How Can the Regulator Participate
in Utility-to-Government Contracts?

By David Jankofsky
Senior Associate, IP3

Abstract

Utilities in the water, electricity, transportation, and telecommunications sectors enter into agreements with governments for a variety of issues. Some may be "privatization" projects and others service delivery contracts with the state-owned utility. Often these agreements do not meet the expectations of the governments and consumers alike for a number of reasons and they are either renegotiated or in some cases, canceled. In this piece, the author argues for a strong regulator to oversee utility privatization and service contracts so as to hopefully avoid the many problems in the recent past. A brief "blueprint" of a successful process for possible regulatory involvement is also presented.

I. Introduction

Since the Thatcher revolution of the 1980s, donors, governments, and consultants have touted privatization of utility services as an important component to overall economic development.
If that is the case, why did The Economist, in its August 28, 2004 edition indicate that the world's three largest private water companies were pulling out of several countries? The London publication characterized this being due to "…the social, regulatory, and political risks being just too high."

The suggestion from this corner is that there is less "privatization" (the outright purchase or controlling interest) of utilities these days and more focus on alternative ways of involving the private sector into utility service delivery. These models, often called "private sector participation" or PSP includes options such as service delivery contracts, management contracts, lease arrangements, concessions, and build-operate-own/build operate transfers schemes. And the typical PSP transaction or contract involves the private sector being involved in a project - such as the construction and operation of a water treatment plant for example, -or in the management of operations through a contract.

Unfortunately over time the words "privatization" and "PSP" have come to be used somewhat interchangeably. They should not be. Perhaps as a result, for reasons stated later in this article, privatization may be falling out of favor. (For a graphical depiction of the waning public support for privatization in Latin America, see The Economist, November 1, 2003, p. 34.)

II. What, then, is the problem often associated with PSP?

Following through on our water treatment plant example, a typical PSP transaction would have a private firm desirous of building such a plant. No doubt, the state-owned water utility/state owned enterprise (SOE) does not have the capacity to fulfill the needs of its service territory. Perhaps the government has even begun a solicitation process to find an entity to build and operate a plant. That usually suits the private firm because it does not want to buy the entire utility, in fact typically, those assets are only as good as efficient and profitable operation of the facility. Instead, it simply wants to build a treatment plant that will provide additional capacity for the SOE. The result is that it will sell water to the SOE that, in turn, will sell the water to its end-user customers.

The private firm then prices its product. It legitimately desires to make a profit. It starts with the risk free rate of return on top of which is added commercial risk, country risk, and foreign exchange risk. These risks can add up to a princely sum. However, they represent what an investor "commands" to make the investment in a given country. Then these firms will, in the words of George Will, a conservative commentator in the United States, seek to "privatize profits and socialize risks." They do so by requiring that the government, on behalf of its SOE enter into a long-term contract with them. This contract often has automatic escalation clauses in it that allows it to raise rates for inflation, exchange rate changes, and possibly other matters. The contract may have a duration of as long as thirty years. In short, the private sector participant succeeds in insulating itself from risk, contractually ensuring that risk is transferred to the government. In other words, the PSP succeeds in protecting itself from the very thing that economic theory states allows it to make a profit: that it is taking a risk.

III. Tariff rates: the political hot potato

Are the rate levels reevaluated periodically by a regulator to determine if they are reasonable and in the public interest? Usually they are not. Why? The short answer is that there is a contract and therefore no clear role for a regulator exists. The reason there is a contract, in addition to the PSP investor desiring to minimize its risk, and the PSP investors may be loathe to submit itself to the decisions of a regulator that may not have much experience and whose decisions could be unpredictable, or outside of the domain of the contract itself.

The result: high-priced water for which the government signs a long term contract on behalf of the PSP investors customer…the state-owned water utility. Sometimes these contracts are take-or-pay arrangements, further obliging the SOE to pay for the water irrespective of whether it is taken and used.

These "upstream" costs will be reflected in the rates charged end-users for water. That, unto itself should argue for some regulatory intervention in the contract (preferably in advance of the solicitation for award) since these costs will translate into the prices paid by end users.

After some period of time the government figures out that in order to pay the private sector operator for all of its capital risks, the government may have to raise end-user rates significantly. It usually will not do so. The result is that the taxpayers (as opposed to ratepayers) end up subsidizing the purchase of water from this private sector project.

Why does all of this happen? I submit that the private sector's (legitimate) desire for profits coalesces with desire of senior government officials to see a Greenfield project take place. A physical water treatment plant built on the banks of river complete with a ribbon-cutting ceremony makes for great media. On the other hand, it is much less visual to slowly, steadily, increase the efficiency of the entire water utility.

After some period of time, though, the government usually determines that it has made a bad deal. Admittedly, studies have shown that people will pay more for an assured water supply. But: 1) there are limits; 2) the PSP is not supplying water to end-users; it is supplying water to the SOE utility. And, by the time the government figures out what has happened, a new government is in power and the responsible individuals at the various donor agencies or financial institutions have moved on.

So the government "backtracks." This then, allows the PSP investor and to cry foul and claim that a particular country has a hostile business climate. In fact, the government has simply come to its senses about the deal it never should have made.

Examples of this type of behavior abound in the world. In 2002, Thames Water had run a plant in China for 4 years before the government ruled that the agreed rate of return was too high. Thames was also involved in Indonesia's 1997 privatization, but consumer resistance and political unease held up rate increases. Suez was involved in the Buenos Aires contract. The debt was in dollars, the collections in pesos. The government did not allow it to raise rates to cover the exchange risk.

The private sector is not to blame in this mess; they are simply trying to make a profit and minimize their risks in doing so. Governments unfortunately do not think of the long-term implications when they seek to have these projects built.

IV. So, what is an answer? Regulatory oversight

Have the regulator approve the draft contract prior to solicitation (all bidders must comply with the regulator's role) and prior to a final award. The regulatory role of protecting the public interest includes recognizing that increased utility costs will result in higher end user prices. If the original contract is let by a bid and tender process it is wise to, involve the regulator at that stage, rather than leaving all up to a PSP Unit or Sectoral Ministry or Municipality who may not have the full capacity to oversee effectively all components of the contract. And, whatever the terms of the contract for PSP, they should include a periodic price review and resetting by the regulator.

Why does this process not happen more frequently? As stated above, the PSP Investors wants limited risk. Additionally it does not want to subject itself to regulatory scrutiny where regulatory capacity may be inadequate or where the role of an independent judiciary is scant. And, perhaps most importantly, regulatory capacity takes years to build-much longer than does a plant. It is, as stated above, also much less "visual."
Nevertheless, increased costs beget increased prices. A water treatment plant is simply an input into a water utility system. It is a cost, just as are the paper clips and staples bought for the utility's administrative offices. And all costs should be scrutinized for reasonableness. That is the job of a regulator.

Whether privately owned/operated or government-owned is really not the issue. The key issue is that many utility projects and contracts simply do not have effective regulatory (aka public interest) oversight of contracts ex ante in the process. The result is the government essentially absorbing the bulk of the risks and the potential benefits of private sector capital, management and technology are not realized. Worse consumers continue to be underserved and private investors, as well as governments, reconsider the merits of such long-term partnerships.

V. A Paradigm for reform and regulatory development

To address this issue, a series of steps can be taken promote more effective utility operations and management that could lead to the eventual privatization. This paradigm could work, albeit slowly. Nevertheless, it could have better and longer lasting effects on the public…and on the reputation of privatization:

1. Corporatize the utility. That is, separate it from the balance of government and keep its books and records distinct. At this stage private sector participation may take place in the form of management contracts or service delivery contracts on behalf of the utility with the goal to improve the efficiency and effectiveness of the utility.
2. Establish a regulator that will oversee these corporatized entities, even though they are still SOEs.
3. The regulator will help the utility gradually become more efficient.
4. At the same time the regulator will build its regulatory capacity.
5. As the utility improves its operations, a private sector operator will recognize that it can make a profit if it owned the utility. The private sector operator also observes that the regulator, having developed capacity over time seems fair and balanced in its approach to setting rates.
6. The country is then in a position to put the entire utility up for sale.
7. Any buyer will have to buy the entire utility, and submit itself to the regulator for rate relief.

Like selling a house, governments should take all necessary steps to improve the appearance and condition of a given utility and the outside forces that might affect it before trying to sell. When it does, however, the entire utility should be sold. The private sector buyer is then free to add capacity (i.e., it can now build a new water treatment plant as a part of the utility it owns) to sell more product and make more of a profit, subject to the periodic intervention of an experienced regulator.

The counter-argument to this approach is that it takes longer to get the private sector involved and that fewer people in the meantime will have access to the additional water that a new plant might bring. That is probably true. However, one might reasonably ask: At what cost? Moreover, under the admittedly slower "corporatize then privatize" approach, no one is worse off than previously. Bear in mind, under all scenarios, governments should do their utmost to maximize competition in order to bring the best value to customers and other stakeholders.

For further information on this article, you may contact the author at:
DJankofsky@aol.com

Copyright 2005© Institute for Public-Private Partnerships, Inc. All rights reserved