Brazil’s murky waters

Like many cities before it, Rio de Janeiro was hoping that by hosting the Olympic Games it would be able to boost the country’s economy, increase its tourism and go down in history as the first Latin American country to host the high-profile event.

But as the Olympics were drawing to a close, the country had found itself at the center of attention for other reasons as well. There were the long queues of visitors waiting as long as 90 minutes to see events they eventually missed, half-empty venues and a swimming pool filled with green-coloured water.

Even before the sold-out opening ceremony, Brazil was already making headlines for the filthy waters athletes would have to compete in, prompting Infrastructure Investor to take a more in-depth look at the cause of the problem.
While Brazil is home to 12 percent of the planet’s freshwater reserves and nearly 90 percent of its inhabitants have access to clean drinking water, sewage coverage is below 50 percent. Rio’s Guanabara Bay and an attempt to clean it illustrate the severity of the problem and the reasons why it is not going away.

“It’s a long story,” Paulo Bessa, a partner in the offices of Tauil & Chequer Advogados, an associate firm of Mayer Brown, says. It goes back to 1992 when the water quality of Guanabara Bay came to the fore during the United Nations’ Earth Summit, hosted in Rio.

The Japan International Cooperation Agency and the Inter-American Development Bank agreed to provide Brazil $1.17 billion for the Guanabara Bay Basin Sewerage System Construction Project, a programme aimed at cleaning up the bay. According to JICA, in the early 1990s, approximately 120 tons of raw sewage were discharged into the bay every day.

Initially envisioned as a five-year project, starting in 1994 when the loan agreement was signed and scheduled for completion in 1998, the project suffered so many delays that by 2013 only 77 percent of trunk lines and 51 percent of sewer networks were constructed.

“CEDAE had built some waste treatment plants but there were no pipelines connecting the network to these plants,” Bessa says, referring to Rio de Janeiro’s state water utility tasked with overseeing the project. “It’s almost unbelievable.”

In its post-evaluation of the project, which JICA ruled “unsatisfactory”, the development agency cited the lack of necessary sewage collection facilities – “either incomplete or unconnected” – as the main reason why three new wastewater treatment plants proved less than effective despite the installed treatment capacity.

The delays in construction were primarily due to politics and red tape.

Fast forward to 2016 and that situation remains along with Guanabara Bay’s contaminated waters.

“In late June, I was at a meeting at the Accounts Court of the State of Rio de Janeiro where officials expressed concern that almost 92 percent of Rio’s state municipalities do not have proper destinations for public and domestic waste,” Bessa explains.

“That’s a very important point because the National Policy of Waste Management that was enacted in 2010 did not include the necessary funding,” Bessa continues, explaining that the law requires every municipality to have the necessary waste collection facilities. The law applies specifically to solid waste, another source of pollution that ends up in the bay and other bodies of water surrounding Rio. “Without money, it’s impossible to solve this issue,” he says.

ENTER THE PRIVATE SECTOR

Brazil is no stranger to partnering with the private sector for its infrastructure needs. Public-private partnerships are common in transportation, energy infrastructure and the power sector. But how common are they in the wastewater sector?

“Whenever the government has been able to privatise, substantial investments have been made by the private sector and sewage improved dramatically,” Bruno Soares, a partner at Allen & Overy’s São Paulo office, replies.

According to Viktor Kats, co-head of IFC Asset Management’s Global Infrastructure Fund, the National Sanitation Law passed in 2007 “was the law that really laid the framework for private sector participation. Since the passage of the law, the share of the private sector has more than doubled to the current 8.7 percent.”

While the private sector’s market share remains small, its contribution to the water and wastewater sector in 2014 represented 20 percent of total investments, the Brazilian Association of Private Concessionaires of Public Water and Sewage Services states in its 2016 annual report.

According to data from SNIS, Brazil’s National Information System on Sanitation, investments in the wastewater sector totaled 10.5 billion reais ($3.3 billion; €2.9 billion) and 12.2 billion reais in 2013 and 2014 respectively, falling short of the 15.2 billion reais Brazil needs to spend annually to provide universal sewerage coverage by 2033, as outlined in the National Basic Sanitation Plan.

While municipal water utilities account for the lion’s share of the market – 70 percent – local construction companies dominate the privately run utilities. “Because of their market knowledge, because of the synergies they would have in the wastewater sector and arguably because they were able to be more competitive and aggressive, they’ve prevailed,” Allen & Overy’s Soares explains.

“If you take Odebrecht, for example, they have Braskem; they have the heavy construction business and they can run a concession,” he adds. Other key players include Galvão Engenharia, OAS Soluções Ambientais and Carioca Nielsen Engenharia. But most of those companies, if not all, are implicated in Brazil’s largest corruption scandal.
As a result, “I see the sector much more open to foreign investment,” Soares remarks.

IFC Asset Management’s Kats agrees. “Yes, I think it will open the sector to some international investors who will be able to bring capital, maintain the core management team that will be able to implement their strategy, without being distracted by these scandals.”

IFC Asset Management is already active in Brazil’s water sector, having invested $20 million in Aegea Saneamento, a private water utility based in São Paulo, in December 2013. In August, IFC Asset Management increased its equity stake, which now stands at 4.8 percent, with an additional $20 million investment.

“Aegea is currently number three in Brazil in terms of market share,” Kats says. “But it’s the only company in the sector that is not affiliated with a construction company and is dedicated to water services and sewerage coverage. And that really translates into their profit margins. The EBITDA margins are 50 percent compared to maybe 20 percent for some of their peers,” Kats explains.

Aegea’s other shareholders include Brazilian private equity firm Equipav, which owns a 71.4 percent interest and Singapore’s sovereign wealth fund GIC, which holds the remaining 18.67 percent stake. The IFC has also invested in the company through three rounds of financing and currently owns 5.49 percent.

According to Kats, Aegea’s success can be attributed to its approach.

“Aegea targets medium-sized and maybe smaller municipalities which are manageable,” he explains. “They identify municipalities where they know they can make operational improvements and where private sector participation is welcome.” One of the first issues Aegea tackles once it has partnered with a municipality is to reduce leakage and to improve water quality.

“You also invest in increasing sewage coverage, which is less than 50 percent, so you can make significant improvements that people can actually see,” Kats says. That in turn gains the company buy-in from both the municipality and the public. “I think then you have a much better basis to grow your business but also to ask for tariff increases to recoup further investments.”

Speaking of tariffs, Kats underscores the fact that rates are at a cost recovery rate in most parts of the country. Ranging from $1.30 to $1.50 per cubic metre for both clean water and wastewater services, Brazil’s tariffs are significantly higher than elsewhere in Latin America while at the same time being affordable for consumers.
“We’re quite optimistic,” Kats says about the Brazilian market. “We’re very keen to be part of this great story and we think investors from outside the country should be looking at this market.”