TARIFF ARRANGEMENTS FOR WATER AND WASTEWATER UNDER PRIVATE SECTOR PARTICIPATION

By Yogita U. Mumssen

About the Author...

Yogita U. Mumssen provides economic advice on infrastructure regulation, restructuring, competition, and private sector participation to public and private utilities, governments, regulators and international development institutions. Ms. Mumssen has advised on the development of best-practice institutional and regulatory frameworks for the water and electricity sectors in Europe, Africa, Latin America, the Caribbean and Asia, with particular emphasis on sector reform and the introduction of PSP. She has provided training to nascent regulators from around the world. Prior to her work as an independent consultant with IP3, Ms. Mumssen worked with Stone & Webster Management Consultants, National Economic Research Associates (NERA) and Pricewaterhouse Coopers. She has a BA in Economics from Brown University and an M.Sc. in Economics from the London School of Economics.

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As with most other commodities, water prices provide a signal to operators about how much water to supply. They provide a signal to consumers about how much to consume. In order to provide these signals accurately, tariffs should embody the following key pricing tenets:

• allocative efficiency, whereby customer prices are kept as close as possible to the costs incurred of serving the customers;
• productive efficiency, whereby goods and services are produced as cheaply as possible at required standards;
• price sensitivity, whereby operators have the incentive to expand supply if demanded; and
• financial sustainability, whereby revenues are adequate to cover costs to ensure the continued financial viability of an efficient service provider

Of course, tariff levels and tariff policy will also be driven by government objectives for the sector. Some common objectives for tariff reform in developing countries are:

• attract private capital into the sector to increase capacity and rehabilitate the system;
• expand services into poor, peri-urban and rural areas;
• make water affordable for vulnerable groups;
• provide incentives to the operator for improved service and quality; and
• make tariff calculation and regulation simple and easy to understand.

The different pricing tenets and objectives for tariff reform are in many ways related, and sometimes exert pressures in opposing directions. For example, allocative efficiency requires subsidies to be minimized, while affordability for vulnerable groups may require large subsidies.

Average Costs versus Marginal Costs

At the heart of the question regarding how to set tariffs in a regulated industry so that prices send appropriate signals to consumers and suppliers is the debate over whether tariffs should be based on average costs or marginal costs. Average costs are calculated by dividing total accounting costs related to supply by total water produced. Marginal costs are the costs incurred by a water supplier for the "last" unit of water supplied.

In general microeconomic theory, pricing according to marginal costs is seen as more efficient than pricing according to average costs. However, for network industries such as water, often the marginal cost of supply is lower than the average cost, and therefore average cost pricing may be more preferable for total cost-recovery purposes.

Much time has been expended on considering how best to depart from marginal cost pricing in order to cover the large fixed costs incurred by service providers in the water industry, without losing the efficiency gains of marginal cost pricing relative to average cost pricing. Long-run marginal cost (LRMC) pricing, which takes into account the costs experienced by the firm as it follows its optimal expansion path, is a possible solution. Although attempts are being made to move towards LRMC pricing, most water and wastewater tariffs are based on average costs, even in developed countries where LRMC research has been extensive.

Key Components of Tariff Formulae

Regardless of what form of tariff regulation is in place, the starting point of establishing the appropriate tariff level for the water and wastewater sector is cost recovery. Thus the key components of tariff formulae are the different types of costs incurred by the provider. These costs are briefly described below.

• Operating costs, often called operating and maintenance (O&M) expenses, are the costs of operating the business and performing routine maintenance of the assets in order to produce and distribute water and/or collect wastewater.
• Capital costs, include the costs of building assets used for water abstraction and production and wastewater collection, distribution, and in some cases costs for buildings and grounds. The capital costs in a tariff formula are comprised of the return on and of these capital expenditures. The rate of return should cover the cost of debt and equity financing, or, the weighted average cost of capital (WACC) of the project. Determination of the WACC is one of the most contentious issues in regulation.
• Overhead and administrative costs do not directly relate to production and distribution of water or collection of wastewater. They include, for example, head office expenses, certain taxes, and special levies imposed by the government. Note that these definitions may vary and are interchangeable. For example, taxes may be considered part of operating costs.

In addition to the key components discussed above, tariff formulae will often include additional adjustment components. For example, all operating costs may be set at an initial cost-recovering level for the first year of a PSP contract, and may be adjusted for following years in line with an index.

What is Regulation? Why Have it?

Regulation is the tool which is used to monitor and enforce arrangements made between the public and private sector in the provision of certain services, the framework under which the relationship of the parties evolves given changing circumstances, and the avenue through which conflicts are resolved. Regulation can also apply between the public sector and para-statals, but this memo focuses on the relationship between the public sector regulator and private sector regulated entity, and the regulation of water and wastewater tariffs.

Because the water and wastewater sector is characterized by long-lived sunk investments with relatively low short-run marginal costs, the sector is often considered a natural monopoly. Therefore, governments do not often seek large-scale competition within the sector (although they may seek competition for the sector). However, regulation is required to ensure that the monopoly service provider does not abuse its power by charging too high prices or providing low quality service. This is especially important because demand for water is inelastic.

On the other hand, private companies face high risks by investing in the water sector. The nature of the assets means that companies are exposed to potential government intervention. Sound regulation can help reduce unnecessary risks faced by investors.

Institutional and Legislative Framework Requirements

Tariff regulation can be administered through a well-developed framework, or, regulation can be administered through a contract, monitored by an independent regulator and/or arbitrator. In most developed countries and increasingly in developing countries, governments have attempted to establish a sound legal and institutional framework for the regulation of network industries such as water and wastewater. Where there is limited regulatory capacity, regulation by contract may be sufficient. In this case, it is best when a well-qualified and independent third party is responsible for monitoring tariff adjustments and is first point of call for tariff disputes. Unfortunately, in many developing countries, the contractor itself is the sole regulator/monitor of the contract.

Because contracts cannot account for all eventual circumstances, establishing a broader regulatory framework within which the contract operates is preferable. In this way, unanticipated events can be handled in a consistent, transparent and predictable manner. However, one needs to be realistic about the extent to which a strong legal and institutional framework can be developed in countries with limited regulatory capacity.

It is interesting to note that different forms of PSP arrangements have tended to rely on different regulatory arrangements. Where governments have fully divested or established concessions and leases, they have attempted to establish more comprehensive regulatory frameworks. With BOT projects and management contracts, on the other hand, governments have tended to rely on contract monitoring with little if any "regulatory" intervention. There is some merit in this practice, particularly in the case of simple and short-lived management and service contracts. But for long-lived BOT projects, it may be more prudent to establish a sound framework under which a regulator can consistently and transparently deal with unforeseen events.

Rate Adjustment Mechanisms

The form of tariff regulation adopted for a sector or project will be partly dependent on the regulatory capacity of the sector. Some of the most common forms of rate adjustment methodologies are briefly described below.

Rate of Return (ROR) regulation. Sometimes known as "Cost-of-Service" or "Cost Plus" regulation, ROR has been the dominant perspective in tariff regulation in the USA. Under this methodology, a regulated company is allowed to charge tariffs that cover its O&M costs and give it a fair rate of return on and of its capital. If the company suffers relevant changes in its costs, it can ask the regulator to re-set tariffs. Rate adjustments can be made frequently, even annually in some cases. ROR regulation is allocatively efficient, and prices on average are close to costs, giving private operators the incentive to expand supply and improve quality. Financial sustainability of the operator is likely to be high. Disadvantages of ROR regulation mainly include possible over-investment in capacity and quality of service (often called "gold-plating") and the lack of strong incentives for improving efficiency.

Price cap regulation. Under pure price cap regulation, most notably used in the UK and some Latin American countries, a regulator defines a maximum (average) price that can be charged by the operator based on an optimal level of service provision and efficiency expectations, without taking into account the exact operational capabilities of the operator. The operator charges the allowed price, on a weighted average basis. Not all costs incurred by the operator will be passed through to customers in the future, but usually only "prudently incurred costs" or those costs not in the operator's control. Price cap regulation therefore promotes productive efficiency. In reality, price cap and ROR regulation are not too different. For example, because price caps should ensure the financial viability of an efficient company, regulators do often de facto require an understanding of the operator's costs, including the opportunity cost of debt and equity. Furthermore, to ensure that the incentive to lower costs does not result in poor quality service, some regulation of service quality is required.

Indexation Formulae and "Trigger Events". Most tariff schemes in PSP arrangements try to define to some extent the criteria for price adjustments. At its simplest form, initial allowed tariff levels will be adjusted in line with inflation. In other cases, prices may be disaggregated into various cost elements and each cost element will be adjusted with indices that reflect changes in those costs.

The regulator and/or transaction advisor determines which costs to index based on the desired risk allocation within the PSP transaction. In pure ROR regulation, essentially all costs are indexed and passed through to the customer, and the risk for the operator is low. Pure price cap regulation is at the other extreme. Usually, tariff adjustment mechanisms in PSP schemes fall somewhere in between. Another important question is how often should the cost components be adjusted -monthly? Annually? In addition to indexation formulae, tariff schemes should outline the "trigger events" that will result in an automatic tariff adjustment. Trigger events are usually events that are not within the private operator's control, and which would have a serious impact on the operator's revenue or cost stream.

There are many policy decisions that need to be made by the government and discussed with the regulator/transaction advisor when introducing PSP to the water and wastewater sector. The choice of tariff formula, rate level and method of regulation are probably the most critical. Because of the variegated interests and objectives related to sector performance and reform, these are also probably the most difficult and contentious issues that must be addressed.