Ways to mitigate risks in water sector joint ventures

By Sunil Seth and Vasanth Rajasekaran, Seth Dua & Associates
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The Indian water sector saw a major overhaul post economic liberalization in the 1990s with the entry of private participation in water sector projects. Subsequently, the formalization of the National Water Policy, 2012, acted as a catalyst in encouraging private sector participation in the planning, development and management of water resources.

With as many as 75% of public-private partnership contracts awarded since 2005, the potential for private sector participation through various joint venture models, in collaboration with state utilities, urban local bodies (ULBs) for water supply, and distribution businesses, stands at around US$1.75 trillion.

Under the Indian constitution, “water” is the subject of legislation at three levels: the centre, states and ULBs. Thus, each state has the prerogative to legislate and establish its own set of rules and regulations governing water supply while the centre looks at inter-state water disputes only.

Sunil Seth
Sunil Seth

Private investment – both domestic and foreign direct investment (FDI) – in the water infrastructure sector is permitted without restriction, in that up to 100% FDI is allowed under the automatic investment route. Having said that, it has been observed that both foreign and Indian players, by and large, prefer to implement projects in this sector through a joint venture model in which both partners together offer an integrated solution to design, finance, build, operate and maintain water services. Usually, a special purpose company (joint venture company) is created by the concessionaire to implement the project.

Typically, the joint venture company enters into a concession agreement (usually for a duration of 20-30 years) with the relevant public authority, under which all the operating, maintenance and investment responsibilities fall upon the joint venture company while the public authority retains ownership of the assets. Thus, an investor in India (foreign or domestic) not only requires strong financial support to ensure smooth functioning of the project but also has to tackle vast administrative and legislative hurdles. The joint venture company must ensure protection against such political risk by negotiating suitable provisions in concession agreements and other facility agreements entered with the public authority, thereby safeguarding its interest (including non-recourse provisions).

Apart from this, the joint venture company is bound to face risks ranging from the design and development stage and the construction stage (cost overruns, delays, failure to meet standards), to operational risks (costs, quality and quantity of water, regulatory approvals), to revenue risks (bulk water charges, changes in tariffs) and financial risks (exchange rates, interest rates), to force majeure and insurance risks.

Vasanth Rajasekaran
Vasanth Rajasekaran

The promoters discharging their contractual obligations through the joint venture company must allocate their risks judiciously and incorporate suitable covenants while entering into the joint venture agreement, defining and limiting the obligations and liabilities of each of the parties to the joint venture company as per the needs, requirements and nature of the project. Revenue risks can be allocated by creating an escrow arrangement for collection of water charges, a letter of credit based financial structure, minimum revenue guarantees by the public authority or payouts during the construction period, etc.

Alternatively, a joint venture company with foreign equity may opt for various recourse and non-recourse financing structures to implement the water project. In a non-recourse financing structure, the collateral will be sought in the form of securing cash flows which will be generated from the project (tariff charges for water) and project assets which are created.

Further, the foreign partners in the joint venture company must make optimum use of the geographical presence, local project environment and local knowledge of their domestic partner while entering into a joint venture agreement. Operation and maintenance risks arising at the ground level such as delay in obtaining permits, regulatory approvals, and limitations in disconnecting water supplies must be addressed by adopting risk mitigating covenants in the joint venture agreement to minimize the impact of any adverse project outcome.

Also, while bringing technological expertise and know-how, the joint venture partners must protect their technology resource pool either by incorporating covenants in the joint venture agreement or by entering into a separate technology transfer agreement.

In conclusion, it can be said that private investors venturing into India in the form of joint venture are exposed to multifarious risks in the water sector and must essentially pre-identify all such potential risks and take suitable mitigation measures to limit their liability accordingly.

Sunil Seth is a senior partner and Vasanth Rajasekaran is a partner at Seth Dua & Associates.

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