1.0 BACKGROUND

1.1 Perspectives and Current Status

International trends in the financing of dams and non-dam options for water and energy resource development must be viewed in the light of broader global, regional and country-specific financing trends and conditions. Moreover, the projected capital investments under "business as usual" scenarios are considerable. Various estimates suggest investments in energy resource development alone will be between 17 and 30 $US trillion globally from 1990-2020. The electricity sector is expected to account for about half of this investment.

Factors which influence the climate for project financing include: the direct capacity of governments to fund infrastructure projects; maturity of the local banking sectors, bond and equity markets; access to international capital markets; the presence of legal and regulatory frameworks in the counties, particularly in the power sector which affect public, private and public-private ventures; deregulation and privatization policies; and the roles and policies of the public international financial institutions. At the other end of the financing spectrum are rural credit schemes and newly evolving micro financing approaches for decentralized local and community based initiatives. These are among the major factors that increasingly influence how water and energy resource projects are financed around the world, and particularly dams. In both industralized and developing economies these factors are dynamic. They influence decision-making, the types of projects likely to be financed and the project financing approaches used. And they help to define government-private sector roles in developing projects, addressing externalities and addressing the social and environmental issues.

The purpose of this thematic review is threefold: (1) to describe recent international trends in project financing for water and energy resources projects, focusing on dams and the associated non-dam options; (2) to highlight the main features of the project financing approaches and models that are emerging in different regions and settings; and (3) to review the key implications relevant to the WCD mandate. The latter includes the influences of the changing project finance climate on the policy, regulatory, planning and decision-making frameworks and practices in the water and energy resource field.

The review will thus provide and overview of the key financing trends for dams, as well as for supply and demand management options for electricity generation, irrigation, water supply, navigation, etc. Recent trends, policies and practices for financing projects involving various mixes of government, public and private utility, local community, private sector, commercial bank, financial market, and international financial institution funding sources will be examined. The manner in which the different emerging financing approaches and models promise to influence traditional government, private sector and community roles in the planning, project selection, design, construction and operation stages of dams and non-dam options will also be assessed. This work will inform relevant aspects of the other thematic reviews in the WCD work programme.

Significant changes have occurred in the financing of large infrastructure investments, especially over the past decade. In industrial economies, adjustment to various forms of deregulation have been among the major motivating factors influencing changes in investment practices and shaping project financing trends, particularly in the power sector. In most developing market economies the manufacturing, telecommunications, transport and power sectors have been significantly influenced by trends toward economic liberalization. This is partly due to the centralized nature and scale of the investments in these sectors; and partly it reflects a broader global trend towards increased reliance on market mechanisms, with the associated legal, regulatory and institutional reforms. Underlying this shift is the fact that governments globally are seeking to reduce spiralling costs of providing physical infrastructure for society, and increasingly considering market competition, in various forms, as a means to make the provision of public services more efficient. Investment practices in agriculture, irrigation and water supply are also subject to similar forces.

At the same time, many bilateral assistance programmes and international development banks are moving away from direct financing of infrastructure projects toward programs and actions that facilitate the mobilization of bilateral and international investment from non-government sources. The private sector (domestic and international) is thus increasingly sought by developing country governments as a partner in infrastructure development. A related aim of governments in this context, is to free scarce capital resources of government to fund other priorities, such as social investments, where access to private sector and global finance pools is more difficult. This process where governments are turning increasingly to market mechanisms and the private sector for project financing, inherently involves the transfer of risk from the government to the private sector. This transition presents many difficult challenges for emerging market economies. Ways to specifying risk sharing between government and private sector entities, and partnerships, are still being explored on a trial and error basis in many countries new to this process.

As many governments increasingly shift to more of a regulatory oversight role rather than a direct investment positions; new legal, regulatory, licensing and other policy frameworks are being established to provide facilitating mechanisms for the private sector to invest in and operate power and other infrastructure projects. To accompany this expansion of investment sources, the structure of the power industry in many countries is being reformed from more traditional state monopoly structures, to more open industry structures with licensing for generation, transmission and distribution functions. This is to permit market entry for the new entities, which may bring project financing.

In developing economies, where over two-thirds of the new dams have been built in the last decade, competition for project financing is increasing. Consequently, financing is now being sough from a diverse range of sources. Among the various approaches being pursued to structure and raise project financing include the establishment of project companies as turnkey, build-operate (BO), build-operate-transfer (BOT), build-own-operate-transfer (BOOT) schemes. Other measures being explored by governments, utilities and project companies to raise financing include: sale of equity in existing assets, issue of subordinate debt, and local and international bond and public equity issues. Other governments are establishing royalty payment provisions, revolving infrastructure development funds, and incentive programs intended to encourage direct foreign investment. The latter include provisions such as government guarantees for foreign exchange repatriation for debt service and dividend payments by project entities, income tax and import duty holidays, and "one window" systems for dealing with the multiple government agencies involved. Many developing countries are competing to attract new sources of project financing and direct foreign investment in developing these incentive packages.

One major consequence of the international trends financing of projects, which is also related to the deregulation of the power industry and greater use of private sector finance, is that use of thermal electricity generation options is increasing globally. These options include natural gas, oil and coal fired thermal generation using families of more efficient technologies with pollution reduction measures. Use of natural gas for combined cycle systems is perhaps the most rapidly developing power generation technology, and expansion of regional and international gas pipeline networks is planned or underway to serve these growing demands. While governments with indigenous hydro potential may have policies to develop their hydro resources, the thermal generation options are proving to be comparatively more easy to finance from non-government sources. This is due to lower perceived risks for these options by potential private sector developers, investors and financial institutions. The thermal options have shorter design and construction lead times, and generally involve less commercial and project risk that do hydropower options. Dams have various inherent project risks such as geo-technical and schedule risks during construction and hydrological risks during operation. Moreover, dams are less attractive to private developers if they have uncertain or unresolved resettlement, social and environmental implications. Consequently, developers and investors require a higher rate of return on their equity for participation in such projects.

Due to a variety of these risk considerations, the current trend in the hydropower field is moving toward financing medium and smaller-scale dam projects of a run-of-river configuration with new practices involving non-government sources.

Another important consequence of the trend in project financing and associated industry deregulation is the impact on consumer and national affordability, particularly in low-income developing economies. These new project-financing processes necessarily translate to cost-recovery electricity tariffs. This in turn requires special attention to tariff structures in developing economies, and policies on "life-line" rates for low-income consumers. For commercial, industrial and higher income consumers, the move to cost recovery tariffs is expected to foster and support demand-side management programs by making such options more financially viable, and in the interest of electricity consumers.

The national affordability issue relates to the ability of the reserve banks of smaller governments to cover the project-specific commitments for repatriation of foreign exchange needed for debt service and payment of dividends on privately financed projects. Limited recourse financing options where the lender looks to the project cash flow to secure debts are being explored as possible approaches to surmount the problem.

In the changing financing climate in the developing world, partnerships and wholly private sector ventures have been slow to reach financial closure, particularly for dams and hydropower. In response, proponents of hydropower including governments, utilities, developers and independent power producers (IPPs) are exploring various new approaches from wholly private and government-private financing ventures to service and performance contracts. The goal of these approaches is generally to separate the various components of the project that involve risk (either identified or quantifiable), and decide how the government and private investors will allocate and cover the risks. Multipurpose dam projects similarly are generally less attractive to private developers because of the irrigation, water supply, navigation and recreation components. Thus approaches are being considered where governments handle the irrigation and social aspects of multi-purpose projects while the private sector handles power components.

Project financing for alternatives to dams for electricity generation (e.g. thermal, wind, solar, and biomass generation), and demand side management programs are similarly influenced by the trends in power sector financing, industry restructuring and deregulation. As utilities are increasingly required to operation on a commercial basis, shorter-term commercial objectives take on a higher priority in decision-making. Consequently the trends in project financing and deregulation generally do not favour investment in options that are perceived as higher risk, or are not proven on a large scale.

Project financing for irrigation and water supply projects and the demand management options associated with these sectors in developed economies is mainly privatized and financed through user fees. Project financing for these sectors in many developing economies is still provided through traditional government financing sources, with or without international financial institution support; though there are a few examples of private sector participation in these areas.

The changes in project financing approaches for dams and non-dam options can influence a range of concerns vital to water and energy resource development. These include: planning and decision-making processes; the scope and timing for participatory planning; availability of financing for both dam and non-dam options; the emphasis placed on social and environmental issues; and, the capacity of government departments and new organizations to perform in newly defined regulatory and institutional frameworks. The financing models may also affect the division of responsibilities for addressing concerns such as social and environment issues during the design, construction, operation and re-licensing/decommissioning stages of hydroelectric projects.

1.2 The main issues

One central issue with respect to the WCD mandate is where the changes in project financing may lead, in terms of the likely availability of financing for dams and non-dam options, and the regional differences. Specifically, what sources of financing can be anticipated for supply and demand management options for water and energy services in the future?

A related issue is how are the policies and practices of international financing institutions responding to changes in the market place, and to what extent are the changes reflecting sustainable development practices in the water and energy resource sectors. This includes financing for larger scale projects of a centralized nature, and project financing for smaller scale rural and community based water and energy initiatives.

Power sector restructuring and de-regulation are increasingly global phenomenon, though the direction and rate of change is country-specific and motivated by different factors. The extent to which the trends in the availability of financing influence the types of projects that are developed (e.g. thermal versus hydro generation options; large versus medium and smaller scale projects; supply side versus demand side options), are increasingly important issues. Related to this issue is the way hydro, thermal, alternatives and demand-side options are valued in electricity system planning and investment decision-making, and in isolated and rural settings.

Another issue relates to the possible impact of financing trends on policies for development of indigenous energy resources. Countries generally wish to develop their indigenous resources for electricity generation, whether they are fossil fuel, hydro, geothermal or other renewable energy resources. The extent to which project financing trends can in practice, reinforce or override government policies to develop indigenous resources is an issue of increasing concern.

The range of financing models for large-scale projects that are being explored today for government-private and wholly private sector ventures is a key consideration in how hydro projects and non-dam options for the services may be financed in future. Multi-purpose projects pose particular challenges if they are to be fully financed by private sector. Given the financing trends, an important issue will be the extent to which financing is available for irrigation, water supply and other water and energy services either separately, or as part of a multi-purpose project developments. In parallel, an important concern will be the amount of money available for government-community, and local initiatives for financing small-scale approaches and options, as well as their participation in the larger projects developed in their community areas.

The influence that project financing trends for dams and options may have on policy, planning and decision making processes are key issues. This is in respect to the roles and responsibilities of the newly formed regulatory bodies, line ministries, the utilities and the private sector participants in water and energy resources projects. There are implications concerning the degree to which project financing considerations impact on the evolving participatory decision making-processes and decision-making roles.

Many of the new project financing approaches, particularly those for dams are complex and involve considerable negotiation on a case-by-case basis. This raises important issues relating to capacity building in developing economies for the new roles. The learning curve, experience and time factors are important considerations in negotiating sustainable outcomes.

The writers on this thematic topic will be asked to review the scope of work and comments on it from the peer review group, then address issues such as the following in the review paper:

• recent global/regional trends in public and private sector financing for dams and non-dam options, including the range of financing approaches and models emerging in practice;
• policies and practices of public international financing institutions (e.g. bilaterals, multilaterals, and export credit agencies) for water and energy resources projects, of a large and decentralized scale;
• the main features and success rates in adopting different project financing approaches for dams and non-dam options, in different regional and urban/rural settings and their contribution to sustainable development principles;
• key characteristics of the associated legal, regulatory, and licensing frameworks and industry structures for dams and options development emerging in different regions of the world complementary to the project financing directions emerging;
• characteristics of the impacts of deregulation of the power industry on financing of dam and non-dam options for both large scale and decentralized applications;
• how various supply-side and demand-side non-dam options may be advantaged and/or disadvantaged and considered in the diversifying project financing climate: both in respect to decision-making and access to financing.
• key issues arising in respect to redefining critical roles for government departments, independent regulatory agencies, public utilities, civil society, communities and the private sector in all phases of the planning and project cycle for dams and options;
• key issues arising from the shift in responsibilities between government and the private sector for dams motivated by changes in government, private sector and community based financing methods;
• good practices in adapting various processes and procedures such as for participatory planning and decision-making around dams and options, environment and social impact assessment, management, monitoring, auditing and compliance - to reflect sustainable development principles, while accommodating changes in financing approaches, risk sharing and roles.

3.1 Linkage to Focal Dam/Basin Case Studies and 150+ Cross Check Review

This thematic review may complement and enable generalisation of findings from the WCD case studies, which are concerned with a historical review of experience. However, as this thematic is looking at recent trends and future issues, the thematic will mainly inform the work in the other thematic areas.

This thematic will have important implications for the options assessment thematic review (electricity supply and demand management, irrigation and water supply). Insights about future project financing, the circumstances under which project financing may be available, and insights on the enabling conditions will be generated. The findings relating to the possible impact of project financing practices on government and private sector roles are expected to be relevant for the following thematic reviews ( III.1 Economic, financial and distribution analysis; IV Options assessment; V.1 Planning approaches; V.2 Environmental and social impact assessment for large dams; and V.3 Consultation and decision making process.)

This thematic review will provide insights and primarily for Outputs 2 and 3. For Output 2, "good practice" project financing models and arrangements that reflect sustainable management principles will be identified. Policy issues around project financing for sustainable water and energy resource strategies will be provided for consideration in Output 3.