A $500 million project in the Netherlands, a $1 billion-plus partial privatization scheme in Germany, a host of potential projects in Greece, Portugal, Italy and Poland - just a few of the deals on offer in the private water sector. Not surprising then, that privately financing water projects in Europe has become a multi billion dollar business and one that is set to take off in the next year. Analysts estimate there is between Eu50 billion ($49.2 billion) and s100 billion of investment required in Europe in the next few years.

French and English water companies have already established their credentials as big hitters in the European market as operators of either privatized utilities or with management contracts across the world. Surprisingly the number of concession contracts on offer has been low. Consequently project finance in the water sector has been limited to a few Scottish and Northern Irish deals carried out under the UK's Private Finance Initiative (PFI) scheme.

"The water sector is some 10 or 15 years behind other sectors in Europe," says Richard Temple, partner and head of water at CMS Cameron McKenna in London. Power stations have been passed into the hands of the private sector across Europe, but beyond the UK the political implications of passing a public resource into the hands of the private sector has been too dangerous to touch - until recently.

New European Union directives on water quality and increasing pressure on outdates municipal systems are forcing governments to upgrade. And a shortage of public funding is pushing many into bringing in the private sector.

Vivendi and Suez Lyonnais des Eaux have already scored some of the big concessions. In particular Vivendi's foray, together with RWE, into the German market with a 49% stake in Berliner Wasser, is seen by many as the first step in the company's move into Eastern Europe.

Meanwhile, Suez Lyonnais des Eaux recently secured s42.5 million from the European Bank for Reconstruction and Development (EBRD) to finance the upgrade of Brno-Modrice wastewater treatment plant in the Czech Republic.

At the same time, the share price of some of the UK water companies has fallen significantly in recent months. Says Michael Wilkins, director in the infrastructure finance department at ratings agency Standard & Poor's in London: "In the UK tough environmental obligations have been forcing up prices by 45% in real terms during the past 10 years. Recently announced pricing resets in the UK will lead to flatter real increases over the next five years after a first year price reduction in part facilitated by assumed greater efficiency and lower capital spending." With profit margins narrowing in the UK, companies are looking to the rest of Europe for more lucrative opportunities. Thames Water, for example, is involved with EDP in the Cascais concession in Portugal and has teamed up with CMS for a build-operate-transfer project in Tangiers, Morocco.

Exporting PFI

Acting as the template for development is Scotland. Under the PFI scheme local water authorities in the north and east of the country have offered a series of water and wastewater projects to the private sector. It is no accident that the authorities managing the $600 million Delfland water concession recently approached the East of Scotland Water Authority to assist on its tendering process.

The success of recent Scottish projects has proved that the design, build, finance and operate (DBFO) model is one that works. Recent deals such as the Stirling Water transaction, managed by Toronto Dominion Securities and SG and the Tay wastewater project, managed by Barclays Capital, have proved that the long-term, low risk nature of water projects makes them prime candidates for bond financing.

In the Stirling project, the lead managers discounted claims that capital market financings are in their very nature inflexible by issuing bonds for the project in two stages. Says S&P's Wilkins: "What Stirling shows is that the capital markets can be used in a similar way to a bank facility. That you can draw down financing in stages. Bond financing can be as flexible as bank debt."

Barclays Capital followed up the Stirling deal at the end of December with a £100 million ($165 million) private placement for the Tay wastewater. Institutional investors buying into the deal include Abbey National, Halifax, DNIB and Prudential.

And Greenwich NatWest is due to come to the market shortly with a £50 million bond issue for the Levenmouth project in Scotland. This bond will be wrapped by MBIA and carry a AAA rating.

Time for a euro project bond issue

But as recent projects in Scotland prove that bond issues can be as flexible and well priced as bank debt, the next step is clearly to take that concept abroad. Jason Russell of SG in London argues that a water project such as the $500 million Delfland project in the Netherlands could be the perfect testing ground for the first euro denominated project bond. "In the Delfland project, the authorities are using the Scottish template as a reference point. But the size of the Delfland project means that it will need to tap a number of funding sources. Part of that financing could come from a eurobond. And we know that institutional investors are prepared to take on a project bond type product."

Says Robert Rees, director at Barclays Capital in London: "We have no doubt that investors are ready and willing to take on well structured eurobond issue paper. And there is no reason why the first deal couldn't be for a water project - you have to start somewhere." Whether investors would be prepared to take on an unwrapped bond is another matter.

Despite the political considerations involved in passing water into private sector hands, water projects offer a safe vehicle for project bond offerings. Says Wilkins: "Water projects typically display fairly standard operating cost profiles and predictable revenue streams. For this reason, financial profiles tend to display high levels of leverage (debt versus equity) and low coverage ratios."

But institutional investors are looking for the right kind of deal. In Belgium, the government is offering a concession contract for Brussels. Early indications suggest that a confusing tendering document is deterring bidders. More importantly if the concession awarder chooses to offer a relatively short 20-year contract, a bond issue might not be suitable.

But in Portugal, Greece and Italy, commercial and multilateral banks are sizing up the options. The European Investment Bank (EIB) recently provided an Eu80 million loan for the Santa Maria da Feira water and wastewater project in Portugal. The EIB loan is guaranteed by a group of Portuguese commercial banks led by Banco Totta & Acores and Banco Pinto Sotto & Mayor. Feira is the first of several water schemes to be financed on a non-recourse basis in the country.

Jon Sibson, partner in the project finance and privatization department at PricewaterhouseCoopers in London, says: "Italy is the market everyone is talking about." Recent changes in Italian law are forcing consolidation in what has until recently been a highly fragmented water system in which authority was dealt with at the municipal level. Under the new regulations, several thousand water authorities will be made into around 150 companies. And all eyes are on Suez Lyonnais des Eaux which holds one of the first concessions in the south of the country. "Others are watching to see how Suez handles its Italian project to see what happens in the rest of the country," says Sibson.

Looking east

Sibson says that there are other countries waiting to adopt the model used by the municipal government in Sofia, Bulgaria. In other parts of Bulgaria, Romania and Poland, local authorities are lining up projects for partial privatization.

"Bond financing may have been attractive in the Scottish transactions because the long tenor of the concessions is compatible with a bond issue," says Sibson. "But if you look elsewhere in central and Eastern Europe, the kind of problems are completely different. It is not a question of which sort of financing to use but how to finance the projects." Assistance from multilaterals such as the EBRD is still required to secure financing. "The EBRD or the International Finance Corporation have to work with commercial lenders and this works better with a bank financing rather than a bond financing." The EBRD is already heavily involved in the Poznan concession in Poland.

In Romania, bids are due in the next two months for the Bucharest water concession. Bidders include International Water, Suez Lyonnais des Eaux, Vivendi and Azurix.

CMS Cameron McKenna's Temple, says that the financing for these kind of concessions has more in common with water projects financed in Manila and Buenos Aires than they do with the PFI deals. The legal considerations are also more challenging.

Says Temple: "The procurement aspect is very different. Documents are less detailed and regulations often not suited to the international tendering process. When you look at the type of contract for the power sector such as the offtake contract, it almost accepted that there will be a certain amount of risk allocation. In water projects there is no acceptance of risk and the project is complicated by all the environmental considerations. In addition to this, central end eastern European countries have generally not grappled with project finance concept before. And all of these considerations have to be addressed at municipal level. It's quite challenging."

But Temple concedes that increasingly the PFI model will be exported to the rest of Europe "as more and more European governments realise that PFI can be used to finance projects".

French and British water companies may have established a firm foothold in the global water market but US companies are making their mark on the sector. The sponsors behind the Catchment International Water consortium include a stake from Bechtel.

Meanwhile, Wessex Water in England was recently bought by Azurix - itself a new comer to the water sector. Formed a year ago; Azurix is part of Enron's strategy to challenge the European's hold on the sector. So far it is too early to say whether Azurix will be able to make much headway in Europe but it has bid aggressively on a number of deals and is in the running for the Bucharest concession.

At the end of January Azurix announced its intention to offer $500 million US dollar and UK pound denominated senior notes due 2007 and 2010 respectively. Proceeds of the offering will be used to repay outstanding debt and to make further acquisitions. Whether these acquisitions will be in the US and Latin America - the two areas Azurix has targeted so far - remains to be seen but further European acquisitions could give the company the weight it needs to challenge the Europeans on their own ground.