Mexico: a lost year for water

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To date 2000 has been something of a lost year for water projects in Mexico. Public and private sector plans have moved forward slowly or stalled completely. The election of PAN party candidate Vicente Fox has raised the prospect of change in the Mexican water sector. However, creating financing options for municipal infrastructure improvements remains a significant challenge.

At least 80 cities are upgrading their potable water distribution and sewerage systems. These include Zacatecas, Pachuca, Morelia, Tulancingo, Ixtapa, Guadalajara, Celaya, Irapuato, Leon and Queretaro. But BOT projects in the states of Guerrero and Veracruz, a desalination plant for Hermosillo in the state of Sonora, and the $1.1 billion Mexico Valley water management programme have stalled or remain on hold
until the new administration takes office on 1 December.

US, British and Mexican economists expect that President-elect Fox will continue the Zedillo administration’s policy of privatisation and deregulation. The Zedillo PRI government granted railway concessions, natural gas distribution permits and ran an airport privatisation programme leading to new investment.

Vicente Fox has said publicly that he will continue efforts to improve the country’s infrastructure by encouraging foreign direct investment. FDI in Mexico has recently averaged $12 billion annually with significant growth predicted over the next five years. Fox’s stated goal of increasing FDI to $20 billion a year is considered achievable. The new president has yet to announce his official plans for the water sector but a team of advisers has been reviewing a range of options to bring private sector capital into the industry.

However, early indications are that foreign investors are uncomfortable with the structure of the Mexican water industry and do not trust revenue streams generated by municipal utilities. Foreign commercial banks are also tightly restricted from lending in Mexico. This is an obstacle to more aggressive private sector participation in the water sector.

Only a few of the larger municipalities were able to develop concessions or tender BOTs during the 1990s. Notably, Mexico City’s Federal District granted a 10-year service contract to Industrias del Agua (IASA) in 1993. IASA was created by Severn Trent Water with its Mexican partner Samsa. In June 1999, Azurix paid $22.5 million to acquire Severn Trent’s 49% stake in IASA. The transaction included purchase of a WwTP in Matamoros and IASA’s technical company Sitepsa.

Azurix also bought 49.9% of a 30-year concession in Cancun in 1999 paying $13.5 million in cash and assuming $25 million in financing and operational commitments. The concession serves over 350,000 people in Cancun and Isla Mujeres. Subsidiary company Aguakan operates three WwTPs, 920km of potable water and sewerage mains and 170 water wells. At the end of the contract there is an option to extend the concession for a further 30 years or it reverts back to the state government.

Other European and US water companies working in Mexico include Suez Lyonnaise des Eaux (Puebla), Degrémont de Mexico (Mexico City, Guadalajara, Ixtapa, San Luis Potosi), Aguas de Barcelona (Aguascalientes), Vivendi Water/US Filter (Compagnie Mexico de Aguas) and Biwater Mexicana (Puerto Vallarta).

The municipal market
The Mexican municipal market was badly effected by the currency crisis which occurred between 1994 and 1998. Private water companies who chose to invest encountered serious payment problems. The inability of municipalities to assume currency risk meant local funds were used to finance projects. Puerto Vallarta was financed by equity, peso loans from Banobras and dollar loans from IFC. Biwater’s peso debt repayments became highly expensive when Mexican interest rates soared.

The economic crisis of the mid 1990s bankrupted a stream of projects with the result that a number of WwTPs were not finished or postponed indefinitely.

Coverage targets set out in the Zedillo administration’s five-year investment plan have consequently not been met. The water resources programme for 1995-2000 aimed to extend population coverage of potable water and sewerage systems to 94% and 82% respectively, by the end of this year. However, the US Embassy in Mexico City calculates that only 84.2% of the population has access to potable water and 72.1% has access to a sewerage system.

One of the main problems facing municipalities has been the lack of financial resources. Few municipal water utilities in Mexico have been able to generate cash flows sufficient to cover infrastructure investment.

Credit rating agency Fitch IBCA, Duff & Phelps reports that annual infrastructure investments in the water sector ranged from 1.8 billion pesos (around $185 million) to 3.2 billion pesos ($330 million) from 1991-98. Total investment in 1998 was 2.6 billion pesos ($290 million)1. The investment required to meet the government’s coverage targets is estimated to be between $10.5 billion and $13 billion.

Fitch also notes that an average of 52% of funding for investment in water services during this seven year period came from the federal government and only 11% from utility cash flows.

The granting of concessions, BOTs and operating contracts has been a difficult area since the general population has had to pay little for water services. In most municipalities, tariffs have lagged well behind costs. A recent Comision Nacional del Agua (CNA) study of 55 Mexican towns showed that tariffs would have to increase by nearly 70% for utilities to cover their operating costs.

This failure to recognise water as an economic good is partly explained by local politicians’ unwillingness to raise tariffs in case of adverse political reaction. A considerable public relations exercise is required to sell the costs and benefits of network maintenance and improvement to Mexican ratepayers.

Mexican municipal utilities have been further hampered by their lack of access to capital markets during the 1990s. Water utilities can only borrow nationally and cannot borrow in foreign currency. Foreign commercial banks can only enter the project finance market on the US/Mexico border, and only if loans are covered under the NADBank loan guarantee programme.

However, the financing of municipal infrastructure is starting to change. Under new legislation passed in April, the federal government will no longer guarantee the debt incurred by individual states or municipalities. Lenders will now have to look more closely at specific municipal or state risks.

Municipalities are now under greater pressure to adopt internationally accepted accounting procedures to access credit lines. This will prove difficult for some, but for those which can demonstrate greater awareness of their creditworthiness, the new law allows them to issue bonds to finance long term infrastructure projects.

Moody’s de Mexico recently assigned Aa2.mx (Mexico national scale) and Baa2 (global scale, local currency) issuer ratings to Aguascalientes. Moody’s de Mexico national scale ratings reflect the ability of municipalities to honour their unsecured financial obligations without incorporating credit support derived from federal revenue transfers – so-called aportaciones and participaciones.

Some analysts see line of credit programmes, such as the Banobras payment guarantee, as a suitable stopgap financial alternative to traditional federal funding of water projects. They claim that long-term
solutions are needed to address inherent structural problems in the municipal market, so short term measures should aim at providing additional liquidity until more utilities become financially self-sufficient.

Another significant problem has been the lack of adequate regulation. One of the challenges facing the Fox administration will be to decide upon a new regulatory and legislative structure to encourage private investment.

Article 115 of the Mexican constitution delegates responsibility for water and sewerage services to municipalities. Most state laws regulating municipal water utilities require administrative consent or local legislative approval before tariffs can be increased. Until the federal government is given power to force municipal utilities to run an economic service, their financial problems are likely to continue.

The industrial market
With municipal market challenges seemingly requiring progress over a long period of time, investors have looked to industrial wastewater treatment projects for the best short term deals.

The federal government enacted environmental legislation to regulate effluent discharges in the mid 1990s. Since then, a growing number of industrial groups have outsourced construction and operation of wastewater treatment facilities to the private sector. Federal environmental regulations have been strictly enforced since Mexico joined NAFTA, under pressure from the US and Canada. Both countries were anxious to avoid a mass relocation of their productive capacity south of the border as companies sought to benefit from poorly enforced environmental standards.

In October 1998, Poseidon Resources partnered with local construction and engineering group Cydsa to win a 12-year BOT contract for construction of a 13.6MGD WwTP for a Pemex refinery at Cadereyta, near Monterey. Since then Poseidon has arranged construction and long term financing of wastewater reclamation facilities at other Pemex refineries.

The first three projects have been completed on time and on budget and nearly $200 million of capital has been invested without Pemex balance sheet liability. Cadereyta was one of the first non-recourse project finance deals in the Latin American water market, achieving financial close in just four months.

The project closed successfully because Pemex was able to assume some of the main risks. Since treated water is vital to a refinery’s operations, Pemex agreed to purchase the plant if the contract was cancelled.

Prequalifiers were also allowed to bid the tariff in foreign currencies with Pemex paying these tariffs in pesos indexed to the selected currency. Resistance to indexing tariffs to foreign currencies has been a problem in municipal markets resulting in much lower investor interest.

Poseidon closed the Minititlan wastewater reclamation project in the state of Veracruz last November with Japanese yen-based debt financing and currency hedges. The lead arranger was ABN Amro. Other participants were HypoVereinsbank (coarranger), Chase Manhattan Bank (currency/interest rate hedge), Grupo Cydsa (construction, operations and equity) and Atlantis Water Fund (equity). Construction started almost immediately and commercial operation is scheduled for May 2001.

Other notable outsourcing contracts include US Filter’s Compagnie Mexico de Aguas (CMA) which has partnerships with over 40 industrial customers in the north west region of Mexico City.

Mexico’s industrial base has prospered under NAFTA and the maquiladora programme has created thousands of manufacturing facilities along the US border. The state of Baja California has the largest concentration of maquiladoras with over 1000 plants. The greatest concentrations are in Tijuana and Mexicali. Some of the largest manufacturers in this area, such as Sony, Sanyo and Samsung have all invested in wastewater treatment facilities and ultimately all maquiladoras will need to invest in some form of treatment.

1 Presentation by William Streeter, Fitch IBCA, Duff & Phelps at \'Mexico: Opportunities for Business and Partnership’ conference, Anaheim, California, October 2000.
2 Presentation by Andy Stein, WestLB at \'Mexico: Opportunities for Business and Partnership’ conference, Anaheim, California, October 2000.