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JULY 2009 Report No. 48511-ZA

THE SOUTH AFRICAN URBAN AGENDA:Municipal Infrastructure Finance

Summary Report

1) Introduction........................................................................................................................................................2

2) What infrastructure investment is needed?.......................................................................................................4

3) Investing in cities: revenues, expenditures and leveraging.................................................................................9

a) Municipal revenues and expenditures..........................................................................................................10

i) Municipal capital expenditure..................................................................................................................12

ii) Development charges...............................................................................................................................12

b) Borrowing and other leveraging of municipal revenues...............................................................................15

4) Conclusions and policy options.........................................................................................................................21

a) Borrowing By Creditworthy Municipalities Benefits All Citizens...................................................................23

b) A Regulatory Framework for Development Charges.....................................................................................24

Annex A – Supporting Papers and Presentations.......................................................................................................26

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1) INTRODUCTION

In 2007, the Government of South Africa and the World Bank agreed on a Country Partnership Strategy (CPS), under which the World Bank committed to support Government policies and programmes related to urban and rural development through relevant analyses. This analytical report focuses on municipal infrastructure finance in urban areas, and is a summary and update of the Municipal Infrastructure Finance Synthesis Report published in May 2009. A list of supporting papers and presentations can be found in Annex A. All papers and presentations listed are available from the World Bank or the National Treasury.

The ability of municipalities, and of the nation, to effectively invest in urban infrastructure is likely to be a major determinant of South Africa’s economic future. This report focuses on the investment needed to ensure South Africa’s cities are vital, sustainable, equitable, and economically productive. Rural needs are no less important, and a similar focused consideration of rural challenges would be appropriate. As the White Paper on Local Government1 noted over a decade ago, the local government financing framework must recognise and accommodate the differences between municipalities, since “urban and rural municipalities, and even those in different metropolitan areas, are in very different financial circumstances,”2 with different prospects for providing adequate services at reasonable costs.

A relatively small group of 27 ‘urban’ municipalities generates 80% of national economic activity, even though these municipalities occupy less than 6% of South Africa’s land area. This small group of municipalities is home to more than half of the population, and will account for the overwhelming majority of South Africa’s economic growth in the years and decades ahead. Adequate and effective infrastructure investment in these growing municipalities will be a major determinant of South Africa’s economic future. This report discusses the types of investment needed in municipalities, and shows that most investment is needed for rehabilitation and growth, rather than for backlogs. The analysis also demonstrates that most ‘urban’ municipalities are financially healthy and have substantial untapped borrowing potential. If there were more own-borrowing by these urban municipalities, scarce national resources could be freed up for other purposes, including investment in rural municipalities with large populations and few resources. For analytical purposes, we have grouped South Africa’s metropolitan and local municipalities3 as follows (see Figure 1 for a summary of their characteristics):

Group 1 (A and B1 municipalities), Group 2 (B2 and B3 municipalities), and Group 3 (B4 municipalities).

1 White Paper on Local Government, 9 March 1998

2 id, Section G

3 Because District municipalities cover the same territory as Local municipalities, the investment needs of both levels of local government have been aggregated for analytical purposes.

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FIGURE 1: MUNICIPAL CLASSIFICATIONS

Group Category Description Characteristics

No of municipaliti

es

GROUP 1:27

municipalities

A Largest cities Metropolitan municipalities

6

B1 Secondary cities Local municipalities with a city in their midst, and with the largest budgets,

after the metros

21

GROUP 2:140

municipalities

B2 Large towns Local municipalities with a large town as the core

urban settlement

29

B3 Small towns Local municipalities with relatively small

population, a significant proportion of which is

urban, but no large town as a core urban

settlement. Typically one or more small towns and

rural areas are characterised by

commercial farms.

111

GROUP 3:70

municipalities

B4 Mostly rural Local municipalities which are mainly rural with, at most, one or two small

towns. The rural areas are characterised by

communal land tenure and villages or scattered

groups of dwellings.

70

Included with relevant local municipalities

C1 District municipalities which are not water services

providers.

District municipalities with few service delivery

obligations and which tend to be aligned with relatively strong local

municipalities.

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Included with relevant local municipalities

C2 District municipalities

which are water services

providers.

District municipalities with more service

delivery responsibility and which tend to be aligned with weaker and more

rural local municipalities.ADAPTED FROM URBAN SECTOR REVIEW: INFRASTRUCTURE INVESTMENT COMPONENT, SUMMARY OF FINDINGS FROM THE MUNICIPAL

INFRASTRUCTURE INVESTMENT FRAMEWORK (MIIF), PALMER DEVELOPMENT GROUP, 2009

Investing in rehabilitation and economic growth will cost considerably more than resolving remaining service backlogs, especially in urban areas. The cost of meeting the remaining service delivery backlogs is the smallest of municipalities’ investment needs. Much larger investments in rehabilitation of core infrastructure are needed to avoid further deterioration and interruption of essential services. The electric power crisis that began in 2007, with its unpopular and disruptive “load-shedding,” has helped focus attention on the need for ongoing reinvestment. In addition, strategic infrastructure capacity is necessary for continued economic growth.

As of July 2009, the global financial and economic situation continues to pose serious challenges. From the start of the democratic era until quite recently, South Africa had seen sustained growth, which enabled generous government spending on local infrastructure. Indeed, the principal constraint was capacity to spend, rather than the resources themselves. For the future, things will be different for an unknown period. Export demand from places like the U.S., Europe and Japan, has plummeted, affecting both commodities and manufacturing. It is now clear that South Africa’s economy is in its first recession in 17 years. The World Bank’s 2009 Global Development Finance Report projects 1.5% decline in South Africa’s GDP in 2009. The silver lining is that the economic contraction has given Government a little breathing room in terms of infrastructure investment. Many municipal water and sanitation systems, electric supply systems, and municipal roads were operating at or above their design capacity as a result of many years of sustained growth. For the near term, Government will run deficits and attempt to maintain spending levels on established priorities, but such deficit spending would not be sustainable indefinitely. The win-win scenario will be strategic investment in local infrastructure which both stimulates the economy in the near term and increases urban productivity in the long term. It is hoped that appropriate urban infrastructure investments will lay the foundation for rapid and robust growth when the global economy recovers.

The report suggests options for financing the infrastructure investment needs of urban municipalities. These include expanded borrowing by creditworthy municipal borrowers which, as a group, are significantly underleveraged. This can be accomplished through strategies to extend maturities of municipal borrowing, and to develop and deepen the secondary market for municipal securities. The DBSA could play a significant role in these two strategies. Other ideas include further restructuring of the Municipal Infrastructure Grant and other capital transfers to allow pledging and to incentivise appropriate leveraging; special funds to support feasibility and pre-procurement studies; a legal and regulatory framework to provide the basis for better use of development charges; and support for long-term capital planning by urban municipalities.

2) WHAT INFRASTRUCTURE INVESTMENT IS NEEDED?

This report focuses on investment needs in the territory of Group 1 municipalities.4 Focusing on the territory covered by this group of 27 municipalities is appropriate first, because with their overwhelming weight in the

4 A supporting paper has data for all categories. See Urban Sector Review: Infrastructure Investment Component, Summary of Findings from the Municipal Infrastructure Investment Framework (MIIF), Palmer Development Group 2009

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national economy, they hold the key to long term sustainability for the rest of the nation; second, because they represent the future – as South Africa continues to urbanise, still more people and more jobs will be located in these 27 municipalities; and third, because they hold the promise of financial sustainability, if they are provided with the right tools and incentives. Our analysis focuses on municipal investment needs in the territory covered by these municipalities, whether the actual investment would be made by local (Category B) or district (Category C) municipalities.5

Across sectors, urban infrastructure investments can be divided into three types:

1) Service delivery backlogs : this refers to investments needed to serve households which do not have access to the basic services that municipalities are meant to provide, such as water and sanitation, electricity, solid waste disposal, roads, and other public services

2) Rehabilitation : this refers to investments needed to upgrade, repair or replace infrastructure that has deteriorated beyond the point that routine maintenance is adequate.

3) Growth : this refers to investments in infrastructure needed to support a growing population and a growing economy.

Service delivery backlogs remain a challenge. The term “service backlogs” refers to households without a service to which they are legally entitled. Backlogs are a function of the definition of minimum service levels. For example, if pit latrines are deemed acceptable, then there are relatively fewer sanitation backlogs, whereas if water-borne sanitation is considered the basic standard, there are more backlogs. Such backlogs are also a function of the number of households without resources to acquire services for themselves. Unfortunately, the number of households living in poverty has increased over time. Because many people remain without services (see Figure 2 below), resolving these backlogs will continue to be a priority.

FIGURE 2: BACKLOGS FOR KEY SERVICES

SOURCE: MUNICIPAL INFRASTRUCTURE INVESTMENT REQUIREMENTS, B.C. GILDENHUYS, JANUARY 2009

5 Most of the districts covering B1 municipalities do not provide significant infrastructure and services, and raise little own-source revenue. An emerging debate in South Africa is whether there is a real need for the district tier in the case e.g. of B1 municipalities. The relatively strong B1 municipalities are different e.g. from many B4 municipalities, where the district tier often does provide substantial services.

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Rehabilitation has been overlooked. Unfortunately, strategic planning in many municipalities has been limited to addressing service backlogs, without adequate understanding of the need to protect the capacity of existing infrastructure networks or of the infrastructure requirements associated with economic growth. The condition of any asset starts deteriorating from the day it is commissioned – at some point it becomes necessary to rebuild or replace parts of the asset to restore it to a required functional condition or to extend its useful life. Rehabilitation generally involves returning an asset to its original level of service requirements. Examples include rebuilding of roads and slip-lining of sewer mains.

Existing municipal assets are estimated to be, on the average, 40--50% deteriorated. Unfortunately there has been little real information on the extent of rehabilitation needs. It is however possible to provide order-of-magnitude estimates. The results of more than 40 municipal infrastructure network condition assessments funded by the DPLG, European Union, the Limpopo Provincial Government and individual municipalities, suggest that roughly 45% of the economic potential of the nation’s municipal infrastructure has been consumed. We can apply these estimates to the current replacement cost of municipal infrastructure portfolios, using data in the Municipal Infrastructure Investment Framework (MIIF), and assuming the average lives of infrastructure networks to be in the order of 60 years based on published guidelines and engineering assessments.

Rehabilitation is important for new users as well as existing customers. Reliable infrastructure networks are needed to support service extensions as well as current users. Extensions typically link in with existing infrastructure. So rehabilitation is a pre-condition for growth. In addition to the actual investment, there is a need to work on institutional capacity to quantify rehabilitation needs, optimise rehabilitation costs where possible by integrating these requirements in asset upgrading projects, prioritise rehabilitation allocations, and ultimately specify and procure the rehabilitation work. Because most municipalities have limited data on the extent of their assets and their condition and capacity, it can be difficult to scope realistic rehabilitation projects.

Sustained economic growth requires sustained infrastructure investment: Modern cities can be thought of as a complex of overlapping infrastructure networks: streets that carry commuters to work and goods from factories; water pipes that deliver reliable water supplies on demand for homes, hospitals, manufacturers; sewage pipes that carry human and industrial wastes out of the city; electricity and telephone lines that power and link all of us together. As the economy grows, and as urban population grows, these networks must be constantly and continuously expanded. A healthy economy requires a certain amount of reserve capacity in all of these networks, so that there is always room for growth. When networks do not keep up, and services cannot be delivered, growth is constrained. Economic growth in South Africa averaged about 3% during the first decade after the end of apartheid, from 1994 – 2004. At that point growth increased, reaching a high of about 5% before the current economic crisis. This sustained period of high growth, unprecedented in South Africa’s history, put severe strains on infrastructure systems across the country. By 2006, it was clear that there was an energy crisis which, it is now believed, could last until 2013, as a direct result of that growth. The nation allowed its reserve energy capacity to be steadily consumed, without adequate investment, until there was no reserve. Many municipal systems in urban areas are in an analogous condition. Hours-long traffic jams in major urban centers have become the norm, sewage plants are working at capacity, and some development projects have been unable to proceed because of lack of municipal services. There is little or no reserve capacity in municipal services in many urban areas. Urban areas are the engines of productivity and growth – and bottlenecks in urban areas seriously constrain economic growth. While there is currently a contraction in the economy that may give some breathing room, one hopes for a return to sustained growth at or above the rates that were being experienced before the recent contraction. For that to happen, investment to remove urban infrastructure bottlenecks is critical. If infrastructure capacity is not on hand to support new private investment, then the urban economy cannot grow, and the nation will lose opportunities for growth and employment. And, if rehabilitation investment is not made as and when needed,

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existing business activity is threatened - with unreliable water or electric services, businesses may cut back operations or investments plans, or even fail completely, with adverse effects on the economy.

Infrastructure is critical to attract job-creating private sector investment. Emphasizing the importance of an adequate infrastructure foundation for economic growth, a recent report entitled “Bridging the Global Infrastructure Gap,” was compiled by the Economist Intelligence Unit for KPMG, and drew on interviews with 328 senior executives from 21 countries, including South Africa. Ninety per cent of those canvassed indicated that the availability and quality of infrastructure will affect where they locate and expand their business operations.6

FIGURE 3: 10 YEAR AGGREGATED ESTIMATE OF MUNICIPAL INFRASTRUCTURE INVESTMENT REQUIRMENTS.

Group 1: 27 m

unicipaliti

es

Group 2: 140 m

unicipali

ties

Group 3: 70 m

unicipaliti

es0

50,000

100,000

150,000

200,000

250,000

300,000

10 year Capex by type of investmentR millions

RehabilitationBacklogsGrowth


The estimates shown in Figure 3 reflect the investment needed within the territory of the three groups of municipalities over a 10 year period, assuming a 15 year target for rehabilitating deteriorated infrastructure, and a 15 year target for eliminating service backlogs. The calculation of investment needs over a given period is naturally dependent on the assumptions one makes about economic growth and the timetable for eliminating service backlogs and rehabilitation backlogs. The quantum and type of investment needed is very different in the three groups of municipalities. As can be seen from a glance at Figure 3, the total investment needed is very different in the three groups, and the composition of the investment estimates is also significantly different. 7 The territory covered by the 27 Group 1 municipalities has the greatest growth and rehabilitation needs, while the area covered by the 70 Group 3 local municipalities remains with the greatest service delivery backlogs. The territory covered by the 140 Group 2 local municipalities has the smallest investment needs, notwithstanding that these account for

6 “Infrastructure quality will drive investment decisions, survey finds,” Engineering News Online, 18 February 2009

7 For the purpose of these estimates, investment needs are territorial, not related to which level of municipality would actually make the investment. Thus, the investment needs of district municipalities are aggregated with the investment needs of local municipalities covering the same territory.

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the majority of local municipalities. Figure 4 below is based on the same estimates as Figure 3 above, but shows the investment needs for Group 1 municipalities over a nominal 10 year period, rather than as a single lump.

FIGURE 4: AN ESTIMATE OF ANNUAL INFRASTRUCTURE INVESTMENT REQUIREMENTS IN GROUP 1 MUNICIPALITIES.

2008 2009 2010 2011 2012 2013 2014 2015 2016 20170

5,000

10,000

15,000

20,000

25,000

30,000

35,000

Annual capex requirements: Group 1R millions

Rehabilitation Backlogs Growth


The investment needs, especially in Group 1 municipalities, are dominated by rehabilitation and growth. As Figures 3 and 4 illustrate, the amount needed for elimination of service delivery backlogs in Group 1 is a small fraction of the total municipal investment requirement. Over the 10 year period, the service extension investment needed for Group 1 municipalities is projected at about R 26 billion, less than 10% of the total investment required by these municipalities. By contrast, the growth and rehabilitation investment needs are each over R 120 billion for the same period, depending on the assumptions one makes about economic growth.8

There is increasing recognition of the need for rehabilitation of core infrastructure, and strategic investment to support growth. The National Treasury recently noted that “the limited provision of strategic infrastructure and a declining quality of service are growing constraints to economic growth and poverty reduction. If this trend is not arrested it might undermine the future sustainability of everything.”9 In other words, if the balance of local infrastructure investment is tilted primarily toward service delivery extension, in municipalities where that is no longer the biggest challenge, there is a risk of ending up with marginally increased access to low-functioning services, and limited ability to grow the economy. In urban areas, the need for rehabilitation is a constant and growing priority, and the need for investments to support growth has become a priority because the inherited capacity surpluses in core infrastructure have largely been consumed. Without new investment, economic growth faces critical bottlenecks.

8 These 2009 estimates reflect National Treasury’s early 2009 prediction of 1.9% economic growth for the year. Since the preparation of this model, expectations for 2009 are for economic contraction. The model used to generate these estimates is available to any interested party, and the assumptions can be easily altered to reflect changing expectations.

9 2008 Local Government Budgets and Expenditure Review, 2003/04 – 2009/10, National Treasury, Republic of South Africa

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3) INVESTING IN CITIES: REVENUES, EXPENDITURES AND LEVERAGING

Cities require constant investment over time. South Africa’s urban infrastructure asset base represents a significant amount of historical investment. Inevitably, this infrastructure is constantly aging and deteriorating. Even with sound maintenance practices (which are not always followed), cities must continually rehabilitate and replace aging infrastructure. And because the urban population and urban economic activity are growing, there are always new residents and businesses demanding services. Infrastructure investment needs are thus not one-time needs – the need for new investment is always there, and the needs grow if they are unmet. Cities therefore need sustainable and long-term strategies for the routine funding of new infrastructure investment.

Most funding for urban investment (and rural investment) must ultimately come from within the cities. As in most countries today, South Africa’s cities10 are home to the greatest share of national wealth, income and productivity. And they hold the key to the greatest future gains in productivity and national economic growth. Since cities are where most economic activity and growth do and will take place, it is where the greatest share of the tax base is. Revenues generated within these cities will therefore ultimately need to pay for the investment that is needed to make them grow and prosper. One way or another, residents and firms in cities will bear the burden of financing urban infrastructure. Even if national grants and transfers are expanded, it must be remembered that the national revenues which fund these transfers are largely derived from cities. So, taxes from urban areas can flow to national government and thence back to cities, as with the current Municipal Infrastructure Grant system, or taxes can stay in urban jurisdictions and be used locally, as with property rates and the former RSC levies. Either way, it is the economic activity and wealth of people in the cities that will pay for urban infrastructure. In this way, urban municipalities are very different from rural municipalities with little tax base and revenue potential of their own. To provide any reasonable level of services, such rural municipalities must rely on transfers from national government. Since the revenue used to fund these equalisation transfers largely originates from taxpayers in the cities, the rural municipalities also have a stake in the health of South Africa’s cities, and their ability to produce a healthy climate for growth, income, wealth, and productive taxation.

Naturally, the revenue potential of South Africa’s cities varies, and the revenue potential as between urban and rural economies varies even more. The own-source revenue potential of any municipality depends primarily on the wealth and economic activity of people and firms within its borders. Similarly, the national revenue generated from any geographic space depends on the revenue potential of that space, with urban areas contributing the lion’s share of national revenues. Because the economic base varies widely from place to place, equalising transfers such as the equitable share play a key role in ensuring that all municipalities have sustainable financing for delivering on their constitutional responsibilities. Conceptually, the purpose of the equitable share transfer is to allow a municipality with less of an economic base to meet its constitutional responsibilities.11

Borrowing, like other capital finance techniques, can leverage available revenues. Borrowing allows financially healthy municipalities the option of tapping into future revenues now. Borrowing is appropriate for municipalities which have revenues in excess of expenditures, and is generally inappropriate for those which do not have reasonable operating surpluses. Borrowing potential depends on the size of the actual or projected operating

10 As noted, we are using the term “cities” to refer to the Group 1 municipalities, acknowledging that these municipalities contain substantial rural areas as well as urban cores.

11 Many South Africans have come to see the equitable share as a way of funding free basic services. However, the free basic services policy is a more recent innovation (circa 2000) that post-dates the constitutional requirement for the equitable share. There is no legal restriction barring municipalities from using their equitable share allocations, which are a constitutional entitlement, for any purpose they choose.

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surplus,12 and our analysis shows that the urban municipalities that have the greatest operating surpluses and the greatest borrowing potential. The discussion which follows is broken into two parts: first, we discuss the current state of finances in urban municipalities; second, we will discuss ways in which these revenue sources can be leveraged through borrowing, PPPs and other long term arrangements.

A) MUNICIPAL REVENUES AND EXPENDITURES

The National Treasury has published comprehensive municipal financial data in the 2008 Local Government Budgets and Expenditure Review.13 The Treasury finds “growing evidence that municipal services are under-priced relative to the cost of production” and that municipalities “have also been wary of actively leveraging private sector finance, through debt, PPPs, and development charges...” The Review also notes an “increasing reliance of municipalities on transfers from national government to fund their activities....limited own revenue effort and a lack of commitment to leverage private finance.” A revenue summary is shown in Figure 5 below.

FIGURE 5: MUNICIPAL OPERATING REVENUE 2003/04 – 2009/10

R millions 2003/04 2004/05 2005/06 2006/07 2007/08 2008/09 2009/10

Property Rates 13,980 16,396 17,401 18,521 21,486 22,770 24,136 Service Charges 36,146 38,735 40,201 44,498 49,223 51,549 54,777 RSC levies 4,983 7,009 7,604 386 95 2 - Investment revenue 1,673 2,115 2,357 2,970 3,845 3,818 4,133 Government grants 8,980 13,742 17,398 27,223 26,571 28,311 28,491 Public contributions / donations 44 588 664 695 - - - Other own revenue 8,025 8,784 10,375 11,763 17,184 16,260 16,167

Total Revenue 73,831 87,369 96,000 106,056 118,404 122,710 127,704

Estimates Actuals

SOURCE: 2008 LOCAL GOVERNMENT BUDGETS AND EXPENDITURE REVIEW 2003/04 – 2009/10, NATIONAL TREASURY, REPUBLIC OF SOUTH AFRICA

The current economic contraction may impact South African local government less than would be the case in most countries. Over 40% of local revenues are service charges – while the recession may limit the ability of municipalities to increase their service charges, demand is likely to be somewhat inelastic. Another 18-19% of local revenues come from property rates, which will not be affected in the first year or two of a contraction – a longer recession which seriously depressed property values or affordability would be required before a substantial impact on property rates becomes an issue. An increasing percentage of local revenues is already coming from government grants – more than 25% in FY06/07 – and Government’s counter-cyclical spending stance means that this would be sustained for at least some years. The diversity of revenue sources is likely to provide substantial robustness in South African local finances.

FIGURE 6: MUNICIPAL OPERATING EXPENDITURE 2003/04 – 2009/10

12 The operating surplus in question can be for the municipality as a whole, if the issue is general obligation debt, or for a particular project. It is possible, though not common, to have viable borrowing or PPP projects in poor municipalities with little revenue potential.

13 2008 Local Government Budgets and Expenditure Review 2003/04 – 2009/10, National Treasury, Republic of South Africa

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R mill ions 2003/04 2004/05 2005/06 2006/07 2007/08 2008/09 2009/10

Employee Costs 21,577 23,433 25,015 27,895 34,820 36,354 38,433 Remuneration of councillors 596 787 955 1,417 Repairs and maintenance 4,459 4,868 5,245 5,925 8,532 8,943 9,587 Depreciation and amortization 2,505 3,945 4,253 4,980 Finance Charges 4,216 3,409 3,123 3,180 7,483 8,029 8,759 Materials and bulk purchase s 17,198 18,243 19,480 21,481 23,827 25,027 26,715 Grants and subsidies 1,435 2,021 2,141 2,339 Other expenditure 19,742 25,557 27,604 28,884 42,897 43,016 42,683 Total Revenue 71,729 82,264 87,815 96,100 117,558 121,368 126,176

Actuals Estimates

SOURCE: 2008 LOCAL GOVERNMENT BUDGETS AND EXPENDITURE REVIEW 2003/04 – 2009/10, NATIONAL TREASURY, REPUBLIC OF SOUTH AFRICA

Employee costs, materials and bulk purchases, and ‘other expenditure’ dominate the municipal expenditure picture, while finance charges are quite small. As shown in Figure 6, finance charges are quite small and falling, at under 4% of operating expenditure per the most recent actual data. This indicates that in the aggregate, there is significant upward potential for increased long term borrowing to fund strategic infrastructure. Interestingly, and perhaps unrealistically, the Treasury projections anticipate sharp increases in finance charges, more than doubling from 2006/07 to the following year, and nearly tripling by the end of the MTEF period in 2009/10.

Because revenue growth has outpaced expenditure growth, municipalities’ aggregate operating surpluses have been growing. Figure 7 below sets out the operating revenue, expenditure and surplus for the financial years 2003/4 to 2006/7. Revenue growth has been higher than expenditure growth by between 2-3% per annum. Part of this increase is due to changes in accounting (municipalities have moved to new accounting standards referred to as Generally Recognised Accounting Practice - GRAP). Another reason for the revenue growth has been the increase in government grants and the economic development in the major cities.

FIGURE 7: OPERATING SURPLUSES GENERATED ON A NATIONAL BASIS

2003/4 2004/5 2005/6 2006/70

20,000,000

40,000,000

60,000,000

80,000,000

100,000,000

120,000,000

R.00

0

SOURCE: CALCULATED FROM BUDGET INFORMATION ON THE NATIONAL TREASURY WEBSITE

I) MUNICIPAL CAPITAL EXPENDITURE

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Budgeted capital expenditure is high relative to operating expenditure, and has increased significantly in recent years. Figure 8 below shows the ratio for the fiscal years indicated.

FIGURE 8: SUMMARY OF BUDGETED OPERATING AND CAPITAL EXPENDITURE

2003/4 2004/5 2005/6 2006/7 2007/8

R000 R000 R000 R000 R000

Operating 69,300,101 80,140,440 87,042,025 98,843,440 117,558,371

Capital 16,762,332 17,291,192 23,638,071 28,462,209 39,735,966

Ratio (%) 24 22 27 29 34

Nominal increase year-on-year (%) 3 37 20 40

SOURCE: A REVIEW OF THE FINANCIAL CAPACITY OF MUNICIPALITIES IN SOUTH AFRICA, ALAN YORKE, MARCH 2009

Capital expenditure budgets for the 2007/08 financial year are more than double the 2003/04 level. This is due in part to the investment in infrastructure that relates to the 2010 Soccer World Cup. For 2008/9 and 2009/10 (not shown in Figure 8), National Treasury projects a decline in the ratio of capital expenditure, after the 2010 World Cup spending is largely complete. Actual capital expenditure lags behind budgeted expenditure, but is also growing, and has nearly doubled from the 2003/04 to the 2006/07 financial years. In addition to this dramatic increase in actual spending, there is improved ability to spend what has been budgeted. Group 1 municipalities show a large and steady increase in actual expenditure, and significantly improved performance against budgets. The municipalities sampled in this group show both absolute gains in spending, and greatly increased spending performance as compared to budgeted amounts. In FY 2006/07, Group 1 municipalities spent 93% of what they had budgeted. Actual expenditures in FY 2006/07 were roughly double those three years earlier. The conclusion is that Group 1 municipalities have been relatively successful in ramping up their spending capacity.

Human resource capacity constraints are a concern, but outcomes in Group 1 municipalities suggest that capacity is growing. There are many programmes aimed at identifying and addressing the capacity gaps. The Synthesis report lists examples of analytical efforts and of capacity building and support programmes. While there are no quick fixes, investment outcomes suggest that capacity to spend is improving rapidly. As noted above, spending on local government infrastructure has roughly doubled from FY 2003/04 to 2006/07. Given the plethora of analytical and training programmes aimed at building capacity, and the increased spending over this recent period, there is reason for optimism that this trend will continue, and that capacity in Group 1 municipalities need not be a binding constraint.

II) DEVELOPMENT CHARGES There are two types of development charges to consider: 1) capital cost recovery fees and 2) impact fees. Both are intended to recover the externalities associated with development from the development activity that creates the cost.

Capital cost recovery fees are imposed by a municipality to recover historic costs that it has incurred to provide services. Such a fee is imposed when a new user connects to municipal networks. After a municipality has invested in plant and equipment in order to deliver electricity or water to new users, it can recover a proportionate

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share of that investment each time a new user connects. If the new user is a high end residential development, or a commercial or industrial user, it would pay the full cost. That cost can then be rolled into the developer’s overall cost structure, and financed through the purchaser’s mortgage bond. This shifts both the cost itself and the financing costs associated with it onto the actual user in an affordable way, freeing up municipal capital for more investment.14 Without effective capital cost recovery, the municipality recovers its capital costs over time in the tariffs it charges – meaning increased tariffs for all users. In practice, tariffs can be difficult to raise, so the full costs may never be recovered, in which case new investment will be discouraged, and the system will generally face financial challenges as it tries to balance its capital and operating requirements.

An impact fee is a development charge for off-site impacts. For example, when a developer builds a new shopping mall, it ordinarily is required to upgrade the streets adjacent to the shopping mall, and to accommodate on-site impacts. But the new mall will also attract additional motor vehicle traffic over a wide area, potentially congesting streets and intersections some distance away. As more facilities are built in the area, new traffic lanes, traffic lights, and even highway interchanges may be required. In addition to the traffic impacts, the paving over of former farm land increases storm drainage loads downstream of the property, and ditches and culverts, even new water detention facilities may be required. These sorts of impacts are incremental and cumulative. It would not make sense for each new developer to expand downstream storm drainage facilities or build parts of highways. But in the aggregate, the lack of effective impact fees eventually imposes serious off-site financial and economic consequences. If off-site traffic improvements are not made, congestion increases, and everyone sits in long traffic jams whether they are headed for the shopping centre or not. If they are made, the public often has to bear the cost of the improvements, and the developer has successfully moved part of his development cost onto the public.

The burden of paying for infrastructure shifts, depending on the source of funds. When investments are funded from a municipality’s general revenues and accumulated surpluses, the capital is provided by local taxpayers and consumers. When investments are funded from national grants, such as the Municipal Infrastructure Grant, the capital is provided by all South African taxpayers. When investments are funded from specific user charges or impact fees, the capital is generated from those who use the infrastructure, or create the need for it. Each of these approaches carries its own social and political dynamic, and has its own economic and financial implications. As a general principle, infrastructure which benefits the nation as a whole, such as that connected with health and education is mostly financed from general, national revenues. This means that the burden is borne by all taxpayers in proportion to their tax payments, with urban residents as a group therefore paying more than rural residents, and the rich paying more than the poor. Infrastructure that benefits residents within a particular municipality, such as the city streets and street lighting, storm drainage, parks, and similar public places are generally financed from general, local revenues. Infrastructure that benefits particular users, or is needed because of development by identifiable parties, can be financed in whole or in part from user fees and development charges.15

Development charges have the potential to allocate costs more equitably: If we accept that affluent households, industrial and commercial users, and others that can afford to, should pay at least in proportion to what they use, or to the impacts they cause, then we would want to consider the role of development charges. These charges are typically imposed when a property is re-zoned or subdivided, or when a new building permit is issued. They can be one way of ensuring appropriate contribution to the cost of additional municipal infrastructure arising out of development and densification. Money which is collected at the time of development is cheaper money for the 14 If the end user is a low income user entitled to free basic services, then Government would pay some or all of the cost recovery.

15 South Africa has determined that minimum levels of basic services to households should be a matter of right and provided as free services. There is less clarity about whether the full cost of free basic services should come from national subsidies, or whether some should come from local cross-subsidies.

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public – it isn’t borrowed, and it doesn’t carry financing charges. By contrast, if the capital cost of new water or sewer outfall lines is recovered through tariffs, then everyone’s cost of water and sewage service goes up. Even low income users must pay more, because they have to cover the capital cost and carrying charges for someone else’s development.

Development charges have a long history in South Africa. One of the earliest recorded forms of development charge was a betterment fee levied in the former Cape Province beginning at least as early as 1935. Beginning from at least the 1970s, the former provincial administrations had land use planning ordinances that authorised the imposition of development charges as a condition of approval of development applications. A typical mechanism involved the developer’s execution of an “Acknowledgement of Debt” (or Notarial Deed in the Natal Province) for anticipated or historical public expenditure related to the development proposal. The charges, or in-kind contribution, were established as part of the planning framework, rather than as part of the financial framework, a practice which continues today in municipalities.

The current legal status of development charges is unclear. Some courts have considered development charges to be “essentially a tax.”16 This may be sloppy use of language, but it points to the need to make a clear distinction, by legislative enactment if necessary. Taxes imposed for the purpose of raising revenue, should be distinguished from fees which seek to recover actual costs. There has also been confusion over when development charges are to be paid, e.g. at the time of the development application or when the owner receives a tangible advantage from selling the land at its increased value or of putting up a building in accordance with the new right accorded to the property.17 This confusion is exacerbated by the fact that many of the ordinances predate the current Constitution and legislative framework for municipal finances.18 In addition to the local planning legislation, the 1995 Development Facilitation Act authorises the Minister of Land Affairs to nationally regulate “the payment by any person of compensation or a development contribution in respect of any such amendment or substitution and the basis for the calculation thereof,”19 though it does not appear that such regulations have been issued.

Processes and amounts vary considerably. Planning departments, individual service departments, and engineering departments play various roles in different cities, and appear to have considerable discretion in establishing what should be paid, and the degree to which in-kind contributions will be made instead of cash payments. Methods and cost averages that were developed before the December 2000 amalgamation of municipal boundaries remain in use in some places. A paper prepared in support of this research is available, which documents the procedures in some detail.20 Particularly striking is the wide variation in effective rates at which reported development charges are imposed, based on revenue received as a function of the value of buildings completed. The Synthesis Report contains a table showing some municipalities collect nothing at all, while others have collected as much as 50% of the value of buildings completed.

16 Johannesburg City Council v Victteren Towers (Pty) Ltd (1975(4)SA334(W)); City Council of Johannesburg v Norven Investments (Pty) Ltd. (386/91) [1992] ZASCA 192 (12 November 1992)

17 Johannesburg v Norven Investments, supra

18 The Municipal Fiscal Powers and Functions Act, No. 12 0f 2007 requires that municipal taxes or surcharges be approved by the Minister of Finance, so that if development charges are held to be such, they may be vulnerable to legal challenge where they have not received such approval.

19 Development Facilitation Act, No. 17 of 1995, section 46(1)(p)

20 Evaluating the Performance of Development Charges in Financing Municipal Infrastructure Investment, David Savage, 2009

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Charges are often calculated conservatively, resulting in under-charging of developers and implicit public subsidies for new developments. Municipalities usually charge only for very specific impacts directly and narrowly related to new development. No attempt is made to charge developers for the capacity they use in shared facilities, nor for other external impacts. Although municipalities are required by Generally Recognised Municipal Accounting Practices to capture revenues from development charges, there is no consistency in this regard. It seems that development charges are actually falling as a percentage of the value of buildings completed and building plans approved. Because of data limitations, it is difficult to be precise about the amount of under-recovery, but we estimate the range for all municipalities at between R500 million and R4,7 billion per year. The result is that this financing burden is transferred to taxpayers in general, i.e. there are implicit subsidies to new developments, including those for affluent residents, commercial, and industrial users. This limits the pace at which municipalities can finance rehabilitation of existing facilities and extension of services to poor residents. Many off-site impacts of development are simply not addressed, resulted in congested infrastructure systems, which impose economic costs on society and act as a disincentive to job-creating investment. By failing to adequately charge for and collect development charges, municipalities are implicitly:

Transferring benefits to private developers through permitting them to maximise their profits at the cost of ratepayers and consumers

Failing to tap into a ready source of infrastructure finance, which relies on the property finance industry and home-owner creditworthiness, rather than municipal balance sheets.

Implicitly reallocating resources away from other priorities, such as pro-poor expenditures Imposing economic costs associated with network congestion Increasing the user charges that must be borne by all users

B) BORROWING AND OTHER LEVERAGING OF MUNICIPAL REVENUES

Leveraging resources through borrowing: Capital investment can be funded using future revenues, by promising to repay principal over time, with interest. This allows a municipality to leverage its resources and build more infrastructure more quickly than could be done on a pay-as-you go basis. The legal agreements that evidence borrowing can take many forms, including loan agreements and municipal bonds. The lenders can be one or more private investors, financial institutions, or public entities and development finance institutions.

Other leveraging arrangements: There are many ways for a municipality to arrange infrastructure investments which are not thought of as borrowing, but which embody the same essential arrangement. For example, a municipality can promise to pay for electricity or treated water over time, in exchange for which a private investor builds a plant that can produce the desired commodity. Or a municipality can promise to lease equipment for a period, in exchange for which a private investor acquires the equipment and leases it to the municipality. These arrangements have many of the same financial characteristics and fiscal implications as borrowing. They can carry most of the same risks, and should be analysed in comparison to debt financing.

All promises to pay from future revenues limit a municipality’s future flexibility, because the funds committed to meet these obligations will not be available for other priorities that may emerge. Binding long-term financial commitments, in whatever form, inevitably reduce municipalities’ future flexibility to finance other investments, or to deal with unanticipated conditions. This is often a wise trade-off, because the capital investment being made will generate growth, or provide services, at a level that could never be afforded on a pay-as-you go basis. But it can be unwise if the capital from such arrangements is poorly invested. Leveraging is powerful - it can increase the benefits accruing from wise decisions, and they impose severe consequences for poor decisions.

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South Africa’s policies are designed to allow leveraging of municipal resources through debt and other long-term commitments. South Africa has taken a clear policy decision that, in order to leverage in private sector investment, well-run municipalities must be able to make long term financial commitments, and meet them either from existing revenue streams (such as intergovernmental transfers, municipal taxes, or user tariffs) or from charges imposed on new users. The progressive development of policy in this area has been clear and consistent:

In 1998, the White Paper on Local Government stressed the importance of gearing in private investment, and of using capital markets to do so.

In 2000, the Cabinet adopted a "Policy Framework for Municipal Borrowing and Financial Emergencies" which spelled out the details of government policy

In 2001, Parliament added a new Section 230A to the Constitution, 21 which authorised a municipal council to legally bind the municipality over the long term, in order to secure loans and investments.22

In 2003, Parliament revised Section 139 of the Constitution,23 to lay the foundation for effective legislation governing resolution of financial problems in municipalities.

Also in 2003, Parliament enacted the Municipal Finance Management Act (MFMA), 24 which laid out clear rules on municipal debt, in Chapter 6, and resolution of financial problems, in Chapter 13.

In 2007, the Minister of Finance gazetted disclosure regulations, prescribing how transparency in borrowing is to be ensured.

The policy framework for municipal borrowing is aimed at promoting market-based borrowing by creditworthy municipalities. The policy framework does not seek to make soft or subsidised credit available to municipalities. Rather, it seeks the discipline of at-risk lenders, who reward good municipal management with access to credit at reasonable prices, and who withhold credit from poorly managed municipalities. Lenders in South Africa are appropriately at financial risk if they irresponsibly lend beyond a municipality’s ability to repay.

Since the enactment of the MFMA, the Johannesburg and Cape Town municipalities have authorised general obligation bonds totalling about R8.1 billion. See Figure 9 below. The first Johannesburg issue was significant, being the first municipal bond issue since the end of apartheid. The subsequent issues and Cape Town’s entry into the market are causes for optimism. Cape Town is now working on a second issue, valued at R1.2 billion.

FIGURE 9: MUNICIPAL BOND ISSUES SINCE 1994

Johannesburg 1,000,000,000 13-Apr-04 11.95 6Johannesburg 1,000,000,000 30-Jun-04 11.90 12Johannesburg 700,000,000 26-Apr-05 9.70 8Johannesburg 1,200,000,000 5-Jun-06 9.00 12Johannesburg 2,268,000,000 5-Jun-08 12.21 15Johannesburg 900,000,000 9-Dec-08 10.82 7Cape Town 1,000,000,000 23-Jun-08 12.57 15

8,068,000,000

Issued amount (ZAR) Issued Date Coupon

rate % Term of years

21 Section 17 of the Constitution of the Republic of South Africa Amendment Act, No. 34 of 2001

22 Prior to this amendment, the weight of legal opinion was that a municipal council could not make commitment that would bind future municipal councils. This was a clear barrier to long-term investment in municipal debt.

23 Section 4 of the Constitution of the Republic of South Africa Second Amendment Act, No. 3 of 2003

24 Act No. 56 of 2003

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SOURCE: BOND EXCHANGE OF SOUTH AFRICA WEBSITE

Notwithstanding these notable municipal bond issues, there has been less borrowing than was hoped for. As of 31 December 2007, National Treasury reports that the total outstanding long-term municipal borrowing stood at approximately R22.7 billion.25 In nominal terms, this represents a slight upward trend over time, but adjusted for inflation, long term debt has actually declined, as can be seen in Figure 10 below. It should be noted that new borrowing from both public and private sources has been occurring, and at the same time old debt has reached maturity and been retired. The net effect of new borrowings undertaken, less old borrowings repaid, accounts for the outstanding debt stock levels illustrated in the figure.

FIGURE 10: MUNICIPAL DEBT OUTSTANDING, ADJUSTED FOR INFLATION USING CPI FOR ALL ITEMS, METROPOLITAN AREAS

2 000

4 000

6 000

8 000

10 000

12 000

14 000

PRIVATE SECTOR DEBT ADJUSTED FOR INFLATION PUBLIC SECTOR DEBT ADJUSTED FOR INFLATION

SOURCE: AUTHORS’ CALCULATIONS BASED ON NATIONAL TREASURY DATA

Prior to the most recent Johannesburg and Cape Town issues, the form of municipal borrowing has been trending in favour of more loans, and fewer bonds. The long term trends shown in Figure 11 below may now be reversing, but through the end of 2007 there had been a trend away from the issuance of securities and toward the placement of loans with specific investors. This has consequences for the secondary market and thus for the liquidity of municipal debt holdings. A more liquid market, which allows holders to dispose of holdings prior to maturity, is desirable both because it limits liquidity risk and encourages more investors to become involved, and because securities can be traded readily among institutional investors and even individuals.

25 Unfortunately, National Treasury does not have complete data since the end of 2007, reportedly because the data which previously came from the South African Reserve Bank is no longer available. As a result, National Treasury has not been able to use the same methodology track municipal borrowing data from the beginning of 2008.

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FIGURE 11: FORM OF MUNICIPAL BORROWING

19971998

19992000

20012002

20032004

20052006

2007

2 000 4 000 6 000 8 000

10 000 12 000 14 000 16 000 18 000

Annuity and other long-term loans Securities

R m

illio

ns

SOURCE: NATIONAL TREASURY DATABASE

Despite the low aggregate level of borrowing, active borrowing effort is reflected in financial statements. New municipal borrowing has been steadily increasing, in both absolute terms and relative to capital expenditure, as shown in Figure 12 below. For our sample of Group 1 municipalities, in FY 2006/7, new borrowings to finance capital amounted to R5.8 billion while total long term borrowing only increased by R 1.5 billion. This implies significant repayments of existing loans, totaling some R 4.3 billion. The amount of new long term borrowing each year has increased nearly four-fold since 2003/04. In FY 2005/06 and 2006/07, borrowing surpassed other sources of capex: grants grew by 115%, while borrowing grew by 272%. In absolute terms, R 2.8 billion more in grants was complemented by R 4.3 billion more in borrowing.

FIGURE 12: FINANCING OF GROUP 1 MUNICIPALITIES’ ACTUAL CAPITAL EXPENDITURE

2003/4 2004/5 2005/6 2006/70

2,000,000

4,000,000

6,000,000

8,000,000

10,000,000

12,000,000

14,000,000

16,000,000

R'00

0

SOURCE: A REVIEW OF THE FINANCIAL CAPACITY OF MUNICIPALITIES IN SOUTH AFRICA, ALAN YORKE, MARCH 2009

Cash and investments enhance the creditworthiness of municipalities. Figure 13 shows that in respect of the sample of Group 1 municipalities, cash and investments on hand actually exceed borrowings as at 30 June 2007. The sampled Group 2 municipalities have net cash and investments that cover more than half of the borrowings outstanding. From a lender’s perspective, these generous ratios of assets to debt, along with the substantial operating surpluses being generated, indicate good creditworthiness, and untapped borrowing potential. Some of the municipal cash and investments represent explicit security for debt repayment. It is not uncommon for

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municipalities, especially non-metropolitan municipalities, to purchase a “zero coupon” investment instrument at the time they borrow.26

FIGURE 13: CASH AND INVESTMENTS RELATIVE TO BORROWINGS

GROUP 1 MUNICIPALITIES 2005/06 2006/07Borrowings (R’000) 17,900,585 19,379,694Cash and investments (R’000) 15,867,188 19,566,342Coverage 89% 101%

GROUP 2 MUNICIPALITIESBorrowings (R’000) 339,979 400,108Cash and investments (R’000) 198,590 235,700Coverage 58% 59%SOURCE: A REVIEW OF THE FINANCIAL CAPACITY OF MUNICIPALITIES IN SOUTH AFRICA, ALAN YORKE, MARCH 2009

With a given operating surplus, the potential leverage depends on interest rates, the term of the borrowing, and the type of amortization. Each R 1 rand available for debt service will support the amounts of borrowing shown in Figure 14. Using these numbers as a guide, we can estimate municipalities’ idle borrowing capacity.

FIGURE 14: GEARING TABLE

interest rate: 8% 10% 12%Level amortization 10 years 6.71 6.14 5.65

20 years 9.82 8.51 7.4730 years 11.26 9.43 8.06

Interest only 10 years 12.50 10.00 8.3320 years 12.50 10.00 8.3330 years 12.50 10.00 8.33

SOURCE: AUTHOR’S CALCULATIONS

Substantial operating surpluses imply substantial untapped borrowing potential . In FY 2006/07, municipalities had operating surpluses of nearly R 10 billion. From the gearing table above, we see that they could sustainably borrow R 80 to R 112 billion in investment capital, which is four to five times the current level. Even with a 1.5 coverage ratio, total borrowing could be R 54 to R 75 billion.27 This is roughly three times the current level.

Annual revenues also support the possibility of additional borrowing: internationally, it is considered reasonable for debt service to consume up to 15% of annual revenues. With aggregate municipal revenues of over R 100 billion for FY 2006/07, one would calculate a sustainable debt level of some R 150 billion. This is more than seven times current borrowing levels.

The ratio of interest expenditure to total expenditure also suggests space for additional borrowing . In FY 2006/07, finance charges for municipalities amounted to only 3.3% of expenditures, while for metropolitan

26 If the municipality borrows with an arrangement to pay interest only until maturity, and then repay the principal, the zero coupon instrument would have a value at maturity equal to the amount borrowed. The principal amount of the loan is essentially guaranteed.

27 The thirteen cities in our Group 1 sample have operating surpluses of about 6 billion. Being conservative, with a 1.5 coverage ratio on level amortization, and interest rates from 8% to 12%, these thirteen alone could be borrowing R 32 to R 45 billion.

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municipalities the ratio was 4.5%. Internationally, recommendations for prudential limits on interest expenditure range from 7-15%, signalling that municipalities could safely handle higher payments than they have currently.

A principal factor in under-leveraging is the relatively short term of municipal borrowing. The relationship between new borrowings and outstanding borrowings suggests that much infrastructure debt is being rolled over, probably because of a mismatch between the borrowing term and the useful life of the assets being financed. The debt service profile of the top nine municipalities is shown in Figure 15 below. This is based on actual principal repayment schedules, with an assumed interest rate of 11% per annum. There is no significant debt with a longer maturity profile than 15 years – the last half of a potential 30 year debt service schedule is completely unused.

FIGURE 15: EXISTING DEBT PROFILE AND UNUSED BORROWING CACPACITY

-

1,000,000

2,000,000

3,000,000

4,000,000

5,000,000

6,000,000

1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30

Interest

Principal

UNUSED BORROWING CAPACITY

SOURCE: AUTHOR’S CALCULATIONS

In light of this substantial additional borrowing capacity, why hasn’t there been still more borrowing, and why has total private sector lending declined? Among the explanations offered by various observers:

Less need for borrowing: Increased grants from national government and increased own source revenues and consequent operating surpluses have limited the need to borrow.

Short maturities: much of the borrowing being done by municipalities is relatively short term, which results in high annual debt service costs for relatively little investment.

Unwillingness to borrow for service extension backlogs: Perceptions of investment need have been oriented primarily toward service backlogs. While these are a moral and political imperative, they are also seen as financially unattractive, because poor people cannot afford to pay the full cost of service.28

Limited capacity to spend: while municipal spending on infrastructure has increased significantly, (now over R 20 billion per year), spending is still far from the levels necessary (over R 50 billion per year).

Rehabilitation investment does not have high visibility. Deterioration of infrastructure is usually unseen until critical limits are reached, and systems collapse.

28 However, there is an argument that many of those who are considered un-served, especially in urban areas, actually have unauthorised service. To the extent this is so, formalising their connections and access could actually result in increased in cost recovery.

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Continued competition from the DBSA for the relatively limited pool of creditworthy borrowers has focused both the DBSA and commercial banks on Group 1 municipalities, and especially on metros

Ring-fencing, revenue pledges, and intercept mechanisms are discussed in the Synthesis Report. The reader is referred to the May 2009 Synthesis Report for a discussion of these issues. In brief, South Africa’s legislative framework allows the pledging of revenues and the creation of mechanisms to provide security to lenders that the pledged revenues will be used to repay debt. However, it does not allow direct intercepts of transfer payments from the Treasury before they reach the municipality, which would put the Treasury into an undesirable direct relationship with municipalities’ lenders.

Public private partnership (PPP) and integrated project development models are also discussed in the Synthesis Report. The reader is referred to the Synthesis Report and to the March 2009 report on Private Sector Investment in Infrastructure, by Claudia Manning and Tebogo Motsoane for further information. It can be briefly noted here that municipal borrowing, PPPs and similar arrangements usually raise the same underlying issues from a financial perspective. The strongest arguments for and against private sector involvement involve management and capacity issues, rather than financial issues.

4) CONCLUSIONS AND POLICY OPTIONS

Municipalities vary tremendously in their physical characteristics, population demographics, investment needs, economic bases, and administrative and political capacity. On the following page is an indicative policy matrix, Figure 16, which is intended to highlight the differing characteristics and issues of the three groups of municipalities, and to suggest policy options targeted to the specific issues of each group. The conclusions presented in this section are primarily aimed at the Group 1 municipalities. Because the borders between groups are somewhat arbitrary, not all Group 1 municipalities will benefit from all of the policy options presented, and many of the Group 2 municipalities would also benefit from some of these options. A detailed analysis of the finances and possibilities of Group 2 and Group 3 municipalities has not yet been done.

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Figure 16: Policy Matrix

Characteristics Key issues Policy options

GROUP 1 27 metropolitan and local municipalities

Significantly urbanised

These municipalities budget and spend increasingly well

80% of South Africa’s GVA (gross value added)

52% of population

54% of investment need

6% of land area

Most borrowing capacity

Access to private sector lenders

R271 billion capex needed over 10 years

91% of capex needed for growth and rehab

critical role in national economy

development costs poorly allocated

MIG & other grants may displace own-investment by these munis

need for longer term borrowing to increase leverage

need for greater critical mass in secondary market

Main focus of borrowing strategy:o Extend maturities o Increase borrower demando Develop secondary market

Target DBSA support at maturities and capital market development

MIG (Municipal Infrastructure Grant) and other capital grants unconditional and pledgeable where council has adopted a long-term capital strategy

MIG could reward municipalities which are more leveraged

Special fund for feasibility and pre-procurement studies

Policy framework for development charges

Support for long-term capital planning

GROUP 2 140 local municipalities

Large and small towns

Commercial farming

Municipal performance mixed

79% of land area 25% of

population 20% of

investment need



Large and small towns play a critical role in agriculture and regional trade

Research on Group 2 key issues and policy options

Capacity building, tailored to gaps identified in annual assessment

Mentoring programs

National funding for feasibility and pre-procurement studies

Integrated development approaches, with ongoing management support

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15% of GVA

Limited borrowing capacity

GROUP 3 70 local municipalities

Mostly rural Subsistence

farming Municipal

performance mixed to low

27% of population

26% of investment need

16% of land area 5% OF GVA

Little or no borrowing capacity



Small tax base, highly dependent on transfers

Most marginalized populations

May need to rethink institutions

research on group 3 issues and policy options

Capacity building, tailored to gaps identified in annual assessment

Mentoring programs Strong and supportive management

interventions Reallocation of powers and

functions? More NGOs?

A) BORROWING BY CREDITWORTHY MUNICIPALITIES BENEFITS ALL CITIZENS

Borrowing reduces resource competition. To the extent local infrastructure is funded through grants and transfers, Group 1 municipalities are in unnecessary competition with Groups 2 and 3. Leveraging in private sector investment can be a game-changer. Creditworthy borrowers can access funds that other municipalities cannot. They have another source of investment capital besides government grants, and one which can largely pay for itself. It is in the national interest to reduce competition for national revenues by encouraging creditworthy municipalities to seek most of their investment capital from private sector creditors.

Borrowing can leverage annual transfers. In Group 1 municipalities, the role of National Treasury can focus on providing stable and predictable transfers over time, and the role of financier can be outsourced to lenders in the private sector and to the DBSA.

Additional borrowing should be consistent with the principles of the existing borrowing framework. The existing policy framework rejects “soft” credit to uncreditworthy borrowers. The current financial crisis shows the wisdom of that policy. Pushing loans on municipalities which do not have sound financial management and a clear ability to repay would only lead to crisis and contingent liability down the road. So, what path is open to Government, to encourage additional borrowing by creditworthy borrowers without risking defaults in the future? Three strategic objectives are suggested: 1) increase demand by creditworthy borrowers; 2) extend maturities to better match the useful life of assets being financed; and 3) re-focus on the secondary market for municipal securities.

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Incentives could increase demand by creditworthy municipal borrowers. The obvious incentives for municipalities to rely more on borrowing and less on national grants would be increased flexibility and increased funding. Government has recently committed to a more flexible MIG program for metropolitan municipalities – MIG-Cities – under which individual project approvals will no longer be required. This is an important step in the right direction. Further flexibility could be introduced by making it clear that municipalities can and should use MIG transfers to meet any of their infrastructure investment needs, and not only extending access to the poor. With the overwhelming need for rehabilitation and strategic investment in the Group 1 municipalities, these municipalities should be encouraged to target their capital spending to address their infrastructure needs in a balanced and strategic fashion. Further flexibility can also be achieved by extending the MIG-Cities approach to all municipalities that have adopted a long-term capital strategy meeting certain minimal criteria. If municipalities can decide for themselves how to spend their capital grants, provided they have applied their minds to their overall and long-term strategic capital needs, then we are likely to see better and more strategic investment as compared to project-by-project decision making at the local or national level. The final carrot would be a rethinking of the MIG formula to give more money to those municipalities, or at least those Group 1 municipalities, which engage in long-term borrowing, thus gearing in more private sector investment for each rand of public funds.

Another stimulus for municipal demand would be special funding for feasibility and pre-design work. Because the early links in the chain of activities that ultimately lead to construction, i.e. needs identification, feasibility studies, environmental assessments, and the like must be funded from municipal operating budgets, there is not a robust pipeline of specific investment projects in most municipalities. More capital finance alone will not guarantee more construction of local infrastructure. Funding for these pre-procurement activities could come through a new window in the MIG programme, or simply by amending the MFMA to allow such preparatory activities to be considered as capital expenditure, and thus fundable through borrowing.

Maturities could be extended with the support of the DBSA. There was a time when even the most creditworthy of today’s municipal borrowers, i.e. the City of Johannesburg, could not access private sector credit. In those difficult days, DBSA served a truly developmental role by extending credit in the context of an agreed recovery strategy, and paved the way for Johannesburg to eventually become the creditworthy borrower and issuer of municipal bonds that it is today. If the DBSA were asked to specifically support the longer maturities in any given debt issue, in collaboration with private sector investors who may be unwilling to take the long term risks alone, it would be doing a major developmental service to South Africa’s urban municipalities and through them to the objectives of national economic growth and recovery.

The secondary market could be deepened with the support of the DBSA, insurers, pension funds and unit trusts. One obstacle to longer maturities is the lack of a vibrant secondary market, which would allow holders of municipal obligations to liquidate them when their own needs so dictated. A robust secondary market allows a variety of new investors, with varying investment appetites, to participate in funding urban infrastructure. The DBSA could be asked to do more of its lending, e.g. lending over a certain rand amount to a single obligor, in the form of tradable municipal bonds, as opposed to loans. In the case of insurers, pension funds, and unit trusts a regulatory audit to discover any barriers to investment in municipal debt should be instituted. In the case of unit trusts, a market analysis could develop understanding of fund managers’ views of municipal debt obligations.

B) A REGULATORY FRAMEWORK FOR DEVELOPMENT CHARGES

Development charges can be useful and appropriate ways to service the costs of municipal borrowing. To the extent a municipality invests to create capacity in its infrastructure networks, it should be able to recover the full cost of its investment – to sell the capacity – to private sector developers. The income from such capital cost

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recovery fees could be pledged to service debt the municipality incurs to create the capacity in the first place. This allocates the cost of infrastructure to those who use its capacity. While municipalities currently use such fees, they significantly under-recover the costs associated with private development. Significant additional revenue is being foregone by municipalities, which could amount to anything between R500 million to R4.7 billion per year.

The legal and regulatory framework that regulates development charges is under-developed and overly prescriptive. A patchwork of different approaches was inherited from the apartheid era. Municipalities in the seaboard provinces assume their powers to levy development charges in terms of a provision of provincial land use ordinances. In the inland provinces the legal basis is more developed. But in both instances, the current system leads to extensive litigation as developers seek to minimise the charges and maximise profits. The inadequacies of the legal framework have resulted in highly restrictive interpretations, and in some cases may have discouraged smaller municipalities from imposing development charges. Legislative reform may be required to clarify the scope of charges that may be levied, reduce incentives for litigation, and facilitate administration by municipalities.

Considerable improvements are required to the data that is available on development charges. A spot audit of actual revenues – in both cash and kind – may be required to establish the extent to which under-reporting of revenues has occurred. More detailed guidance on appropriate accounting practices may be required as well, including a method to reconcile reported revenues with underlying costs. Improved national monitoring of trends in development charges can assist in mitigating potential economic costs of delayed investment and infrastructure maintenance arising from municipalities not managing this revenue source appropriately.

Municipalities should improve their management of development charges. Current practices do not allow reconciliation of actual and intended expenditures. Calculation methods currently used are highly technical, and reliant on regular updating of unit cost data, which is seldom done. It may be wise to revisit the practice of managing development charges by planning or engineering departments, as opposed to municipal treasuries. This segregates development charge revenues and expenditures from the overall budget process, and prevents normal financial oversight. It has allowed municipalities to administer vastly different policies on development charges across different parts of their jurisdiction, and has resulted in the ongoing decline in actual revenues received.

Few municipalities are actively engaging their counterparts, or other spheres of government, on best practices in development charging or the efficacy of the current regulatory framework. The South African Cities Network, or the National Treasury, may wish to convene an information sharing workshop with municipal practitioners to achieve consensus on the major policy and operational issues, and to make recommendations on appropriate regulatory changes.

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ANNEX A – SUPPORTING PAPERS AND PRESENTATIONS

This summary paper is based on the following papers and presentations, copies of which are available on request from the World Bank or National Treasury:

World Bank, The South African Urban Agenda: Municipal Infrastructure Finance Synthesis Report, May 2009

Boshoff, Louis, Memorandum re: appropriate DRC/CRC % to calculate the extent of current renewals requirements, November 5 2008

Boshoff, Louis, Estimates on municipal infrastructure rehabilitation, PowerPoint presentation, November 2008

Gildenhuys, Burgert; Municipal Infrastructure Investment Requirements (MIIR), January 2009

Manning, Claudia and Motsoane, Tebogo; Private Sector Investment in Infrastructure, March 2009

Palmer Development Group; Urban Sector Review: Infrastructure Investment Component: Summary of findings from the Municipal Infrastructure Investment Framework (MIIF); prepared as background for the foregoing World Bank report, January 2009

Savage, David; Evaluating the performance of Development Charges in Financing Municipal Infrastructure Investment; March 2009

Yorke, Alan; A Review of the Financial Capacity of Municipalities in South Africa, March 2009

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