Innovations In Drought-Resilience Infrastructure Financing

By Dustin Baker

Water is a fundamental element of life. The scarcity of it has long plagued many parts of the world, resulting in devastating consequences for human life, animals, and the environment. Yet, getting water anywhere and everywhere isn't easy. And it can be expensive. 

Across the U.S., states and private organizations are seeking ways not just to fund water shortages but also to mitigate climate-related threats through innovative financing. As extreme weather becomes more frequent and more intense, many states are facing a critical level of critical infrastructure projects seen as essential to mitigating human-life risk. You can see this across all areas of infrastructure, including repairs to roads and bridges, and crumbling water systems that simply cannot handle the changes of intensifying climate conditions. 

Where The Drought-Related Risks Are 

Numerous factors are plaguing the U.S. water infrastructure system. None may be more prevalent than that of the lack of upgrades to public infrastructure. Long-overdue maintenance, which some estimate to be more than $1 trillion worth in deferred maintenance alone, is not simplistic to fund or "catch up."  These undermaintained systems are vulnerable to the rising frequency and intensity of natural disasters. 

It's a mistaken belief that drought means no risk to these structures. With no water, it may seem that these are not applicable concerns. In drought conditions, many systems experience much lower water pressure. That leads to a higher risk of poor water quality and, ultimately, a greater need for emergency repairs. Pipe corrosion can cause pipes to break down and fail, clog, or back up, requiring repairs. 

In drought conditions, hydropower availability is much lower. This also creates a much higher cost for energy production. While drought conditions often focus heavily on human risk, it's far more expansive than this. For example, agricultural conditions are directly impacted, from plants to cattle. Across the agricultural impact from droughts come the extensive, costly implications. 

When drought conditions exist, water utility operations are impacted heavily: 

• Water pressure and water supply drop. 
• Poor water quality is coming from the source. This means there is a need for additional treatment to ensure the water available remains healthy to drink and meets all necessary standards. 
• Alternative and supplementary water sources can be difficult to access because demand for those sources has increased. That means other users of those alternative sources may limit access. 
• Customer demand increases and cannot be fulfilled. 
• Costs increase, and reduced revenues escalate. 

To build drought-resilience in water utilities, it is critical to be able to respond to water supply threats quickly. That also means it's essential to have the financing solutions necessary to: 

• Maintain existing conditions 
• Make necessary repairs to poorly maintained systems 
• Upgrade to modernize systems to improve efficiency 
• Handle emergency drought conditions more effectively 
• Prevent the risk of droughts in the future with better water management 

The question is, then, where does the money come from to achieve these goals? 

Creating Water Security 

Before considering potential strategies to mitigate these risks, define what water security actually means. The term, at its simplest, refers to the essential need to ensure water is available. With climate change and growth pressures that put more importance on infrastructure resilience, the goals for most countries around the world are the same: 

• Ensure there is safe, accessible, affordable drinking water. 
• Ensure enough water is available to support industry and agricultural needs. 
• Ensure water management is maintained to the highest level to create livable communities. 
• Protect water to protect the environment as a whole. 

Considering these objectives on a grand scale, it's important for organizations to consider cutting-edge financing innovations and funding strategies that may look beyond what is considered traditional. Strategic funding models create opportunities for each of these four areas to be built with confidence. 

Advanced Technology And Strategies 

Water infrastructure is a starting point, but as drought conditions increase and worsen in areas, it becomes necessary to find new ways to meet demand. That includes advanced technologies in areas such as water reuse and desalination. 

There are some federal funding plans in place to focus on these two specific areas. The Bureau of Reclamation's WaterSMART program is a large-scale water recycling program that aims to focus on water reuse and drought resilience planning through desalination. Funding desalination construction projects is a critical component of the process and a high-cost, high-energy-intensive process. Such programs remain consistently at risk, however, amid political strife and their uncertain viability. 

The Role Finance Plays In Water Security 

Various factors make financing the water industry complex, including that it is very capital-intensive. There are also many regulations that vary from one state to the next. In addition, standards continue to change, and often for the better. 

Financing is necessary to achieve several critical goals: 

• Replace infrastructure when it reaches the end of its useful life. 
• Refurbish as much as possible to extend the lives of core components. 
• Expand to meet growing needs in areas where population and demand from industry are growing. 

The bottom line: There is a need for a significant initial investment, followed by ongoing financial support to meet the ongoing demands of water infrastructure. 

At the heart of this problem, in various states and numerous countries around the world, is that many government organizations simply do not have the ability to allocate as much necessary funding to these changes as they need to. That means there is an increasing need to invest in and fund infrastructure by expanding the availability — and affordability — of capital through alternative funding solutions. It simply cannot be on the shoulders of the property owner to maintain these higher standards. 

By improving financing access and capital affordability, water security becomes more within reach. 

Alternative Financing Models For Meeting Water Infrastructure Needs 

So, solutions? 

Alternative financing models for water infrastructure are necessary, and a range of prospective opportunities exists. This comes from a variety of investment sources. Keep in mind that while this is very much a significant problem in the U.S., it is also a global epidemic. As such, other countries have spurred new financing opportunities and alternative funding strategies to meet their needs. All of those opportunities should be considered. 

Each alternative financing source focuses on the specific needs of the assets and companies involved. In comparing options and considering future endeavors, organizations must determine the most appropriate model that ensures structure allocation and assessment of risk in the most efficient manner. For example, a core component of this process is choosing parties that are capable of managing and reducing risks or creating a strategy for addressing those risks. 

When considering alternative models in this area, some of the most common risks associated include: 

• Construction and commissioning 
• Reputational risks 
• Management of the project 
• Supply 
• Offtake 
• Operations efficiencies 
• Environmental impact 
• Economic objectives and feasibility 

When considering a project, it becomes necessary to determine the proper structure for the project. Factors to consider include size, age, capital demand, and profile. Integration of such programs, operational controls, and ultimately, both on and off-balance sheet treatment must be thought of. There are various governmental drivers as well, including political opposition. 

Let's take a look at some of the strategic funding models and how they operate. 

Understanding The Scope Of Drought Financing 

Existing disaster risk financing resources are very limited. Countries around the world must explore other sources of development assistance to have the resources they need to manage drought. 

Domestic resources typically involve three main sources of government revenue: 

• Taxes 
• User fees 
• Transfers, such as development assistance in the form of grants 

Taxes are fees placed on the backs of citizens and firms. Taxes like value-added tax (VAT), capital gains, or personal property taxes are commonly used. User fees, often called tariffs, are voluntary and typically tied to the use of a specific public service. This could be electricity, water supply, or irrigation. Transfers are all types of other government revenues, including development assistance that comes from grants and private philanthropic support. This generally only includes development assistance that flows through the government systems themselves. 

In some situations, development partners fund projects directly. This is done by creating a parallel system to that used by the government. This is not considered a type of government revenue. 

These three sources — taxes, user fees, and transfers — are types of government funding. That is much different from financing, though the terms are often used interchangeably. While funding pays for current-year financial needs, such as operational expenses and emergency costs, financing is borrowing. For larger capital investments, such as using national sensor networks or irrigation canals to improve drought conditions, it is necessary to spread these costs over several years. To do that, the government has to borrow, and that's where financing comes into play.

Realistically, government funding just is not enough to meet needs since capital investments are so expensive. Moreover, the costs can be spread over years during the usable lifespan of the structure. This reduces the upfront costs of the project investment. It also builds incentives to ensure the asset is used productively. 

Commercial Sources Of Financing 

Who is financing these projects?  Financing can come from commercial investors. That could include, for example, bond issuance, or it may come from a development bank. This is more accessible in modern Western countries. The same structure used in developing countries would not be applicable, as commercial sources are limited in those areas. 

Notably, using commercial sources means repaying at a much higher cost. Borrowing means that today's investment impacts tomorrow's costs. Debt service, which is the cost of repaying both the principal borrowed and the applicable interest on the loan, must be covered on an ongoing basis in future years. That means, in the future, resources will be less available to meet needs. There is value in borrowing, but it is critical that, at the end of the day, the future benefits of reducing drought must be greater than the future costs of paying for the funding. 

Saving Instead 

For those who balance their checking account at home, it may seem like the better option is to save money so that there is no need to borrow it later for such projects. Savings and insurance are both strategies that may be applicable. They require highly advanced fiscal planning and the ability to maintain fiscal responsibility by setting aside current funding for the future. There's a cost to saving, too. The money being tucked away could potentially be used for a more productive need right now. 

Insurance programs are another form of saving for the future. They allow for risk transfer. The insurance costs premiums are to cover costs, which are paid through current funding. The costs, though, relate to risks. Some areas have a much higher risk of drought, and therefore, the cost of obtaining insurance in these areas could be quite prohibitive for some governments. 

In short, each area must consider the benefits and tradeoffs associated with each of these methods: borrowing, saving, and insuring. Balancing tradeoffs to secure resources for drought management and mitigation is necessary, and having a comprehensive drought finance strategy often involves using all of these strategies to some degree. 

Building A Financial Strategy For Drought Management 

To develop a financial strategy for drought management and prevention, it becomes necessary to consider the individual sectors applicable. Government, households, and the private sector all face threats and need access to financial resources to aid in managing assets and transferring risks. Finance models must match the specific needs. Here's a look at some of the core areas. 

Infrastructure financing 

The initial step is to identify resources necessary for the construction, maintenance, and ongoing operation of infrastructure components. This includes not just water infrastructure but also land and agricultural sectors. These areas require capital investments for projects that may amount to hundreds of millions of dollars in investments to create solutions that last for decades. 

It is quite challenging to finance these assets on a fully commercial backbone, especially in areas outside of the U.S. or in areas of the country with less development. Infrastructure financing will likely include: 

• Infrastructure to improve the water supply 
• Sanitation infrastructure, including treatment plants 
• Improved storage reservoirs and distribution networks 
• Water resource management 
• Irrigation strategies 
• Land restoration and rehabilitation 

Disaster risk finance 

Billions of dollars are tucked away to manage disasters like tornadoes and hurricanes, but droughts — though often equally as devastating — receive far less disaster risk mitigation investment. The objective here is to arrange financial protections before the drought and devastation occur. The use of contingent financing and insurance tends to be the most common strategy. Large-scale insurance investments are mandatory. That means countries, individuals, and businesses, as well as specific organizations, such as farmer associations, must utilize multiple instruments to reduce these risks. 

Climate finance 

Climate finance is of growing importance in a drought finance strategy, especially as climate-related effects continue to contribute to these threats. Climate finance represents potentially numerous financial instruments and a broad range of strategies. That includes reductions in greenhouse gas emissions and adoption of drought-specific change investments. 

One such strategy is to use adaptation finance, which focuses on the Green Climate Fund, the Global Environment Facility's Least Developed Countries Fund, and the Adaptation Fund. These and other development banks provide access to loans, guarantees, and grants to support drought planning that's closely linked to climate strategies within any single country.

Environmental finance 

Yet another strategy that's closely related to climate finance is environmental finance. This focuses on the use of financial instruments to support the sustainable use of natural resources. Consider it more of a preventative strategy. The goal of this focus is to identify investments that support both financial and ecological returns. This means ensuring environmental, social, and governance (ESG) investing objectives are met. 

Environmental markets are a type of environmental finance. Many people have heard of carbon credits, a type of market-based mechanism. Some countries around the world, including Australia and South Africa, are also trading water rights. These markets are particularly beneficial to countries with water scarcity and involve voluntary trading of water in some form, or the right to use water from one user to another. This water market strategy supports more efficient water use and manages demand, thereby enhancing drought resilience. 

Financial inclusion 

Financial inclusion is the utilization and expansion of the concept of microcredits. That is, allowing anyone access to affordable, relevant financial services. Financial inclusion initially focused on just business investment, but also incorporates insurance products, savings products, and consumer credit today. For those in drought-risk locations who have traditionally only had the option of borrowing from lenders or saving in the form of livestock or building materials, financial inclusion offers poor households another strategy. 

The development of fintech, including mobile money, has created a new financial service layer that reduces transaction costs and eliminates the need to step into a bank. These providers include non-governmental organizations, microfinance companies, and mainstream banks, including some state-owned banks. 

Agricultural finance 

It's impossible to overlook the importance of alternative financing solutions within the agricultural sector. Cattle hedging works to mitigate financial risks for producers whose yields may be threatened by drought. Agricultural finance is a set of tools that assist in improving production efficiency along with managing risk. For example, the use of crop insurance has often been a critical component of drought management strategies. 

Today, there are many other strategies available to help farmers, such as agricultural loans and lines of credit. Many specialized institutions and state-owned banks offer them. Repayments are tied directly to harvest cycles, providing a valuable cash flow solution. 

The Types Of Financial Instruments Necessary For Drought Finance 

Explore the strategic funding models currently in use that offer a range of solutions for drought finance. 

Credit 

Credit enables the investment in solutions to mitigate future drought risks. Credit is an agreement between a borrower and a lender that allows for cash to be received now and paid back with interest. There are various types of credit avenues used in this area: 

• Concessional loans: Provided by development banks, these are typically meant for governments on a national level. The planning ministry manages the relationship between the banks and those within the applicable sector. This allows for access to below-market interest rates and long tenors not available in commercial markets. 

• Bonds and commercial lending: This strategy employs the use of bonds, a debt instrument that requires set repayments of the principal and interest that can be traded by investors. These have high transaction costs and can be issued as general obligation bonds or revenue bonds. 

• Green bonds, blue bonds, and climate bonds: These bonds are targeted to specific ESG investors, support climate mitigation and adaptation, and earn market-rate financial returns. Organizations such as Climate Bond Initiatives screen efforts receiving such funding to ensure they deliver positive climate and environmental benefits. Costs tend to be lower or the same as traditional bonds, and these bonds trade at a premium, which reduces the cost of borrowing. 

• Impact bonds and resilience bonds: These are fixed repayment scheduled bonds linked to improved social and environmental outcomes. The financing is tied to a specific objective required to be obtained. Resilience bonds let governments invest in projects that reduce future natural disaster risk, thereby lowering the cost of financing. The savings are paid in the form of a rebate, which can be used to finance the project. 

• Blended finance: Both government organizations and companies struggle with sole commercial-term financing in the area of drought resilience. This strategy combines grants, concessional lending, and commercial lending to support projects that have a strong likelihood of creating social impact that may not otherwise be commercially bankable. Developmental banks and export credit agencies provide this type of financing with credit enhancements like partial guarantees. That helps to cover a portion of the commercial lender's potential losses. 

• Microcredit: For vulnerable households and organizations, microfinance provides a solution where other finance has been inaccessible due to a lack of collateral or credit history. These tools rely on social capital instead of credit history and allow for smaller, more frequent repayments to keep risks lower. 

• Contingent finance: This type of loan is available when a specific natural disaster occurs. The loan is arranged in advance of the disaster, and, as a result, the funds become readily available when there is a need. This method doesn't necessarily mitigate drought risks, but it serves as a means for disaster preparedness. 

Savings 

Savings at all levels are essential for reducing risk and minimizing the shock a drought can cause. Savings is the surplus of funds put aside after spending in a given period of time. At the government level, this typically includes contingency funds or special reserve accounts that are contributed over a multiyear plan. At the household level, it includes savings accounts at banks and credit unions. For companies, it includes an investment in the balance sheet under cash or liquid assets. 

Insurance 

Insurance is a type of financial instrument that offers households, companies, and governments a way to hedge against the risks associated with a possible future event. A regular premium is paid to secure the insurance policy, which then allows for the transferring of the risk to a third party. Insurance costs are directly related to risks. Putting in place insurance products before risks occur is a critical step in preparing for drought risks. 

Agricultural insurance is a long-used tool. It can be provided by the public sector or through private insurers that have substantial public support. Since agriculture is particularly vulnerable to droughts, this type of insurance product is an essential component of most drought financial strategies. 

Other forms of insurance products that may be applicable include microinsurance, which provides a strategy for low-income households, informal risk management, often used in rural communities that do not have access to formal insurance markets, and business interruption insurance for companies. 

Risk pools are an alternative option. Instead of working within the traditional insurance provider pool, governments can cooperate with other countries within the region to purchase insurance together. This creates a risk pool. This allows for a way to mitigate costs, especially in the highest-tier risk countries, which may not be able to afford other drought financial strategies. Risk pools create a portfolio that allows for investment that's more balanced, with safer and higher-risk assets. 

Public-private partnerships 

Public-private partnerships, or PPP structures, are a long-term contractual arrangement made between a project sponsor and a government to provide a public service. These arrangements require a capital asset, such as a toll road, that is managed by a project sponsor. The ownership and the responsibility are transferred to the government. 

Debt and equity financing are provided by investors. PPPs are complicated, but they can provide a strong avenue for mitigating risks, especially in high-risk projects like desalination. One core benefit of that is the access that PPPs tend to offer for developing success, like high-end technical expertise and off-balance sheet financing. Many governments are using PPPs for developing projects. These are commonly seen in the energy and transport industries, but they can be just as applicable to water infrastructure. 

Countries like Peru are using PPPs to finance water supply and sanitation projects, including large-scale irrigation infrastructure. In this example, the irrigation infrastructure was financed through an auction of the land to be irrigated. The infrastructure was then constructed and is managed by private operators. 

Bringing The Pieces Together 

There are many elements to creating a water infrastructure and drought financial strategy. It centers around not a single solution but numerous components that must work together to achieve the end result: less risk when drought occurs. 

Generally, there is a need for a national coordinating body to stand in the middle with arms outstretched in every direction to facilitate solutions across areas such as: 

• National government responsibility 
• Independent public entities 
• Private sector funding 
• Household responsibilities 
• Sub-national governments 

This form of multipronged effort creates risk layering, mitigating the risk that a single entity faces. 

To be effective, drought financial strategies must consider the current need to upgrade and modernize, requiring immediate access to capital to do so. It must also include savings and insurance products that mitigate risks when an event happens. Climate finance and environmental finance must also be present as they work to reduce the risk that drought conditions will occur, alleviating some of the pressure on the entire structure of this strategy. 

An effective drought finance strategy allows for the arrangement of a number of financial instruments to spread risk and identify the most important ways to reduce drought conditions. There is no single method that works in every situation, but by utilizing alternative and innovative drought resilience infrastructure financing, it's possible to create a more effective way of taking control over drought's real risk on every person, animal, and the planet itself. 

Dustin Baker is the Director of Education and Research at Commodity & Ingredient Hedging, which provides risk management and commodity hedging strategies that allow clients to sustain and grow their agricultural businesses despite market volatility. Baker helps market participants deepen their understanding of agricultural margin management concepts and strategies. In addition to leading educational initiatives, he regularly contributes to CIH’s publications that support risk management for agricultural producers and buyers.