6. Funding Options for Phases 3 - 5

The funding structure options available for the development of water enhancement projects fall into three broad categories:

business finance;
project finance;
Build, Own, Operate, Transfer (BOOT).

The applicability of each funding structure differs depending on individual scheme objectives and circumstances. However, each funding structure has different requirements and in many cases a scheme will not meet the criteria for all of these structures.

Each of the above funding structures require a combination of the following funding mechanisms:

debt;
equity;
hybrid equity;
other financial support:
- financial guarantees;
- revenue underwriting.

6.1 Business finance

Business finance refers to traditional commercial lending, where an entity borrows funds for a project based on projected cash flows, backed by strong security giving the lender comfort that the debt will be recovered in the event that the cash flow projections are not met.

This was the structure applied by the BNZ to both the Waimakariri and the Opuha irrigation schemes during the 1990s.

Debt/Equity

Providers of debt funding to water-enhancement schemes under this structure are likely to require at least 50 percent equity for the project. This has been demonstrated in the funding arrangements for the Waimakariri scheme (55 percent equity) and the Opuha scheme (initially 45 percent equity, then raised to 66 percent equity).

Security Requirements/Financial Guarantees

In addition to adequate cash flow, the key to gaining business finance is security. This is one of the principle funding constraints for water enhancement developments, as there is limited security in the underlying value of the assets. Financiers are comfortable accepting high debt levels (60 percent – 80 percent) for house loans, commercial loans for plant, buildings and similar assets because these items have an easily realisable market value. It is difficult to recover the cost of dam and ditch construction in the same way.

In most cases security needs to be provided from another credible source. The likely contenders for providing this security are water users, by way of a charge over their land and physical assets (if they have the equity available), or in the form of a Government guarantee.

There are serious issues for the scheme and the financier to consider if security is to be provided by way of mortgage over the water users property. The primary issue is that it is administratively difficult and significantly complicates the tradability of water. Essentially each sale/transfer of a water right would need to be registered and approved by the lender. This would include a financial assessment of each buyer to ensure that the lenders security has not diminished through the transfer. The other key issue is whether the water users have the required level of equity in the farm to provide the level of security given the extent of the on and off farm works to be completed.

The logical party to provide security for an irrigation project is Government (local or Central) by way of guaranteeing the repayment of debt, as was the case with both the Waimakariri and Opuha irrigation schemes.

Term of Finance

In the current commercial environment, the term of a business finance loan to a water enhancement development is not likely to extend beyond 10 – 15 years. Even with strong security (i.e. Government guarantees) 15 years is likely to be the maximum lending term.

Applicability of Business Finance to Water Enhancement Schemes

This is the traditional financing structure for a water enhancement scheme and has been applied to all new developments since deregulation in the mid-1980s.

This structure does have the following limitations:

Access to large amounts of upfront equity (50 percent +) is a constraint for these schemes, particularly given the additional on-farm capital that is also required from water users. Recent studies completed for a South Island irrigation scheme have shown that on farm costs are almost double that of off-farm costs. Many water users simply do not have the ability to fund on and/or off-farm development. A list of possible equity providers is discussed in detail below.

The term of the debt is significantly shorter than the life of the scheme. This may impact on the affordability of the scheme over the debt repayment period. There may be opportunities to spread the debt further by refinancing after the project has an operational track record. This does open the scheme up to the risk of interest rate increases either from general market conditions or if scheme performance has not meet expectations and the lender perceives the risk to be higher.

A scheme is likely to need access to secondary security, either from water users or more likely from Government (local or Central) guarantees particularly over the initial 3 to 5 years of operation when take-up risk is high.

The arguments for and against provision of guarantees from Government are discussed further in Study 3 – Role of Central Government and study 4 – Role of Local Government.

Although there are limitations under this funding structure, schemes have been successfully funded using this method. For water enhancement schemes that do not meet the criteria for project financing this may-be the only structure available.

6.2 Project finance

Project finance refers to a structure that relies primarily on the strength of the project's cash flow for debt repayments with the underlying asset value held as secondary security or collateral.

Project finance is not a new concept in business, but has not been used to fund large-scale water enhancement schemes in the past.

For a water enhancement scheme to be eligible for project finance the following criteria must be met:

very high certainty of revenue (i.e. long-term take-or-pay supply agreements with all water users); and

very high quality of revenue (i.e. proof that customers will be able to meet contract payments over a long term period). Where the quality of revenue is an issue, a scheme may require an underwriter to guarantee revenue capacity to be funded under this structure.

This underwriting role, if required, is not likely to be provided by water users as it is an assessment of the water users inability to meet the commitments that necessitates the role of an underwriter.

Debt/Equity

The equity requirements are significantly lower under a project finance structure. Equity requirements may be as low as 20 percent for a water enhancement development with strong water user contracts.

Security Requirements/Revenue Underwriting

The strength of project cash flows (under pinned by water user contracts) provides the security for the debt. Security requirements in addition to this are secondary. If the lender does not consider the contract holders to be credit worthy then additional guarantees may be required to underwrite revenue capacity.

Term of Finance

Under this structure, the term of the loan is dependent on the term of the customer supply agreements. The loan term is likely to be extendable to within two to three years of the supply agreement term i.e. if a supply agreement is for 25 years, it is likely that the loan term could be extended for up to 22 - 23 years.

Applicability to Water Enhancement

Large-scale water enhancement schemes are well suited to project financing criteria. There are clear advantages for schemes given the lower up-front equity contributions and extended repayment terms afforded under this structure.

A scheme seeking funding under this structure will need to assess the impact that the long-term take-or-pay supply agreements have on the ability to allow water trading.

Project financing is the preferred funding structure for irrigation development.