Since updating its sanitation framework, Law 14,026, three years ago, Brazil has aimed to increase access to water and sewage services. However, S&P Global Ratings still views Brazil's sanitation regulatory framework as having a short history relative to those of other countries. In addition, we think the variety of regional, state, or local regulators, rather than a single national one, results in less transparency and increases the likelihood of political influence. Under the current framework, federal entity Agência Nacional de Águas e Saneamento Básico (ANA) is responsible for managing water resources and for establishing reference standards, among other responsibilities, which do not include regulatory authority. Instead, authority remains fragmented, with regional, state, or local regulatory agencies overseeing the sector, as defined by the 1988 Brazilian Constitution. In our view, the absence of a single and experienced regulator for sanitation services is still a weakness of the water utility sector's regulatory framework, especially when compared to the one for Brazil's electric utilities.

When we assess the credit quality of water utilities, we don't evaluate an entity's competitive position, given the monopolistic nature of their business, but instead we assess the regulatory advantage. We analyze the framework's stability and transparency, the predictability and consistency of the tariff adjustment process, and the regulatory body's independence. This is the core of our analysis of the utility industry because inflation-indexed tariffs and the stability and predictability of consumption--based on the essential nature of the service and client concentration in the less volatile residential segment--guarantee resilient cash flow for water utilities. In our view, Brazil's current framework focuses on regulatory stability, aiming to attract and foster private investment in the sector to achieve universal access to water and sewage services in the country by 2033. The regulatory target is that 99% of the Brazilian population will have access to drinking water and 90% to sewage treatment and collection, with expected investments totaling R$800 billion-R$900 billion during the next decade.

Since July 2020, major auctions have taken place, including large concessions in the states of Rio de Janeiro, Ceará, Amapá, Alagoas, Mato Grosso do Sul, and Rio Grande do Sul. Through these auctions, private players have increased their market share in the sector to about 9% from 6% (in terms of municipalities served) and they now serve over 20% of the country's population. However, we expect the recent government decrees could reduce opportunities for private investment in the sanitation sector.

New Decrees By The Lula Administration Aim To Preserve State-Owned Companies' Role In The Sector

After President Luiz Inácio Lula da Silva's administration took office in January 2023, the new government's first action involving the sanitation sector was to enact two decrees on April 5, 2023 (Decrees No. 11.467 and 11.466). These decrees aim to give more flexibility to the role and amount of public companies' investments in the sector, and involved the following main changes to the regulatory framework:

• Removal of the 25% cap for government contributions under public-private partnerships (PPPs), with the goal of making smaller concessions more viable and attractive for both public and private investments.
• Extension of the deadline for public companies to provide evidence of economic and financial capacity to meet the regulatory universalization targets to March 2024 from December 2021. We think this should unlock public companies' access to federal funding for basic sanitation for the next two years. Furthermore, the government extended the formation of regional blocks for collective sanitation contracts to Dec. 31, 2025, from March 31, 2023.
• Granted permission for state companies to provide services in bordering municipalities, metropolitan regions, and urban agglomerations exempt from the bidding process, as long as they have authorization from the state or federal entity of the regional blocks. This is a material change to the current regulatory framework, which imposes mandatory competitive bids allowing private and public players to compete for the concession of the services.
• The regulatory agency, ANA, to follow quality and coverage guidelines provided by the federal government and the Ministry of Cities.

In our view, the measures included in these decrees aim to preserve the role and share of state-owned companies in the sector. However, there's still uncertainty if the additional two years will be sufficient for state-owned companies to rectify their contracts by preparing the studies and business plans necessary to prove their economic and financial capacity to meet Brazil's regulatory targets for water and sewage services, and to form the regional blocks. In addition, despite the changes in these decrees, we still expect some privatizations to occur, particularly the ones already being structured by Brazilian development bank BNDES (Banco Nacional de Desenvolvimento Econômico e Social) in the states of Rondônia, Sergipe, and Paraíba in the North and Northeast regions. At the same time, we expect a slower pace for new privatizations, with a smaller share of private players and higher share of public funding. In our view, this ultimately could delay the execution of the regulatory service targets, given the historical underinvestment in water and sewage by government-related entities in Brazil.

Comparison Of Brazil's Previous Water Regulatory Framework And Recent Updates

Sanitation Status

Service coverage is a key aspect in our analysis. In Brazil, average water service coverage was 84.2% in 2021, up 10 basis points (bps) from 2020. However, when comparing the country's various regions, we see significant differences. The Southeast has the highest water coverage, 91.5%, and Northern Brazil has the lowest, 60.0%. In the meantime, the country's water losses remained generally stable at 40.3% in 2021, a slight increase from 40.1% in 2020. The Midwest has the lowest losses, 36.2%, and Northern Brazil has the highest, 51.2%.

Sewage services coverage is substantially lower, with a national average of 55.8% as of 2021 (up 80 bps year-over-year). Like in water services, the Southeast has the highest sewage coverage, 81.7%, and the Northern region has the lowest, 14.0%.

We note that these metrics are below some countries in the region, such as Chile, Argentina, and Mexico. They are also subpar compared to more developed countries such as the U.S. or countries in Europe.

Sanitation Investments

According to the National Sanitation Information System (SNIS: Sistema Nacional de Informações sobre Saneamento), investments in the sector totaled R$17.3 billion in 2021, 26% higher than in 2020 (see the chart below).

Nevertheless, the Brazilian Sanitation Association (Abcon Sindcon) estimates that R$893.3 billion in investments would be required to reach the 2033 targets, with R$164.0 billion for water investments and R$436.6 billion for sewage. In addition, another R$292.6 billion would need to be invested to maintain the existing infrastructure until 2033. This would mean investing R$39 billion (about 0.4% of Brazil's GDP) per year, which we view as challenging, considering that it would require doubling the amount invested in 2021.

Challenges And Opportunities For The Sector

Resiliency of the regulatory framework will attract private funding sources

We think confidence in the updated regulatory framework--the stability, transparency, and predictability of the tariff adjustment process and ANA's role--will continue to be crucial to attract the much needed investments in the sector. Private sources of funding, like incentivized infrastructure debentures (which give investors tax benefits), have taken an increasing role, especially in the last couple of years. Private issuances in the sector grew to R$3 billion in 2022 from R$500 million in 2019, as investors expect to benefit from the transparent regulatory framework and stable cash flows.

BNDES's role

In the past few years, BNDES has acted as a financial advisor for the sector, structuring the privatization process of CEDAE in Rio de Janeiro and other processes for utilities in the states of Alagoas, Amapá, Ceará, Espírito Santo, and Rio Grande do Sul. The development bank is also in advanced stages of privatization modeling for water and sanitation companies in the states of Rondônia, Sergipe, Paraíba, and Rio Grande do Sul). In addition, BNDES has continued to be an important source for long-term capital expenditure financing in the sector. However, under the Lula administration, we think it's still unclear whether or not the government will maintain BNDES's role in structuring, advising, and financing new auctions.

Opportunities for privatizations, despite recent decrees

Although the recently enacted government decrees seem to support the higher participation of state-owned companies in the sector, we still think that in-process privatizations are likely to occur. This is because they depend on the state/regional/municipality authority granting support to move forward, not the federal government. Below, we list some privatizations that we think are likely to occur:

• Companhia de Saneamento Basico do Estado de Sao Paulo (SABESP: BB-/Stable/--; brAAA/Stable/--) is the largest water and sewage company in Latin America based on net revenue. The company operates water and sewage systems in 375 municipalities in the state of São Paulo, which generate about 32% of Brazil's GDP. It supplies water to 28.4 million people and provides sewage collection services to 25.2 million people. The company is a government-related entity (GRE), because the state of Sao Paulo is SABESP's controlling shareholder with a 50.3% equity stake. On April 11, 2023, the company signed a contract with International Finance Corp., which will act as advisor in the privatization process.
• SANEPAR (not rated) is a state-owned utility in the state of Paraná in southern Brazil. It operates water and sewage systems to 346 municipalities, serving most of the state, which has an estimated population of 11 million. The company has an average water coverage of 100% and sewage coverage of 78.9%. On April 13, 2023, SANEPAR launched a public bid to contract a PPP that would be an administrative concession for sewage services in 16 municipalities, which together have a population of about 421,000.

BNDES is also conducting preliminary studies in:

Source: BNDES Projects Hub.

Solid Waste Management

Brazil's basic sanitation framework also incorporates solid waste management and disposal. In our view, there are significant opportunities to increase the disposal of solid waste at sanitary landfills while also reducing the amount of waste that gets sent to them by increasing recycling in the country. Recycling is currently present in 32% of the municipalities in Brazil, mostly in the South and Southeastern regions.

In terms of collecting solid waste, as of 2021, the national average for collection coverage was 89.9%. Of the waste collected:

• 73.3% is destined for sanitary landfills, which have permanent technical and operational controls to avoid damage to public health and the environment from the waste.
• 11.8% is sent to controlled landfills, which have standards mostly related to workers' safety and access to the site, and are considered a temporary measure between sanitary landfills and open dumping.
• 15.0% goes to open dumps, which don't have any type of controls--health, safety, or environmental--and receive waste from all origins.

Although most of the solid waste (by volume) goes to sanitary landfills, there are more than twice as many open dumps in Brazil than landfills. The country has 1,572 open dumps, while it has 696 sanitary landfills and 595 controlled landfills.

Comparison Of Regulatory Frameworks In The Region

To compare different regulatory frameworks in the region, we share below the main differences among the sanitation companies that we rate.

Iguá Saneamento S.A. (Iguá) and Aegea Saneamento e Participações S.A. (Aegea) are both Brazilian water utilities exposed to the city of Rio de Janeiro--around 40% of Aegea's pro forma EBITDA comes from the city and 50% for Iguá. We consider that both have operational turnaround challenges in their respective blocks in the Rio de Janeiro concession. The regulatory framework has a limited history and delinquency and water loss rates are still high, which directly affect the profitability of these companies. In addition, the two companies significantly raised their leverage ratios after acquiring the Rio de Janeiro concession blocks, which we reflect in their financial risk profiles: Iguá's is highly leveraged and Aegea's is aggressive.

When we look at the concessions in other regions of Brazil, such as São Paulo--a more mature market operated by SABESP--we view the regulatory framework as more transparent and robust, which gives SABESP a stronger regulatory advantage. São Paulo's framework is regulated by the state regulatory agency, Agência Reguladora de Serviços Públicos do Estado de São Paulo (ARSESP). In addition, compared to other regions in Brazil, SABESP's concession has higher water and sewage coverage of 98% and 92%, respectively, and lower water losses of 33.8%. The consolidated delinquency rate in SABESP's concession is about 4.5% as of 2022. SABESP serves 70% of customers in the state of São Paulo--approximately 28.4 million customers--and is the largest water and sewage company in Latin America in terms of revenue.

We also rate water utilities in other Latin American countries. The Chilean market has one of the most mature sanitation frameworks in the region. Aguas Andinas S.A. benefits from a regulatory framework for sanitation that has existed for almost 30 years; exposure to Chile, which has a lower country risk than Brazil; and a good operational and competitive performance, supported by its customer base of 2.2 million, mainly concentrated in the less volatile residential segment. In addition, the company's monopoly concession areas serve 43% of Chile's population and 50% of the country's residential water consumption. Águas Andinas' concession areas are concentrated in the metropolitan region of Santiago. This area is the richest in the country, is already mature in terms of population growth, and has high service coverage--sewage collection is at 99%.

Elsewhere in the region, Integrated Utility Holding N.V. (Aqualectra)'s regulatory advantage compares unfavorably to Brazil's given that Curacao's regulation is still developing, in our view. Furthermore, given its geographic concentration, Aqualectra has a much smaller scale and weaker margins compared to the other peers.