The municipal environment in SA is characterised by substantial infrastructure backlogs as well as an inability to mobilise suffiecient funding to eradicate these backlogs. This situation forces municipalities to prioritise projects in order to allocate the limited capital budgets available. This in turn leads to allocation inefficiencies but also prohibits the upgrading of infrastructure 'across the board" which will ultimately lead to improved cost recoveries and financial efficiency.

It can be stated that this problem is an "apparent" lack of funding - in actual fact the SA market is characterised by a potential oversupply of funding for infrastructure projects. This is partially caused by exchange controls, which limits the foreign investment capacity of insurance and pension funds (the major form of savings in this country) as well as that of individuals. In addition, the SA financial industry is of a world class standard with highly competent and developed project finance capabilities through which funding available in the capital markets may be channelled to fund the infrastructure backlog.

The vision of Government for municipal finances and borrowings is clearly outlined in the: "POLICY FRAMEWORK FOR MUNICIPAL BORROWING AND FINANCIAL EMERGENCIES" published by the Deparrment of Finance during 2000. While it is not appropriate to present the detailed document here, certain key aspects emerging from the document are enlightening. Three of the four key factors that have driven the formulation of the policy framework are listed in section 1.2 as (presented in abbreviated form here):

1. The Constitution (S230) grants to municipalities the right to borrow and creates the expectation that these rights will be coherently regulated by legislation passed by central government.

2. The long term debt market - which is especially critical for providing financial resources for municipalities for investment in infrastructure which is critical to both economic and social development - has largely dried up.

3. Government has repeatedly emphasised that private finance will need to form an important source of funding for capital investments in the municipal sector. Such funding will not be guaranteed by the central fiscus. In stead, municipalities will have to raise private finance on their own books and bear the responsibility for servicing the debt.

Section 1.4 addresses limits of the financial framework and notes specifically that mechanisms such as PPP's fall outside the ambit of the framework and is dealt with separately as part of the MSP process managed by DPLG. It is specifically noted that the financial framework will in itself not render municipalities creditworthy and that central government cannot take over the function of local financial management from municipalities.

In section 2.1, it is specifically stated that: "Ensuring access by local authorities to sufficient investment capital to allow them to play their constitutionally mandated role is thus a critical element both of the overall structure of governance in SA and to government's delivery objectives."

In section 2.2 government 5 vision is outlined in more detail. It is clearly stated that central government wants to avoid underwriting of municipal borrowing, thereby transferring municipal liabilities onto itself. It is further recognised that the policy framework should promote the growth of a market for other forms of municipal debt such as bank lending which will be critical for municipalities in the short and medium term.

Section 3.3 deals with the types of debt that may be issued by municipalities and covers specifically the form of security that may be provided to lenders. Two broad principles that characterise the policy position are:

1. The contracting parties should be allowed broad leeway to craft security provisions that meet their needs.
2. Certain limits should be applied to the assets or revenue streams that municipalities may pledge as security.

These two principles highlights a specific dilemma ("the Security Dilemrna") that is often faced with debt finance in the municipal sector and that requires innovative mechanisms to sufficiently protect the interests of lenders while ensuring that municipalities remain within the policy position.

One would hope that any amendments to legislation dealing with local authorities should attempt to eliminate any inhibiting factors that are currently preventing municipalities from accessing the private capital markets and to further government's vision as clearly stated in the policy document. That would be essential to ensure that municipalities can responsibly and competitively access the necessary funding to eradicate infrastructure backlogs. Any proposed legislative amendments should therefore be tested against the stated vision and policy framework.

The current proposed amendments to the Municipal Systems Act as published in a Draft Bill ("the Draft Bill") fails this test on a number of counts. This is due to the fact that under the Draft Bill:

1. No municipality will be able to raise non-recourse project finance;
2. The flexibility that existed to raise non-recourse project finance for a project under the ownership control of a municipality will be removed;
3. Municipalities that wish to raise non-recourse project finance due to the fact that their own borrowing capacities are limited will only be able to do so through privatisation of the assets or through a private concession;
4. Public-Public Partnerships (the preferred service delivery mechanism of most municipalities and organised labour) financed through non-recourse project finance will be eliminated;
5. It is extremely unlikely that any service utilities will be erected - a powerful tool available to municipalities is thus effectively eliminated.
6. In a number of instances the impact of the Bill directly contradicts government's own vision and stated policy.

This paper examines the contents of the Draft Bill and highiights the various issues that lead to the conclusions listed above. As is clear from this introduction, the focus of this paper is very much on the financing capabilities of municipalities and factors that will enhance or reduce these capabilities. Anyone reading this paper that is not fully familiar with the concepts of balance sheet finance and non-recourse finance is urged to first read Appendix 1 where a simple introduction to these concepts is given. The central and critical role of non-recourse project finance in the municipal sector is clear.

In this section the negative impact of specific measures contained in the draft amendments to the Municipal Systems Act ("the Act") is discussed.

2.1 Eliminating the lender's step-in rights
In Appendix 1 the key role that step-in rights to the lender plays to facilitate non-recourse project finance is highlighted. In the municipal sector it is very difficult to provide effective step-in rights to the lender. This difficulty stems from the procurement requirements of organs of state such as municipalities. In instances where the provision of basic services such as water and electricity supply is financed, the situation is even more complex due to the Security Dilemma (as discussed in the introduction). Both these issues are best explained by way of an example:

Say a municipality erects a company as a business entity (under the Act). The company procures non-recourse finance from a bank in order to acquire the assets necessary to supply bulk water to the municipality. The municipality enters into a bulk water supply agreement with the company. This agreement will regulate the volume, price, quality and performance aspects of each party.

There are two key features of this project structure to bear in mind:

1. The agreement between the municipality and the company (municipal business entity) is not subject to procurement regulations as it is an agreement between two organs of state (as stated in the Act);
2. The risk of the transaction is clearly ring-fenced in the company and the only obligations of the municipality would be to purchase and pay for the water. This clearly limits the risk of the municipality in line with government's stated vision.

It would appear that the lender to the company could acquire step-in rights as is normally achieved through various security arrangements. These arrangements will include a cession of the shares in the company. This appearance is incorrect however because if ever the lender exercises its rights in terms of the cession (in the event of a default), the agreement between the company and the municipality may become not valid, as the company is no longer an organ of state. The same dilemma would effectively apply to each of the other traditional mechanisms through which a lender may affect step-in rights (through the Security Dilemma). This is a critical problem associated with non-recourse project finance in the municipal sector that is inhibiting the entry of many financiers into this market sector. In the current form of the Systems Act, there is an elegant solution to this problem. The solution lies in not utilising a company as the legal form for the municipal entity, but rather to use a trust.

How does a trust solve this problem? The answer lies in the fact that a trust is an effective mechanism that separates ownership and control. With a trust, ownership of the assets of the trust vests in the beneficiary of the trust whereas control vests in the trustees. With a company on the other hand, ownership as well as control vests in the shareholder and cannot be separated except for very short periods of time. A trust as municipal entity therefore offers an ideal mechanism to ensure that ownership of the assets is never removed from the municipality (as beneficiary of the trust), although control of the assets may from time to time vest with the lender(s). Even in the period that the lender may control the trust, the trustees (and therefore the lender) is legally obliged to manage the assets of the trust on behalf of the beneficiary (the municipality). This does not only solve the complex legal problem of an agreement that becomes not valid and binding due to some external factors, but also solves the Security Dilemma. A trust therefor is instrumental to meet government's stated vision. In fact, a trust is the only legal form through which this vision of government can be realised.

The use of a trust to facilitate non-recourse project finance has recently been pioneered on a project by the city of Tshwane Metropolitan municipality ("CT~M"). CTMM has successfully raised R530 million of non-recourse project finance for a project using this mechanism. Many other municipalities have rightfully identified this mechanism as a way to assist with the eradication of infrastructure backlogs. Moreover, Organised Labour has put its stamp of approval on the mechanism in the CTMM case and has recognised that this is an ideal mechanism to finance new assets without the municipality relinquishing control and ownership over the assets.

The Draft Bill will effectively remove a trust as a municipal entity through clauses 86B (2) and 93K (1) (a). From the discussion above, the negative consequences of this for municipalities and their service delivery abilities is clear.

2.2 Legislative elimination of non-recourse project finance
Apart from the envisaged impact of the Draft Bill as discussed above on the abilities of municipalities to raise non-recourse project finance, there is an even more definite and direct impact that completely eliminates non-recourse project finance as a tool for municipalities. This is effected through a number of clauses discussed below:

Clause 86K dealing with the disestablishment of service utilities: if a service utility is disestablished all its liabilities and obligations vest in the municipality. This by definition means that all finance raised by a service utility is of a full-recourse nature. This will severely hamper and limit the borrowing capacities of municipalities. It is important to note that a service utility is a form of municipal entity envisaged under the Draft Bill. Potential lenders will be forced to evaluate the financial situation of the municipality and take a credit decision on that basis, rather than evaluating the project or specific investment and making a credit decision on that basis.

Clause 93B(c) dealing with disestablishment of municipal entities: a municipality may liquidate and disestablish a business entity if it experiences serious or persistent financial problems. This is a unilateral right of a municipality without affording the lender any step-in opportunities. A trust as legal form would overcome this problem by providing other stakeholders with suitable protection. The most likely result of this is that lenders will shy away from non-recourse project finance and will only consider full recourse finance as indicated above.

Clause 93F dealing with the appointment of directors to a municipal entity: Although a municipality retains full ownership of the entity and therefore also controls it, it is imperative that other stakeholders in the entity such as the lender(s) secure the right to nominate directors. Without such rights non-recourse finance would not be obtainable. Again, a trust is the perfect example of a legal form that would eliminate this problem.

From the issues raised above, it is clear that many of the adverse consequences of the Draft Bill on the financing abilities of municipalities may not have been considered or identified by the legislators.

2.3 Privatisation remains the only option
The Draft Bill provides through clauses 86C and 861(1) that municipal entities are fully owned by (i) a municipality, (ii) a number of municipalities or (iii) municipalities and other organs of state. The impact of this is that it forces one of two ownership extremes on the municipality:

- Full ownership; or
- No ownership.

Due to the impact of the Draft Bill it is already clear that non-recourse project finance is eliminated under the full ownership scenario. The only remaining way that non-recourse project finance can be deployed by a municipality to fund infrastructure is through privatisation (i.e. the no ownership scenario). The legislator is thus effectively forcing municipalities to privatise essential and other services as well as infrastructure in order to eradicate backlogs and improve service delivery. [This is diametrically opposed to the agreed strategy between government and organised labour that privatisation will be a last resort.]

2.4 Elimination of risk sharing/transfer
Through the current provisions of the Act, a municipality can effectively transfer risks to other "project partners" such as the lender. This transfer of risk can be achieved without relinquishing ownership or control of the project through the use of a trust. Such risk sharing is highly beneficial to a municipality as ultimately it enables the municipality to secure greater investment in infrastructure with the limited resources at its disposal. This is directly in-line with government's stated policy and due to the risk transfer will protect municipalities against the effects of over-gearing. This potential for risk transfer will be eliminated completely by the Draft Bill, due to the limitations placed on the legal form of municipal entities.

2.5 Negative impact on housing developments
Many municipalities, in an attempt to facilitate housing provision, have established Housing Associations. Due to the considerable pressure on the Banks, there is renewed vigour in finding adequate mechanisms through which large scale housing developments in the low cost and affordable housing brackets may be financed by the banks. These developments will most likely be based on housing associations financed through non-recourse project finance mechanisms. It is also highly likely that a private company will not be a suitable legal form for housing associations for such developments. Under the conditions of the draft Bill, this will prevent municipalities from playing any role in these housing developments. Government's premier delivery mechanism in the housing market will thus be eliminated through government's own legislation. Given the housing situation in this country that would be a disaster.

2.6 Other mechanisms
Municipalities own and operate significant infrastructure and assets. Due to the fact that many of these assets are critical to public health and well-being, these assets have to be insured comprehensively. The cost of insurance has increased significantly in recent years. This has forced municipalities to cut back on insurance or to investigate alternative insurance mechanisms. One option would be for municipalities to self-insure an initial portion of their exposure. This would lead to significant cost savings and will inspire a level of due diligence, risk management and preventive maintenance/management that is directly in-line with government's stated vision. The measures of the Bill which limits the legal form of municipal business entities to a private company will eliminate this option for municipalities.

It is clear that while the contents of the Bill may achieve certain governmental goals, its consequences and effects may not have been considered and appreciated in sufficient detail. Specifically the impact on the ability of municipalities to finance new infrastructure and service delivery mechanisms through project finance and more specifically non-recourse project finance will be severe. Government should only pass this legislation in its present form if it is fully committed to fund the infrastructure backlog or to guarantee all municipal debt. Both of these options clearly lie outside government's stated vision.

The reasons why a trust presents lenders with a certain degree of comfort and risk mitigation have been explained.

It is therefore recommended that no limitation should be placed on the legal form of a municipal entity.

if trusts are to be eliminated as municipal entities then it is imperative to ensure that the other legal forms of municipal entities are suitable vehicles for non-recourse project finance.

There are a number of technical reasons why a private company as municipal entity cannot achieve this. The only other alternative is to ensure that the definition of a service utility is expanded to include the necessary measures to render it suitable for non-recourse project finance. In this regard it is recommended that the following broad changes be effected to the clauses in the draft Bill dealing with service utilities:

1. The definition of service utilities should include the recognition of other stakeholders, such as financiers.

2. Other stakeholders should be afforded certain rights for the duration of their contractual involvement with the service utility. Such rights should at least include:
a. the vested right to nominate director(s) to the board of the utility;
b. the provision that a utility may only be unwound/disestablished with the expressed consent/agreement of these stakeholders.

3. It should further be made clear that any provision in the constitution of the service utility, that allows the director(s) nominated by the lenders to the utility to exercise the majority of votes at the board of the utility under certain circumstances (such as default) is permissible under the Act.

It is strongly held that these additions to the Bill would render service utilities suitable for non-recourse finance and therefore municipalities would not be denied access to this important market.

There are two principal forms of finance that may be employed by municipalities to finance infrastructure:

- Balance sheet finance; and
- Project finance

Both forms of finance are discussed briefly

5.1 Balance sheet finance
Balance sheet finance refers to the classical style of finance where a lender will analyse the credit risk of a client based on the strength of its balance sheet. When a lender makes such a facility available to a client, it is not overly concerned with what the money will be used for - that is at the client's discretion. Similarly, the lender is not overly concerned with the exact source of income of the client's that will generate the cash to repay the loan. The client may even raise another loan to repay the first loan.

Traditionally municipalities used balance sheet len4ing to finance all activities and infrastructure requirements. This was possible because:

- Lenders perceived all municipal debt to be guaranteed by central government. That made financing cheap and the borrowing capacities of municipalities were "unrestricted".
- The borrowing requirements of municipalities were relatively small as their activities were focussed on the "whites only areas". Most "black areas" lay outside the borders of municipalities and were the responsibility of central government in any case.

Under the new dispensation:
- It is very clear that central government does not stand behind or guarantee municipal debt. This has placed the balance sheets of all municipalities under severe strain and has severely limited their borrowing capacity.
- Municipalities have inherited large underdeveloped areas with huge infrastructure backlogs.

It is clear and widely recognised that alternative financing mechanisms will be utilised in the new era for municipalities to finance their activities: project finance.

5.2 Project finance
In its simplest form project finance is simply that: finance for a specific project. From this description the differences with balance sheet finance are clear. With project finance the lender is very concerned with:

- What the money is used for it may only be used to finance the project;
- Where the money to repay the loan will come from - it will (only) come from the cash that is generated by the project.

Because of the nature of project finance and the 'controls" associated with it, projects are often "ring-fenced" so that the project, its assets and its cash flows can be clearly demarcated. The most effective way to ring-fence a project is to set it up in a separate legal entity. The diagram below shows the classical project finance structure:

[diagram not included]

Traditionally the project entity will have the legal form of a company but other legal forms have also been used successfully.

Apart from the effective ring-fencing of a project this project structure has some further benefits:

- It provides an effective way for the lender to gain step-in rights; and
- It enables non-recourse project finance;

Both of these issues are discussed in more detail below.

5.3 Lender's step-in rights
The relationship between the owner of a project and the project entity as outlined in the diagram in 2.2 may vary considerably. Most often the owner will be the major or controlling shareholder in the project entity and as such will also manage the business of the project entity. In other cases, the owner of the project may have no relationship with the project entity other than a contract to purchase its products produced (an off-take agreement). In such an instance a third party will be contracted to manage the affairs of the project entity. Many variations on this theme exist and can be found throughout the world. Whatever the identity of the manager, the lender relies on the manager to ensure that the project achieves its projected cash flows and therefore is able to repay its loan.

One of the main factors that differentiates project finance from balance sheet finance is the conduct of the lender in the event of default i.e. when the project entity cannot repay the loan. The question of why projects and companies fail has been researched intensely and will continue to be research in future. The most common answer from all of these research efforts is: bad management. In the case of project finance, the lender will scrutinise the performance of the manager as soon as a default arises. It is a core principle of project finance that under such a default scenario, the lender always has the right to replace the manager of the project. Effectively the lender steps in and manages the project itself or appoints a new manager - thus the phrase step-in rights.

As stated above, step-in rights is a core principle of project finance and a large amount of effort is always spent in documenting this right of the lender in any project finance transaction. In most cases, it is very easy to achieve step-in rights: the lender takes a cession of the shares in the project entity and in the event of default the lender effectively becomes the shareholder and can therefore manage the company as it sees fit. It is thus clear, that by housing a project in a separate legal entity, step-in rights for the lender can be simplified.

5.4 Non-recourse project finance
Ring fencing of projects is not peculiar to project finance transactions although it is such a cornerstone of the project finance industry. Many companies and investors exploit the various benefits of ring-fencing a new project irrespective of how it is financed. In fact, the diagram presented in 2.2 as the classical project finance structure may apply equally to balance sheet financing for the same project. In that instance there will be one major difference, the owner of the project will guarantee the loan of the project entity. This is illustrated below:

[diagram not included]

In this instance, if a default occurs, the lender will not necessarily exercise its step-in rights, but will simply call on the guarantee of the owner. In fact, the lender will only exercise its step-in rights if the owner defaults on the guarantee.

This illustrates the difference between the two main sub-sections of project finance:

- Non-recourse project finance: where the lender enjoys no guarantees and is fully exposed to the risks of the project.
- Limited-recourse project finance: where the lender enjoys some guarantee from the owner of the project and is at least partially shielded from the risks of the project. In the extreme case where the owner guarantees the full obligations of the project entity to the lender, limited recourse project finance equates to balance sheet finance obligations of the project entity to the lender, limited recourse project finance equates to balance sheet finance.