Decentralization, Municipal Finance, and Public-Private Partnership Modeling

By Katia Karpova
Regional Coordinator,
Europe and the NIS
Institute for Public-Private Partnerships

About the Author...

Katia Karpova is the Regional Coordinator for Central and Eastern Europe for IP3. She is a frequent trainer in IP3 courses on topics such as financial analysis, tariff structuring, and financial modeling for private sector investment in infrastructure projects.

Introduction

Investment in infrastructure services continues to increase as countries worldwide seek to utilize more and better infrastructure capacity as a catalyst for economic growth, trade, and investment in a cross-range of sectors. This trend, coupled with the increasingly popular strategy to "decentralize" the financing and management responsibilities of such investment from central to local authorities is causing governments everywhere to rethink their basic tenants of infrastructure service delivery. This, in turn, has created a number of new challenges and questions for governments, donors, private business, and citizens alike to address:

• What services should continue to be the responsibility of the central government and what services should be shifted to local government portfolios?
• What central government policies tend to promote better management and accountability on the local level?
• How much national regulation verses local autonomy is necessary?
• What "credit enhancement" techniques can local governments use to increase borrowing capacity and improve overall fiscal planning and management?
• When should a municipality consider public-private partnership (PPP's) options versus conventional public borrowing?
• What types of public-private partnerships are suitable for municipal services?
• How does one balance the need for cost recovery in service delivery while striving to ensure that services remain affordable?

This article reviews briefly the key issues of decentralization and its impact on municipal financing of infrastructure services via conventional borrowing or PPP models. Two country case studies, New Zealand and South Africa are featured to illustrate useful lessons for policy-makers.

Decentralization

The rationale behind decentralization is to give autonomy to local governments and achieve smaller, more responsible and responsive governments that cater to the needs of local constituents. Many countries are undergoing massive decentralization programs, some with significant successes. As a result of decentralization, public services tend to match the demands of the population, governments become more accountable to their voters and strive to provide better service, and consumers tend to be more willing to pay for the services they receive.¹ Additionally, fiscal decentralization is a viable mechanism to achieve a better matching of municipal revenues with expenses and investment decisions based on the local needs and population preferences. Many argue that for administrative reasons local governments may very well be in a better position to take advantage of greater local fiscal capacity because of their greater familiarity with the local tax base.²

With the newly acquired autonomy, local governments now face the challenge of making capital-intensive infrastructure investment decisions that were previously reserved for the national government. The key issues here involve making prudent management and finance decisions to bridge the gap between local investment needs and the usually insufficient local revenues. The two most obvious choices explored by municipalities are a) sub-sovereign borrowing through traditional debt channels and b) involving the private sector to finance, manage, and/or operate a municipal service.

Conventional Borrowing versus Public-Private Partnerships

Ultimately the choice between accessing the debt markets and engaging in a public-private partnership will depend on whether the municipality is seeking private sector's management practices, ownership transfer, or just the capital investment. When borrowing either through loans or issuance of municipal bonds, local governments retain the managerial function, often without adequate capacity, however, to do so. Additionally, borrowing is in effect not an additional source of revenue, like private capital, but rather the action of using future revenue sources for today's needs. To borrow effectively and on acceptable terms, municipalities need to implement measures to enhance creditworthiness and improve the financial viability of their operations, with the ultimate goal being borrowing at the best possible rates and tenor.

On the other hand, a variety of public-private partnership techniques enable municipalities to match the specific needs of the project with the appropriate PPP option, i.e. management contracts, service contracts, leasing, or a BOT arrangements for example, and allocate risks more efficiently. In many instances, municipalities worldwide are gravitating towards a solution that involves both debt financing mechanisms and PPP solutions- the key is finding the right combination of both to address the wide range of municipal service delivery needs. The cases of New Zealand and South Africa illustrate the use of a unique decision-making tool to help make the choice between borrowing initiatives and public-private partnerships.

New Zealand

As a result of 1989 decentralization reforms, New Zealand went from 675 municipalities to 86. These reform were founded on three key principles:

• Transparency - open access to information about how the government works;
• Accountability - decision makers accepting responsibility for their actions; and
• Contestability - use of competition to achieve value for money.

The reforms envisaged separation of policy-setting functions from operations and extensive community consultation efforts. The key distinctive feature of the reform was the decision to adopt the rationale for differentiating public and private good municipal services and the resulting directive to fund these services from taxes or via user charges, respectively. In effect, the municipality would determine the extent to which the service is a "public" or a "private" good and would mobilize resources to finance it appropriately.

The overall underlying philosophy of the New Zealand reform process was to "blend best business management with the best of decision-making." Its neighbor, Australia, offers another success story from having introduced benchmarking of service delivery costs for municipal services, which proved extremely effective during this country's municipal reforms.

South Africa

South Africa accomplished significant success in decentralizing central government functions and empowering local authorities throughout the country. South Africa created a system of "wall-to-wall" municipalities through amalgamation, or the process of uniting black and white areas to enable redistribution of revenues. Amalgamation resulted in 843 municipalities merging into 284 by December 2000. As a result of amalgamation, even unpopulated areas belong to some municipality. This provides a greater revenue base now "shared" by financially stable cities with surrounding townships. In South Africa, municipalities are responsible for the provision of water, sanitation, electricity, solid waste, and "municipal health" services. The municipalities are able to generate up to 92% of their revenues internally, from tariffs (32%), property taxes (21%), and other levies.

Effective decentralization strategy grants South African municipalities, through the Constitution, the right to impose property taxes, surcharges on municipal services, and set tariffs, while national legislation reserves the right to regulate rates and surcharges. Intergovernmental transfers to local authorities are based on unconditional equitable share, calculated through the poverty-based formula, which in 2003-2004 will total 7.18 Billion Rand ($900 million). The equitable share is basically a central government grant to "equate" revenues from municipality to municipality.

Since decentralization, South African municipalities have been successful in raising debt and engaging in public-private partnership transactions to meet the needs of their populations. Key factors contributing to the success in South Africa are a sound legal and regulatory framework granting autonomy to municipalities, well-designed and marketed city development plans, strong poverty targeting strategies, and stable institutional arrangements to support municipal public-private partnerships.

Tariff Structuring and PPP Models

When using public-private partnerships in municipal service provision, an important emphasis should be made on the ability of the private sector to recover its costs and attain the required return on investment. The rate making process thus becomes a significant consideration involving key decisions about the cross subsidization policies, options for providing basic needs services for free, ability and willingness to pay and collect tariffs, the regulatory technique used, as well as a variety of political constraints.

To remain a stable resource and partner to the municipality, the private sector must recover its return through a cost-recoverable tariff. This tariff, however, should not necessarily be passed on to the consumer in the form of "straight up" user charges. Municipalities should develop targeted subsidy programs and pro-poor strategies to ensure that low-income populations have access to basic needs services. In effect, a municipality's only responsibility should be to put pressure on the private sector to cut costs to arrive to the lowest possible tariff through effective regulation, and design and administer social support strategies for the poor.

Countries worldwide deal with "bridging this gap" in a variety of ways. South Africa, for example, provides minimal basic human services for free. This includes exemption of property taxes on property valued at 50,000 Rand ($6,250) and below, free electricity for the first 20kWh, and free water for the first 6 kl. As a result, the city of Cape Town, for example, has achieved a 95% collection rate and a greater credit rating.

Chile, on the other hand, implemented a targeted subsidy program for the poor. The water tariffs were raised to the true economic cost with the central government covering 25-85% of a household's bill for the first 20 m3 per month through a means-tested subsidy program. To be eligible for the subsidy, the individual consumers had to undergo interviews and complete paperwork to determine their needs and ability to pay for the subsistence level of consumption. This approach resulted in significant savings for the government and complete service coverage for those in need and is a solid model to emulate in countries where the costs of subsidy are not sustainable and the desire for improved service delivery is high.

Conclusion: Some Practical Tips from Southern Africa Municipal Leaders

Recently, officials from a number of municipalities and other agencies from Zimbabwe, South Africa, Uganda, Namibia, Mozambique, Zambia, Ghana, and Nigeria, gathered in Cape Town, South Africa to attend a training course on "Local Government Finance and Management." The officials identified some practical solutions and strategic directions for today's municipal managers and other stakeholders that are related to the lessons discussed in this article. The summary of the conclusions discussed in Cape Town included:

1. For a municipality to be creditworthy, the entire system must be stable. In many countries and as a decentralization policy, central governments expect municipalities to provide quality services but often fail to fulfill their commitment on grants or transfers to the municipality. Hence there should be a continuous effort to ensure that the system is healthy, with predictable revenues, efficient and targeted legal and regulatory framework, stable boundaries and policies. Achieving stable revenues is key to a creditworthy municipality capable of further increasing its borrowing capacity and acquiring debt on favorable terms. The first step in achieving revenue stability for municipalities should be their ratemaking independence.
2. Municipalities must focus on developing viable marketing, strategic, and financing plans to promote the city, develop awareness, attract investment, and encourage tourism and commerce. These plans should be actively marketed to the investment community and financial institutions globally. "Excellence" in marketing a city globally is strongly linked to excellence in business development locally. The key is to ensure that communities and stakeholder groups play an active role in the planning process.
3. Municipalities should strive to operate as a business and understand that good corporate governance improves the municipality's credit rating. It is also critical to develop viable community outreach programs to educate consumers on the need to provide services using sound business practices.
4. When implementing non-equity public-private partnerships options (such as management contracts or lease arrangements), it is critical to ensure that sufficient capacity is developed within the municipality to take over the project after the private sector contract is completed (if not competed again).
5. Many municipalities face the spiraling problem of "low quality of service leads to low tariff rate collections which in turn leads to further deterioration in service delivery" and the inability of the municipality to maintain facilities and ensure service reliability. In order to "bridge the gap," both ends of the problem need to be addressed - a continuous service quality control coupled with strategies to improve collection. It is widely known that the culture of non-payment is often related to the culture of non-collection.
6. In targeting this most significant problem facing municipalities, some Southern African countries experimented with the following practices to improve collection of property taxes and user charges for municipal services:

1. Create payment incentives and publicize them systematically
2. Build in a surcharge on spread payments (e.g. 3 installments)
3. Aim to develop a system of better collection enforcement, such as through warrantees or an effective court system
4. Include the summary of policy in the monthly bill
5. Decentralize collection functions
6. Engage community based organizations (CBOs) in communicating policies and creating liaison with collection officers
7. Aim to improve the reliability and quality of services you provide

7. Finally, municipalities should explore best practices and international experience of models and proven techniques to municipal finance and management, and strive to build capacity on the local level to adopt these best practices to their particular municipalities.

¹ Fiscal Decentralization: Lessons for South Africa, by Roy Bahl

² Ibid.