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Melamchi Water Supply ProjectFSB Team PanchaMarch 1, 2014Chris FreemanNabin KhanalWaqas SattiAbhinav UpretiGrace WebsterMelamchi Water Supply ProjectThe Executive Director of the Melamchi Water Supply Development Board (MWSDB),Krishna Prasad Acharya, gazed out of his office at the majestic Himalayan Mountains. InJanuary 2014, the Board had gathered to review the progress to date on the Melamchi WaterSupply Project (MWSP), a key initiative to supply clean water to the region’s 2.5 millioninhabitants. The project that had long been stymied by political turmoil, cost overruns, poorproject management, and a revolving consortium of international financiers. Recent studiesproved that the water supply project remained technically feasible and economically sound, butadditional financial support would be necessary.After restructuring the loan agreement with the Asian Development Bank (ADB) in 2008,the MWSDB now needed an additional 38.1 million to cover cost overruns and ensurecompletion of the project by 2016. The Government of Nepal (GON) agreed to provide 13.1million through issuing long-term bonds, but a funding gap of 25 million still remained. TheBoard was considering asking the ADB for an additional loan to cover the remaining costs, orseeking out private sector investors in Nepal to provide the additional funding. Given theheavily subsidized loans that the ADB had already provided for the project, any private sectorinvestor would need to consider the real cost of capital and projected return on investment.The Melamchi Water Supply Project is the most critical component of the water supplysystem in Kathmandu Valley and a reduction or cancellation of the project at this stage wouldresult in (i) waste of project expenditures, (ii) failure to achieve the government’s social sectoragenda, and (iii) reputational risk for the multilateral development agencies involved. Acharyareviewed the project’s history and financing plan and considered the options for additionalfunding.Nepal: A Brief HistoryBordered to the north by China and to the south, west, and east by India, Nepal is amongthe poorest and least developed countries in the world, with about one-quarter of its populationliving below the poverty line (See Exhibit 1 for a regional map). The country is home to eight ofthe world’s ten largest mountains, including the world’s tallest peak, Mt. Everest. A landlockedcountry, Nepal is one of the most vulnerable countries in the world to the effects of climatechange and natural disasters such as earthquakes, floods, landslides, and glacial lake outbursts.The lack of public sector infrastructure and development further exacerbates these environmentalchallenges.1

Melamchi Water Supply ProjectFSB Team PanchaNepal was ruled by the Shah dynasty of kings from 1768 until 1951, when the Nepalimonarch ended the century-old system of rule by hereditary premiers and instituted a cabinetsystem of government. Further reforms in 1990 established a multiparty democracy within theframework of a constitutional monarchy until an insurgency led by Maoist extremists broke outin 1996. The ensuing 10-year civil war between rebels and government forces witnessed thedissolution of the cabinet and parliament and assumption of absolute power by the king. Severalweeks of mass protests in April 2006 were followed by months of peace negotiations betweenthe Maoists and government officials, and culminated in a November 2006 peace accord and thedeclaration of an interim constitution. Following a nationwide election in April 2008, the newlyformed Constituent Assembly overwhelmingly favored the abolition of the monarchic system inpreference of a democratic republic, and elected the country's first president in in July 2008.Between 2008 and 2011 there were four different coalition governments, led twice by theUnited Communist Party of Nepal-Maoist, which received a plurality of votes in the ConstituentAssembly election, and twice by the Communist Party of Nepal-United Marxist-Leninist. InAugust 2011, Baburam Bhattarai of the United Communist Party of Nepal-Maoist became primeminister and, after the Constituent Assembly’s failure to agree over the type of federal structurefor a constitution by the May 2012 deadline, dissolved the Constituent Assembly and called fornew elections. Months of negotiations failed to produce a new election date until in March 2013,the chief justice of Nepal's Supreme Court, Khil Raj Regmi, was sworn in as Chairman of theInterim Council of Ministers for Elections to lead an interim government and charged withholding Constituent Assembly elections by December 2013.In a country of 28 million people comprising more than 100 ethnic groups, the prolongedpolitical conflict revealed that the Nepali state had been associated with exclusionary political,social and economic institutions that did not reflect the country's diversity. Poor law and order isa growing concern in some parts of the country and enforced strikes are frequently called bypolitical parties which close down the country for extended periods.More than one-quarter of Nepal’s population lives below the poverty line and food priceshave risen quickly, further hampering the poor. As of 2012, nearly half of Nepal’s 18 millionstrong labor force is unemployed and of those who are employed, agriculture provides alivelihood for nearly three-fourths of the population and accounts for over one-third of Nepal’sGDP. Due to the country’s high unemployment rate, many Nepali citizens have left the countryin search of work, with India, Qatar, the United States, and Thailand being the more populardestinations. Nepal has considerable scope for exploiting its potential in hydropower, with anestimated 42,000 MW of feasible capacity, but political instability hampers foreign investment.Nepal embarked upon a new economic policy regime in the mid-1980s and has carriedout various components of economic reform policies including fiscal, trade and FDI policiesduring the last decade. Quantitative restrictions on imports have been fully removed and customsduties have been rationalized and substantially reduced. Reforms have also been implemented onthe foreign exchange front. However, political instability has stopped the reform process and theambitions of the business community.2

Melamchi Water Supply ProjectFSB Team PanchaForeign Direct InvestmentAs one of the least-developed countries in South Asia, Nepal attracts the least amount offoreign investment in the entire region. The inflow of direct foreign investment in Nepal began inthe early 1980s through the gradual opening up of the economy. From 1980 to 1989, foreigninvestment inflows to Nepal were minimal with an annual average of 500,000. A clear-cutpolicy towards foreign investment was introduced in Nepal in the 1980s, with the enactment ofthe Investment and Industrial Enterprise Act of 1987. In its pursuit of outward oriented policies,Nepal began to encourage private foreign investment in every industrial sector (medium andlarge-scale), with the exception of defense activities. FDI inflow showed a distinct accelerationduring the 1990s averaging 11 million per annum during 1990-2000, peaking at 23 million in1997. This was primarily due to Nepal’s more liberal trade policies, which comprised tariff ratereductions, the introduction of a duty drawback scheme, the adoption of a current accountconvertibility system and liberalization of the exchange rate regime. A reversal in the rising trendtook place from the beginning of the 2000s. As of January 2014, China has overtaken India tobecome the largest contributor of FDI to Nepal. In the second half of 2013, FDI from Chinareached 174 million, accounting for over 60% of the country’s total FDI commitment. SeeExhibit 2 for foreign direct investment inflows from 1980-2008.In terms of foreign private investment, in large industries exporting more than 90% oftheir total production, foreign equity was allowed up to 100%. New projects by foreign investorsrequire the formal approval of the Foreign Investment Promotion Division of the Ministry ofIndustry. In a step to further liberalize its foreign investment policy, Nepal announced a new setof incentives through the 1987 Act, under which the full remittance of dividends for investmentsin convertible currency was allowed.Kathmandu ValleyLocated in the foothills of the Himalayas, the Kathmandu Valley is home to sevenUNESCO World Heritage sites and at least 130 important monuments, including severalimportant pilgrimage sites for Hindus and Buddhists. Being a capital city, Katmandu Valley isalso the most important urban concentration in Nepal and a center for trade, tourism, education,health care, and government. However, the increase in population and unplanned, haphazardurbanization has resulted in the city becoming a polluted municipality with open sewers andunhygienic disposal of waste leading to the pollution of all the existing rivers in Kathmandu.More than 2.5 million people in the Kathmandu Valley have long suffered from inadequate andunreliable clean water supplies and resorted to expensive bottled water, collecting rainwater, ordrilling wells, leading to increasingly polluted wells and falling water in key aquifers.Insufficient clean water continues to undermine public health in and around Nepal's capitalThe Melamchi Water Supply ProjectIn 1998, the Government of Nepal initiated work on a unique water supply project to easethe chronic water shortages and sanitation concerns in Kathmandu Valley. The Melamchi WaterSupply Project (MWSP) supports infrastructure and institutional reforms that are critical toimproving the Kathmandu Valley’s water supply and aims to alleviate the shortage of potable3

Melamchi Water Supply ProjectFSB Team Panchawater by diverting water from the nearby Melamchi River to Kathmandu Valley. At the time,water pollution was a major reason for water shortage. As rivers flowed into the core areas of thevalley, the water was polluted by industrial and domestic waste and it was common to findexcess ammonia, methane, iron and manganese. Some independent analysts at the time alsocriticized the Government of Nepal for the inadequate water supply system. A major weakness atthe institutional level was the Nepal Water Supply Corporation, which was infested withinefficient red tape and bureaucracy.In April 1998 the Government of Nepal introduced a new Water Supply Sector Policy,according to which water supply projects were to become semi-autonomous and thegovernment’s role was curtailed to being a facilitator. The Ministry for Physical Planning andWorks set up an independent Melamchi Water Supply Development Board to look after theMelamchi Project. The core essence of the project was to transfer 170 million liters per day offresh water from the adjoining Melamchi River to Kathmandu Valley in Phase I, and thenaugment this supply by an additional 170 million liters per day from the Yangri and LarkeRivers, which lie in the upstream proximity of Melamchi, in Phase II. By providing clean waterto the residents of the valley, the Nepali government hoped to promote health and well-being ofthe residents, businesses, and tourists who frequent the area.Project FeaturesPhase I of the project required major capital expenditure to set up i) a 27.5 km (17.1miles) diversion tunnel (the Melamchi Tunnel) and a surface area of 8 square meters, ii) aconventional water treatment plant to be set up at the end of the tunnel, iii) a bulk waterdistribution system to carry treated water to reservoirs, and iv) the rehabilitation andmodernization of the existing distribution system.Given the nature of the program and environmental hazards involved, the initial programalso included the following: i) social development support, ii) waste water management, iii)resettlement and compensation for the affected people, iv) coordination with non-governmentalorganizations, and v) an environmental impact assessment.Phase II of the project will bring an additional 170 MLD water from the Larke andYangri Rivers in the Melamchi Valley. Kathmandu Upatyaka Khanepani Limited (KUKL), thestate authority responsible for distribution of drinking water in the Kathmandu Valley, estimatesthe current (2013) demand for drinking water at around 350 MLD, while the supply only reaches180 MLD. With a 10% expected increase in water consumption every year, by the time Phase Iof the MWSP is completed, Kathmandu will be on the brink of another era of water shortages.Successful completion of MWSP Phase I is critical for garnering additional funding from donoragencies and private sector to complete Phase II. According to independent studies, the expandedMelamchi project can also generate up to 225 MW of hydropower and provide irrigation to morethan 30,000 hectares downstream.Financing the Melamchi Water Supply Project: 2000 - 20084

Melamchi Water Supply ProjectFSB Team PanchaThe Government of Nepal reached out to multilateral and bilateral agencies around theworld to help finance the Melamchi Water Supply Project. The first major success was achievedwhen the Asian Development Bank (ADB) approved initial funding for the project in December2000. The funding became effective in November 2001 and it was originally estimated that theproject would cost 464 million. While the ADB was the major lender, additional financesupport came from a variety of multi-national organizations. Consortium and capitalcontributions included the following1:Asian Development BankGovernment of NepalWorld BankJapanese Bank of International Cooperation (JBIC)Norwegian Agency for Development Cooperation (NORAD)Swedish International Development Cooperation Agency (SIDA)Japan International Cooperation Agency (JICA)Organization of Petroleum Exporting Countries (OPEC)Nordic Development Fund (NDF) 120 million 118 million 80 million 52 million 28 million 25 million 18 million 14 million 9 millionHowever, after the funding was approved, the project quickly became embroiled invarious controversies. In 2004, the Kathmandu Valley Water Supply Board attempted to promptprivate sector participation and engage Nepali investors to co-finance a portion of the project.The World Bank’s funding participation was conditional on the private sector running theOperations and Management of water services after the project was completed. After manyattempts from the Government of Nepal to engage private sector investors remainedunsuccessful, the World Bank withdrew its support. Furthermore, three more developmentpartners withdrew financial support from the MWSP, citing ongoing political unrest andinstability, leaving a funding gap of 133 million. In June 2005, there were additional allegationsof corruption in the procurement process, leading to further delays in project planning andexecution.Financing the Melamchi Water Supply Project: 2008 - 2014In 2008, the Asian Development Bank approved major restructuring of the MelamchiWater Supply Project, allowing the project to move forward. The major change was the removalof a loan covenant requiring a private sector performance-based management contract forawarding the contract for constructing the Melamchi Tunnel, as well as a reduction in some ofthe social development initiatives in the project. This allowed construction of the MWSP tocontinue with a revised budget and timeline.A revised loan agreement between the ADB and Government of Nepal dated April 6,2008, provided a loan for the purpose of financing three major project components of theMelamchi Water Supply Project. This new agreement specified major changes in the scope andimplementation arrangements of the loan and affiliated projects in response to a new project1The Melamchi Valley Water Supply Project was valued and financed in USD. All loans and valuations numbers inthis case are listed in USD.5

Melamchi Water Supply ProjectFSB Team Panchadesign, funding consortium, and changed institutional setting. To improve operationalefficiencies, the MWSP was divided into two subprojects with different implementationagencies: the Melamchi Water Supply Development Board (MWSDB) would oversee theMelamchi River water diversion subproject (Phase I), and the newly established water utility,Kathmandu Upatyaka Khanepani Limited (KUKL), would oversee the water supply andsanitation subproject (Phase II). Exhibit 3 provides the details of each project component. Afteradditional amendments to the initial agreement in 2008, the ADB agreed to provide a 137 MMloan through the Asian Development Fund.The ADB loan terms charged interest at a rate of 1% per annum during the loan’s 8-yeargrace period, and 1.5% per annum for the next 24 years, for a total loan maturity of 32 years.2Interest charges were due semiannually on June 15 and December 15 of each year. TheGovernment of Nepal also sought funding from other development agencies to supplement theproject financing. The modified consortium after the project revisions is below, for a total projectinvestment of 317.3 million:Asian Development BankGovernment of NepalJapan Bank for International CooperationJapan International Cooperation AgencyNordic Development FundOPEC Fund for International Development 137 million 90.6 million 47.5 million 18 million 10.5 million 13.7 millionExhibit 4 provides additional details about the revised funding consortium. Projectcovenants placed by the ADB required that the project be carried out with due diligence andefficiency and in conformity with sound administrative, financial, engineering, andenvironmental and water management practices. Throughout the tumultuous project history, theADB remained a consistent partner for the MWSP and provided ongoing financial support andtechnical assistance to ensure sound project management and fiduciary stewardship. However,the increased costs and uncertain development timeline clouded the future of this relationship.As of June 30, 2013, 166 million of the original 317.3 million had been disbursed,including 64.26 million by the Asian Development Bank. Undisbursed finds from the originalcommitted amounts included 72.74 million for the ADB, 2.54 million for the NordicDevelopment Fund, and 4.35 million or the Japan International Cooperation Agency.The Asian Development BankThe Asian Development Bank is a multilateral development finance institution formed in1966, whose mission is to support the economic development of countries inAsia. Approximately 1.7 billion people in the region are poor and unable to access basic goods,services, assets and opportunities. The ADB seeks to eradicate poverty by financing projects infive core areas of operations: infrastructure; the environment, including climate change; regionalcooperation and integration; finance sector development; and education. The ADB provides2The grace period is the period prior to payment of the first principal amount of the loan.6

Melamchi Water Supply ProjectFSB Team Panchavarious forms of financial assistance to its developing member countries, including loans,technical assistance, grants, guarantees, and equity investments.The ADB is modeled after the World Bank and currently has 67 voting member countries– of which 48 are from within Asia and the Pacific. Funds are raised through bond issues on theworld market, as well as contributions from member countries, retained earnings from lendingoperations, and loan repayments. As of December 2012, the United States and Japan hold thetwo largest proportions of shares at 12.78% each. Additional shareholders include China with5.45% and India with 5.36%. Exhibit 5 displays a list of all member countries, their subscribedcapital, and percentage voting power. In 2009, the ADB obtained member-contributions for itsFifth General Capital Increase (GCI) of 200%, in response to a call by G20 leaders to increaseresources of multilateral development banks so as to support growth in developing countriesamid the global financial crisis. For 2010 and 2011, a 200% GCI allowed lending of 12.5-13.0billion in 2010 and about 11.0 billion in 2011. With this increase, the bank's capital base tripledfrom 55 billion to 165 billion.To finance projects, the ADB offers "hard" loans from ordinary capital resources (OCR)on commercial terms. For OCR, members subscribe capital a 50% paid-in ratio for the initialsubscription (including paid-in and callable elements), 5% for the Third GCI in 1983 and 2% forthe Fourth GCI in 1994. The ADB borrows from international capital markets with its capital asguarantee.The Asian Development Fund (ADF) affiliated with the ADB extends "soft" loans fromspecial fund resources with concessional conditions. Funded by the ADB's member countries,the Asian Development Fund offers loans at very low interest rates as well as grants to helpreduce poverty in the ADB's poorest member countries. Bridging the development gap in Asiaand the Pacific, the ADF is a major instrument of concessional financing that has supportedequitable and sustainable development in the region since 1973. In 2009-2012 alone, over 220loan and grant projects totaling 11.8 billion were made to developing member countries ofADB. See Exhibit 6 for a list of ADF eligible countries and resource allocation by region.The ADF countries consist of ADF-financing only and blended countries with access tolimited amounts of both ADF and ADB resources. These include 17 ADF-only countries and 12blend countries. ADF eligibility is based on two criteria: gross national income (GNI) per capita, using the World Bank's GNI per capitaestimates based on the Atlas method and the International Development Association'soperational cut-off for eligibility creditworthinessThe ADB as a Development LeaderThe Asian Development Bank links the allocation of Asian Development Fund resourcesto country performance. This system is based on the principle that aid is most effective inaccelerating economic growth and poverty reduction in countries where policy and institutionalperformance is strong. Under the performance-based allocation policy, the ADB evaluates therelative performance of eligible borrowers with access to the ADF by conducting annual country7

Melamchi Water Supply ProjectFSB Team Panchaperformance assessments and uses the results to derive ADF allocations. Each country’sperformance is assessed based on the (i) quality of its macroeconomic management, (ii)coherence of its structural policies, (iii) degree to which its policies and institutions promoteequity and inclusion, (iv) quality of its governance and public sector management, and (v)performance of the ADF project portfolio in the country. The country performance assessmentratings for 2012 are displayed in Exhibit 7.The ADB works with each developing member country to define a medium-termdevelopment strategy and operational program called a Country Partnership Strategy (CPS). TheCPS is aligned with the country's development plan and poverty reduction goals, and isdeveloped in close consultation with the government and other country stakeholders includingcivil society, non-government organizations, private sector, as well as the country's otherdevelopment partners. The CPS timeframe is aligned with the country's strategic planning cycle,where relevant and feasible. Adjustments in the timeframe can be made if justified by majoreconomic or political developments. In such cases, an interim CPS with a time horizon of amaximum of two years and abbreviated business process may be prepared when there isconsiderable uncertainty.One of the key goals of the ADF’s loan-making activities is to encourage thedevelopment of private sector partnerships in member countries. Many of the poorer membercountries lack the political stability and financial infrastructure to foster private sector investmentand concerns about poor public financial management, procurement, fiduciary oversight,accountability, and transparency are widespread. Government reforms at the national and locallevel are essential to enhancing the efficiency and effectiveness of public services anddevelopment projects. The ADB further works with individual member countries to advise thegovernment on basic reforms that create a welcoming business environment and support accessto financing opportunities and the development of the private sector. Elements of each country’sCPS emphasize leveraging co-financing and knowledge about ADB and ADF lending programs,as well as connecting investments with reforms and institutional changes.Nepal and the ADBThe ADB’s partnership with the government of Nepal extends back to 1968 when thecountry joined the ADB as a founding member. For 2013-2017, the strategic priorities for thecountry partnership strategy focus on (i) accelerating growth by addressing infrastructurebottlenecks in energy, transport, urban infrastructure, and irrigation; (ii) promoting inclusionwith enhanced access to education and skills development, water supply and sanitation, ruralinfrastructure (electricity and roads), and services; and (iii) strengthening institutions for higherportfolio performance, asset sustainability, and governance. As of December 31, 2009, the ADBhad committed nearly 3 billion in loans and grants to Nepal, including ADF loans of 2.42billion, an ordinary capital resources loan of 2 million, ADF investment grants of 495.65million, and non-sovereign loans of 49.5 million. In addition, Nepal has received technicalassistance grants amounting to 137.9 million.As of August 2013, the active ADB-financed portfolio in Nepal amounted to 1.53billion, with 45 on-going investment projects financed through 19 loans and 26 grants. In 2012,8

Melamchi Water Supply ProjectFSB Team Panchadisbursement of funds was hindered by the dissolution of the constituent assembly in March2012 and the establishment of an interim government in March 2013. Labor strikes, slowprocurement, and poor project management further delayed progress on ADB-fundedinitiatives. The poor quality of available contractors and project management professionalsfurther strained the local government agencies tasked with executing these projects, who werealready pressed for resources and capital, both managerial and financial.Eight of these projects support water supply initiatives and other municipal infrastructure,and the ADB assistance was focused on the timely implementation of the MWSP and associatedprojects to extend distribution systems in the Kathmandu Valley, and providing water supply andsanitation, and other urban infrastructure in secondary and small towns. Exhibit 8 details theADB’s cumulative loans to Nepal by sector.Nepal has also benefited from many venture initiatives launched by the ADB. Nepal waschosen as the pilot country for the ADB’s small wind power initiative, where Nepal installed itsfirst mini wind–solar hybrid power in a village of Nepal’s Nawalparasi district. Two sets of 5kilowatt (kW) wind turbines have been installed to help meet the village’s electricity demand.Private Sector ParticipationThroughout the MWSP’s history, the local Kathmandu Valley government sought privatesector investors to supplement support from international development finance institutions.During the early years, private sector bidders were not interested in a lease contract to managethe water services portion of the project, resulting in the World Bank’s departure from thefunding consortium. In determining the cost of capital investors knew that the project wasgranted at 1- 1.5% interest by the ADB and other international development partners, whichrepresented 71% of the total capital raised. The Government of Nepal would contribute 29% ofthe capital through a bond issuance at 10% coupon rate. At an inflation rate of 1.9%, the realinterest rate on the bonds would be 7.95%. This cost of capital was much higher than the 1% to1.5% interest rate on debt that the development agencies were providing for the project.However, the ADB’s calculated the cost of capital as the opportunity cost of investing in theMelamchi project, versus investing in other financial investment. Therefore the return demandedneeded to be at least 7.95% or greater.Calculating the cost of capital for the MWSP was more complicated. Nepal is considereda developing country with a host of issues not common in the developed world. While thenational government was committed to the project, it was not well equipped to enforce financialand project implementation discipline. Additionally, the government was experiencing a series ofreforms whereby democratic monarchy was replaced by absolute democracy, leading toinstitutional uncertainty and instability and the decade-long Maoist insurgency caused foreigninvestment into Nepal to dwindle. Private sector involvement, which is readily available in manyother countries, could not be relied on in Nepal. Due to the uncertain business and politicalclimate, the private sector was hesitant to get involved in a long-term infrastructure projects. Itwas critical for the development agencies to factor these risks into their valuation.9

Melamchi Water Supply ProjectFSB Team PanchaDetermining the cost of capital considers risks such as currency exposure, expropriation,wars and terrorism, and natural disasters. Each is weighed appropriately and incorporated intothe overall cost of capital calculation. While the aforementioned risks would potentially increasethe cost of capital, there were other factors that could potentially reduce the cost of capital suchas the presence of other development agencies as a syndicate in the financing and otherinternational partners. Nepal relied on other development agencies and foreign governmentassistance to support other public service projects all around the country. Such dependencegreatly reduced expropriation (direct, indirect or creeping) risks for the ADB. Exhibit 9 showsthe projected cash flows for the MWSP. Spot rate for USD to Nepali Rupee in ear

holding Constituent Assembly elections by December 2013. In a country of 28 million people comprising more than 100 ethnic groups, the prolonged political conflict revealed that the Nepali state had been associated with exclusionary political, social and economic institutions that did n