally, it will need to take se-riously such tasks as community service programs andmarketing campaigns to sell to consumers the virtues ofprivate investment in this vital industry.

The failed concession for the northern Argentineprovince of Tucumin clearly demonstrates the risks thatprivate investors face when the environment turns hos-tile. A consortium led by the French water company Viv-endi was awarded a 30-year concession to run Tucumdn'swater and sewage system in July, 1995. To finance anaggressive investment program, the new company,Aguas del Aconquija, doubled tariffs within months ofthe privatization. Shortly after this increase, there was achangeover in Tucurmdn's provincial government. Thenew governor was opposed to the privatization and al-leged that the process lacked transparency because it wasapproved during the last days of the previous govern-ment. The governor opposed tariff increases and evenencouraged consumers not to pay their bills. More than80 percent of the population heeded this advice. Vivenditried to pull out of the concession in August of 1997, butthe government insisted that it keep operating untilMarch, 1999. Forced to keep providing the water despitethe non-payment, 3 Vivendi alleged that it was losing$2.8 million per month. Fearful of alienating foreigninvestors, then-president of Argentina Carlos Menemtried to smooth over the differences and the federalgovernment offered to take over management of thewater company until a new tender was organized. Viv-endi was finally able to rescind the contract in Octo-ber, 1998, the first such rescission of a contract in thecompany's 145-year history. Vivendi has filed a suitclaiming damages of more than $200 million before theWorld Bank's International Centre for Settlement ofInvestment Dispute in Washington.

The Regulatory ChallengeA second challenge that must be overcome if the tran-

sition towards private management and control is to con-tinue relates to the often conflicting regulatory regimesthat apply to the Latin American water sector. Becauseof the monopolistic nature of the water business, the in-dustry is highly regulated to protect consumers fromexcessive charges and to ensure adequate water qualityand wastewater treatment. However, in any one market,regulation is often within the jurisdiction of more thanone governmental authority (e.g., health, environmental

and antitrust authorities) and often exists at both thenational and the local level.

Jurisdictional disputes over regulatory issues of-ten can be fatal to the privatization process itself. Thishas certainly been the case in Brazil where, for ex-ample, the privatization of Rio de Janeiro's Cedae wasabruptly canceled by the Brazilian Supreme Courtshortly after it was announced as a result of a disputebetween the state and city authorities over ownershipof the assets. Even when these issues do not prevent aprivatization transaction from going forward, lack ofregulatory clarity can affect the valuation of the busi-ness or significantly delay the process.

After a system is privatized, the difficulty of dealingwith multiple regulators is frequently compounded bythe fact that the regulations are new and untested, regu-lators are often given wide latitude to interpret contrac-tual or statutory provisions regarding critical matters,such as rate adjustments, and the regulatory process isfrequently not transparent. Although it may be possiblefor an investor to reduce the level of discretion given toa local official when it negotiates or comments on theterms of the privatization documentation, it is often dif-ficult to do so and, in any event, disputes may arise. Anadditional difficulty is that in most Latin American coun-tries the applicable regulatory regime and related admin-istrative law principles are not well developed. With the

From a financing perspective, LatinAmerican water projects present a

number of challenges.

exception of Chile (which overhauled its entire regula-tory system before embarking on its privatization pro-gram), most jurisdictions develop the applicable regula-tory scheme as part of the privatization process. Thismakes it more difficult for a private investor to make in-formed judgments as to the integrity of the regulatoryprocess prior to bidding on a concession.

To address the challenge presented by this situation,host countries should consider adopting the appropriateregulatory scheme for the form of private investment theyare seeking prior to the actual privatization. In the con-cession context, for example, a host government shouldidentify the regulatory tasks that will be required whenoperation of the system is turned over to the private sec-tor and determine what changes in the applicable legalregime need to be made (including whether there areoverlapping or conflicting laws that will affect the opera-tion and management of the system or the privatizationitself). Issues such as how much regulatory discretionshould be permitted, what incentives and penalties


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should be included, and what reporting and oversightwill be required need to be fully considered and resolvedprior to the privatization. For the private investor, theapplicable regulatory framework is a critical aspect of itsinvestment decision and the clarity, capacity and contentof the regulatory system will influence both its willing-ness to participate and the cost of such participation.

The Revenue Challenge-Upgrading Facilitieswhile Keeping Rates Low

Another big challenge that participants in LatinAmerican water projects face is reconciling the oftenambitious capital improvement projects required by theterms of a concession with the need to maintain a sus-tainable and affordable tariff for consumers. Frequently,water concessions require the concessionaire to satisfyspecific performance targets relating to coverage, system

upgrades, and operating criteria (e.g., agreed decreasesin unaccounted for water). To meet these requirements,the concessionaire must increase tariffs but, for politicaland social reasons, such increases are often difficult toimplement even if such increases are provided for in theterms of the concession.

The Financing ChallengeLatin American water projects present a number of

financing challenges.4 First, Latin American waterprivatizations tend (with a few notable exceptions) tobe relatively small in scale. Many of the municipalwater privatizations in Latin America involvefinancings requiring less than $50 million in total fund-ing needs. As a result, it is often difficult to attract theinterest of multilaterals, let alone commercial banksor institutional investors.

Second, many of the Latin water privatizations in-volve sub-sovereign governments such as state and


0


Higher Tariffs Result in Customer BacklashIncreases in water charg-esz can have disastrous consequences on the viability of a concession. In 199.9, the Bolv

iangoermet oldth pblc ate sstm f ochbaba Bliia' tir lrgst it, o goupofinesorled by International Water Limited, :an affiliate of the U.S. company.Bechtel. Withint months of the sale, the newwater company, Aguas del Tunari, reportedly increased rates so dramatically that customers were paying nearlydouble the rates. they had been payingprior to the: privatization. In ~a cutywee the minimum wage~ is. lessthan $100 prmnhcosmrrertdywere suddenly receiving water bills amounting to $20 ormoeRsidents took to the strees staged a general strike and shut do wn h city for four days. Following failed negotia-~tions between community leaders and the gvrm ntrots ensued and martial law was declared in the prov-iner. Facingmounting pressurethe interatonal consortium puldout of the ~$200 million projectin April of tiyear and the water cmpn is now back in the hands of the state.

Despite the seerming conflictbetween sastisyigoper~ating and capital cm tensrequired by the concessionand avoiding tariff increases, governments and investors have found ways to address this issue. One method ofmeeting these requirements without substantially increasingthie tariff is through the adoption by the new conces-sionaireof improved operating proceduresi and inexpensive capital improvements. For example, it iswdl nwthat state-run water companies 'in Latin America suffer from inadequate billing and collection practices. TheorIginal bid documents for the privatization of Cedae Vindicated, for example., that 51.7 percent of the water pro-duced was lost to technica inefficiencies: (i~e., broken pipes, leakage, theft) and that 22 percent of the invoicesbilled were not collected. In such a case, increasing the billing and collection rate alone through 'better manage-ment can markedly increase the~ company's revenues. Additionallyreducing operating expenses by optimnizingthe company's work force is another fertile ground for improving the company's financial performance and therebylesseni-ng the severity of future rate increases.

Another means Of increasing the concessionaires revenues withoutuimpacting the level of the tariff is to permitthe concessionaire to generate revenue from non-water-related activities. The Cochabamba concession in Boliviawas structured this way, although the concession was termuinated before the concessionaire could realize revenuefrom the generation and transmission of the hydroelectric power that it was; authorized to provide. Other conces-sions have pDermitted concessionaires to generate non-water revenue through the provision of telephony services,the laying of fiber optic cable or the provis~ion of other utility services.

In the end, if significant additional investment in the Latin American water sector is to occur, there will need tobe a greater government commitment toxridsing tariffs to permit private investors to meet their contractual com-mitments and realize reasonable returns. Although tariff regimes should always be structured to protect the poor-est in the community through targpeted subsidies, local governments will need to do a better job of educating theircitizens to the link between expanded access and improved service and higher tariffs.

August 31, 200030

SPECIAL REPORT


municipal governments. To the extent these entities areproviding credit support for the payment of tariffs, theconvertibility of local currency or changes in exchangerates, they generally do not have an established credithistory or track record when it comes to satisfyingthese types of obligations. In addition, sub-sovereigngovernments tend to be more susceptible to changesin policy when it comes to issues affecting foreign in-vestment than their federal or national counterparts(perhaps due to the latter's greater sensitivities to theramifications of such changes on future investment).All of this makes the concessionaire's task of arrang-ing satisfactory financing more difficult.

Finally, because water and wastewater projects arecapital intensive (more so than electricity and telecom-mUnication projects, for example) and there are sig-nificant practical limitations on the concessionaire'sability to increase tariffs, the tenor of the financing that

Host governments, developers andfinanciers need to devise new methodsfor financing water projects on a cost-

efficient, long-term basis.

the concessionaire needs to obtain to make the projecteconomically viable needs to be longer than other in-frastructure projects. If long-term financing cannot beobtained at attractive rates, the concessionaire willcome under increasing pressure to increase tariffs be-yond levels that may be sustainable.

Role of Multilaterals and Export Credit AgenciesHistorically, multilateral and export credit agency

financing have been key sources of funding for waterand wastewater projects in Latin America. The partici-pation of institutions such as the IDB or the IFC in waterprojects offers real advantages to the concessionaire.Aguas Argentinas was one of the first concession-basedprojects to be financed under an IFC umbrella with thesupport of commercial banks. The early participation ofthe IFC in the project was essential in obtaining the largeamount of financing required for that project. The par-ticipation of the IFC, which not only provided loan fi-nancing but also took an equity position of 5.12 percent,lent transparency and credibility to the project, widenedinternational interest in the project, increased competi-tion in the bidding process and gave other lenders com-fort regarding issues of political risk.

Although the terms and tenor of multilateral andexport credit agency financing are generally more f a-

vorable to the concessionaire than traditional commer-cial bank financing (except in rare cases), the tenor ofsuch financing is not as long as what is available inthe project bond market for other infrastructureprojects (e.g., 15 plus years).

There are other problems as well. For one, exportcredit agency financing is not always practicable in theprivatization context given the limited amount of con-struction work that is initially required and the eligibil-ity and other procedural limitations that are associatedwith export credit agency financing (e.g., "reachback"and domestic content rules, etc.). Another problem in-volves the high transaction costs and lengthy time peri-ods required to obtain these types of financings, whichmake multilateral lending and export credit agency fi-nancing less than ideal in the smaller municipal waterprojects that are subject to tight time schedules due tocompetitive bidding procedures.

One of the most important challenges that host gov-ernments, developers and financiers face in attractingadditional private sector investment to the Latin Ameri-can water sector in the coming years is devising newmethods for financing such projects on a cost-efficient,long-term basis. The recent increase in general munici-pal bond financings in countries such as Argentina, Bra-zil and Colombia, is a possible sign that capital marketinvestors may be getting more comfortable with some ofthe political and economic risks associated with thesecredits. In addition, financings involving partial riskguarantees (such as the Salitre water and wastewaterproject in Colombia) and programs of the type recentlycreated by the Overseas Private Investment Corpora-tion and certain private sector political risk insurers(whereby political risk coverage is provided to capitalmarkets investors) offer some hope that financingstructures can be devised that will address the signifi-cant capital requirements of Latin American water andwastewater projects and the limited capacity of thenewly privatized businesses to generate additionalcash flow through rate increases.

The Information ChallengeState and municipal water systems in Latin America,

as in other emerging markets, are generally not able toproduce accurate information and records regarding theirassets, liabilities, procedures, revenues and costs. Thissituation is compounded by the fact that the systems aregenerally poorly maintained and difficult to inspect giventhe underground nature of the piping system and otherequipment. This lack of information can not only affectthe bidding process and the valuation of the concessionby the private investor, but can also affect the allocationof responsibility and liability under the concession byobscuring the baseline from which to monitor a


August 31,2000LATIN AMERICAN LAW & BUSINESS REPORT 3

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August 31, 2000 31

SPECIAL REPORT


concessionaire's performance or allocate responsibilityor liability under the agreements.

Host country governments need to address this situ-ation, which is more acute in the context of theprivatization of an existing water or wastewater systemthan the development of a greenfield water or wastewa-ter facility. Independent consultants and auditors shouldproduce reports concerning the water company prior toits privatization. If this is not possible or feasible, con-sideration should be given to having the concessionaireenter into an interim management contract prior to theprivatization to afford it and the local government an

With the largest territory, population,and economy in Latin America, Brazil

presents the greatest number ofopportunities for water and wastewatersystem privatizations, not only in Latin

America, but worldwide.

opportunity to determine whether the tariff structure andexpansion requirements are realistic and sustainable.Every effort should be made to produce comprehensive,quality information that can be shared in a transparentmanner with all interested parties. To do otherwise is toinvite private investors to discount the value of the con-cession and!/ or to seek to renegotiate the tariff after theyacquire the concession.

ConclusionAlthough the investment opportunities in the Latin

American water and wastewater sector have never beengreater, there remains a number of important challengesthat need to be overcome if the investment needs of thissector are to be met. Given the global competition forcapital and the significant returns that are possible in lesspolitically risky markets, successfully meeting one or afew of these challenges may not be enough. Local gov-ernments, multilaterals and industry participants willneed to make a concerted, systematic effort to find cre-ative solutions to the challenges facing the market if sig-nificant progress is to be made.

1This article generally focuses on privatization and similartransactions involving existing water and wastewater systemsrather than greenfield projects involving the development,construction and operation of new facilities. Althoughgreenfield projects represent an important segment of the wa-ter and wastewater market in Latin America, they generallyare smaller in scale and less politically and socially controver-

sial than privatization transactions. For an analysis of the dif-ferent options for private sector investment in internationalwater and wastewater projects and the different considerationsrelevant to investments in existing facilities and greenfieldprojects, see Richard J. Cooper and Chantal E. Kordula, TheNew Wave: Private Sector in International Water, Project Fi-nance International, Feb. 23, 2000, at 52.2The concession was subsequently reinstated following fed-eral govemnment-brokered negotiations.3In many emerging market jurisdictions local laws prevent theconcessionaire from shutting off a user's access to water evenin the case of non-payment.4The financing issues associated with greenfield water projectsare often more manageable. Greenfield projects tend to be lesspolitically controversial, do not present the labor and infor-mation challenges that privatization transactions do, often ben-



The Labor ChallengeLatin American water companies are notoriously

over-staffed and frequently unionized.5 fin addition.Othere is usually a dearth of talented managerial ta-ent. Addressing the issues associated with entrenchedand poorly trained work forces is one of the most dif-ficult issues that host country governmnents face when:trying to attract private investment to the water sec-tor. For the pri'vate investor, addressing this situationis crucial1 not Only because of the obvious financialimnplications for the newl privatized comnpany (at thetime it was privatzed it was estimated that approxi1-mately 70 percent of the current and expected oper-ating costs iof the Buenos Aires water system. was. at-tributable to labor, expenses) but also because of thepolitical and social consequences that may result froma volatile workplace envaironment. 6

Investors often seek to address staffing and laborissues in the privatization documentation, and hostgovernments sometimes have been willing to agreeto redeploy employees to other public sector ~jos orto consent to iand bear the cost of post-closing work.rationalization plans 'If private participation in thewater sectoristo conitinue toexpand in Latin America,investors will need to be insulated from the oftensig-niicn leaetitosand financial burdens (eag.,intcludin :generous severance payments and exten-sive health and benefits coverage) imposed on inves-

tosseeking to optimize their newly inheritedworkforce. Given the host government's greater br

gaiin poiton and ability to absorb these costs orredplo thseresources, it makes sense for the local

government to take the lead in dealing with thesel is-sues prior to the Privatization. Failure to Adequatelyand dearly address these issues willat a minimum,increase the cost :of private in-vestment ~and, 'in theWorst case scentari, deter private investors from par-ticipating in the market.

6N

01

August 31, 200032

SPECIAL REPORT

Water Projects frm page 32)

efit from offtake commitments or support from governmentcounterparties, and attract the interest of export credit agen-cies because of the construction aspect of the project. Of course,greenfield projects present other, more typical financing chal-lenges (e.g., completion risk, etc.).5 0n average, publicly-owned water facilities in developingcountries have a ratio of 5 to 10 employees per 1000 waterconnections whereas a similar system in the U.S. or WesternEurope might have a ratio of 2 to 3 employees per 1000 wa-ter connections.6 Many emerging market water privatizations are structuredso that employees of the privatized utility are entitled to anequity stake in the privatized entity (with corresponding boardrepresentation), thereby further complicating the investor'sability to optimize the labor force and negatively affecting theproject's economics for the investor, including by reducing itspercentage of the project's equity. [U

Market Notes (from page 5)

Argentina account for 95 percent of the auto sector tradewithin the customs union. Because of the huge share ofMercosur trade represented by the auto sectors of Brazil. and Argentina, the latest dispute between the two na-tions has mobilized government officials and auto ex-ecutives from both countries. Negotiations for a solutionbegan on August 16 but made no progress. A new roundof talks was scheduled for August 23. Brazilian diplo-mats said that Brazil would continue to insist that whatcounts is the auto accord signed in June and not the Au-gust 1 Argentine decree. Prior to the auto dispute on July24, Argentina adopted punitive action against importsof Brazilian chicken meat, accused of dumping. The Ar-gentine government set a minimum price of $0.98 perkilo for the frozen chicken, a level that Brazilian produc-ers charged would price them out of the Argentine mar-ket. Brazil's official reaction came quickly with angrypublic statements by government officials and threats totake the question to the World Trade Organization. For-eign Trade Secretary Lythia Spfndola said that Brazilwould appeal to the Mercosur's dispute settlement or-gan and if that failed would ask for a WTO dispute panel.

Foreign Direct Investment up by 40 percent for firstsix months. Brazil's current account deficit ended the firstperiod at $11.3 billion, over $1 billion below the total of$12.447 billion for the same period last year and the low-est result for the semester since 1996. The June deficitwas $2.4 billion, down from $2.9 billion in June, 1999.The annualized deficit totaled $24 billion in June, the. equivalent of 3.96 percent of gross domestic product. Thiscompares with $32.7 billion and 4.92 percent of GDP inJune, 1999. Foreign direct investment in June soared to

$3.7 billion, the highest figure of the year. FDI for thefirst six months of the year totaled $13.8 billion, easilycovering the semester's current account gap. Althoughprivatization revenues have fallen this year, in the se-mester non-privatization FDI rose 40 percent over thesame period last year. According to figures released bythe Central Bank, the services sector accounted for 73percent of the semester's FDI, including $2.3 billion forthe telecommunications sector and $2 billion destinedfor financial institutions. Investments in industry ac-counted for 24.8 percent of FDI and the farm sector re-ceived 2.2 percent. Most of the improvement in the se-mester deficit resulted from the trade balance which wentfrom a gap of $620 million in 1999 to a surplus of $819million this year. The services deficit showed little varia-tion, increasing by $688 million from 1999 to $13.1 bil-lion this year. Net profit and dividend remittances fellfrom $2.35 billion in the first half of 1999 to $1.9 billion.Debt interest payments increased slightly from $8.8 bil-lion in 1999 to $8.9 billion this year. International travelby Brazilians picked up in the second quarter, leavingtotal net travel related outflows at $833 million, up from$569 million for the first semester of 1999, a period whentravel fell sharply due to the January currency devalua-tion. Foreign issues by Brazilian firms declined in June,totaling only 13 with total volume of $889 million. Thisleft inflows for the semester at $9.2 billion, down from$13.6 billion for the same period last year. Brazil's readyreserves fell $306 million in June to $27.6 billion.

BoliviaEmpresa Petrolera Andina assets may be losing

their appeal. Argentine oil companies Perez CompancSA and Pluspetrol Resources SA are reportedly consid-ering selling their interests in Bolivia's Empresa PetroleraAndina. Sources have attributed the sudden interest tosell to the realization of limited growth potential in Bo-livia. Andina is 50 percent owned by a consortium com-prised of Perez Company, Pluspetrol, and Repsol YPFSA; the other 50 percent is held by private Bolivian pen-sion funds. Perez Companc has nearly 41 percent of theconsortium's share and Pluspetrol 19 percent.

ColombiaAutotote halts services contract with Equus

Comuneros. Autotote Systems Inc. said it suspended per-formance of a services contract with Equus ComunerosSA of Colombia, effective August 1, due to a debt of morethan $500,000. Autotote is the exclusive provider of com-puterized wagering services to Hipodromo de Colom-bia under a contract that runs from January 1, 1999 until2006. On July 26, Autotote initiated international arbi-tration proceedings against Equus Comuneros and threeaffiliated companies to recover a total of more than$1,150,000 in unpaid fees. Autotote Systems and its


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