PPP International Best Practice and Regional Application Tegucigalpa, Honduras April , 2008 Sponsored by the Spanish Trust Fund

Service Standards, Tariffs and Subsidies Sabino Escobedo, TAG Financial Advisors Best Practices in PPP Session 4.1

Private Sector View Session 4.1 PPP Approach PPP Approach Day 1: Session 1.1 Overview of PPP Day 1:Session 1.2 Challenges: Latin America Day 1:Session 1.3 Considering Private Participation Day 1:Session 2.1 Planning the Process Day 1:Session 2.3 Involving Stakeholders Day 1:Session 3 Case Study: Transmission Day 2:Session 5 Case Studies: (1)Highways (2)Water & Sanitation (3) Ports Day 2 :Session 4.1 Standards, Tariffs, Subsidy, Financials Day 2 :Session 4.2 Selecting an Operator Day 1:Session 2.2 Regulation & Institutions Upstream Policy Readiness of Government Capacity Building For PPP Day 2 – Session 6 Readiness of Government Day 2- Session 4.1 Standards, Tariffs, Subsidies & Financials Day 2- Session 4.1 Standards, Tariffs, Subsidies & Financials

Session What will we cover? What are the issues to get effective private and public financing for Private Participation? Can we define realistic, affordable targets for Coverage and Quality of Service? Management Contract for Jordan Valley Authority, Irrigation Water Supply, may be the first of its kind. What are the key issues in establishing a mix of Tariff and Subsidy? What is the importance of Cost Recovery? How are Levels of Services, Cost, Tariffs and Subsidies interlinked?

Balancing Service Standards, Tariffs & Subsidies In this Module we describe an iterative process, to answer the question How can we afford better services under a new Arrangement? Set Tariffs & Subsidies Estimate Cost Specify Services YES Does it work? NO IMPLEMENT Design Finance START

Specifying Service Levels To start the process we need to choose preferred Levels of Service and define the technical and operational basis needed to reach these service levels. IMPLEMENT Set Tariffs & Subsidies Estimate Cost Specify Services YES Does it work? NO Design Finance START First we look at how service goals are set for the Utility under the proposed Private Participation Arrangement Two main issues to be defined: Coverage of service Quality of service

Service: Coverage targets There are three main ways of defining utility service coverage targets % age of roads with tertiary pipe New Connections or %age of households connected Geographic area to be served Served by direct connections, kiosks, standpipes etc, and public latrines or other improved services (for sanitation)

Buenos Aires: Service Levels Service Levels Precise geographic areas specified for expansion. Targeting poor areas. Five year expansion program. Objective to increase connected households from 49% to 79 % for water and from 21% to 40 % for sewerage. Tariff Subsidy FinanceTargeting poor required 15 percent of investment but only brought 1 percent more revenue. Structured to bring a lot of private finance near the start of the contract to bring early major new infrastructure (over $1.6 billion) ScopeWater and sewerage utility serving major conurbation, with plan for improving existing infrastructure and expansion of served connections. 1.6 million connections in first 8 years, half of those connected live under poverty line. ModelConcession

Cost of Service The Cost of Service has three elements Operating & Maintenance Expenses Depreciation Return on Capital Day to day expenses involved in providing services and keeping the system functioning, including labor, electricity, chemicals, maintenance etc.. The interest on debt and the return on equity. The weighted average cost (of debt and equity) is an appropriate measure of return on capital Reduction in value of the assets over time or the amount of money needed to be set aside to replace assets as they wear out

Estimating Cost of Services IMPLEMENT Set Tariffs & Subsidies Estimate Cost Specify Services YES Does it work? NO Design Finance START Once initial objectives have been set, Government should estimate the cost of providing the service.

Cost of Service When a Utility cannot cover its cost, service will suffer Estimating Cost of Service: Once initial objectives have been set, Government should estimate the cost of providing the service. Average costs are used as an effective basis. This is an important step, since it will be important to determine to what extent Cost Recovery can be achieved by the chosen Tariff level. The reasoning behind this assessment of the level of Cost Recovery is that : "When a Utility cannot cover its cost, service will suffer If you cut back on essential expenditure the services suffer. Similarly reduction in maintenance, renewal or expansion of the system may also increase the costs of operation in the medium term Cost estimating is difficult and technical, but need to look at three main elements: Operating & Maintenance Expenses Depreciation Return on Capital Essential to first have a clear idea of total costs, then you can separately decide whether the tariff should cover all of those costs, or whether tax payers should subsidize the service.

Cost recovery and tariff implications Can we afford to pay for better services? IMPLEMENT Set Tariffs & Subsidies Estimate Cost Specify Services YES Does it work? NO Design Finance START

To be viable: Tariffs + Subsidies = Total Cost of Service Service Quality Service Coverage COST OF SERVICE TARIFF INCOME Cost Recovery and Tariff INCENTIVES SUBSIDY

External Benefits Social Acceptability To be viable: Tariffs + Subsidies = Total Cost of Service Service Quality Service Coverage COST OF SERVICE TARIFF INCOME Cost Recovery and Tariff INCENTIVES SUBSIDY Willingness to Pay

Use of Subsidies If Cost of Service exceeds Tariff income, then a Subsidy will be needed IMPLEMENT Set Tariffs & Subsidies Estimate Cost Specify Services YES Does it work? NO Design Finance START

Types of subsidy Private Participation can involve suitable subsidy arrangements Who Subsidy paid To Where Subsidy comes From This Table illustrates some of the main categories of Subsidies. Subsidies can be categorized: Where the money comes from?: Customer Revenue Government Revenue Development Agency Grant or Loan with concessional element. (These are generally used to make structuring a subsidy fund easier, or for easing in a new tariff structure in the short term) Where subsidies are paid to and for what? This Table illustrates some of the main categories of Subsidies. Subsidies can be categorized: Where the money comes from?: Customer Revenue Government Revenue Development Agency Grant or Loan with concessional element. (These are generally used to make structuring a subsidy fund easier, or for easing in a new tariff structure in the short term) Where subsidies are paid to and for what?

Types of subsidy We will look at some specific Input and Output Subsidy forms….

Ensure that subsidies and the tariff level give the operator sufficient resources and a financial incentive to connect and serve poor households When many poor households are unconnected, prefer access or connection subsidy to consumption subsidies Ensure subsidies are targeted, transparent, and triggered by household demand Get enough information to tell whether a proposed tariff or subsidy will hurt or help poor households Because tariffs and subsidies have to be adjusted over time, work out how to incorporate concerns about the poor in decisions to adjust tariffs Targeting the poor The objective of targeting benefits to the poor needs careful design and implementation to be effective, and the following issues should be considered…..

Output Based Aid OBA

Balancing Service Standards, Tariffs & Subsidies This is an iterative process. Can we afford better services? IMPLEMENT Set Tariffs & Subsidies Estimate Cost Specify Services YES Does it work? NO Design Finance START

Develop options, looking for an acceptable trade-off between tariffs, services and subsidies Finalizing Tariff, Subsidy and Service Level INCENTIVES COST OF SERVICE TARIFF INCOME SUBSIDY 4. Now we have reached the point where we have to consider if we have reached a Balance between Costs and Tariffs. If the tariff/subsidy revenues are not sufficient then we can look at various alternative ways of adjusting our tariff/cost of service arrangements, for example: Adopt cost recovery tariffs for all customers Set Tariffs below cost for some customers and apply a subsidy Reduce costs (and thus necessary tariff levels) by reducing coverage and service levels Balancing the cost & tariff issues Once we are happy with the balance between Cost, Tariff and subsidy we can proceed to incorporate them into the design of the Private Participation Arrangement. Following our Process, we have: 1. Arrived at Cost of Service Following our Process, we have: 2. Looked at acceptable Tariff scales Finally we have: 3. Evaluated any necessary subsidies

What key issues should we include in the Private Participation Arrangement design? IMPLEMENT Set Tariffs & Subsidies Estimate Cost Specify Services YES Does it work? NO Design Finance START Design & Implement: Design Issues

Design Issues The Arrangement has to cover various issues: –Cost of Service = Management Costs + Operations + Capital Investment –Operators fee in a Management Contract may be financed by others, and payment linked to outputs. –Investment elements in lease and management contracts can be partially financed by governments, investors and operators –Concession models have been developed that can include subsidy, such as using Output Based Aid, retaining Government control of how the subsidy is used PP is possible even if Tariffs dont cover costs Example: Amman Management Contract Cost Recovery for O&M

Design & Implement: Financing Implications How to involve private and public finance? IMPLEMENT Set Tariffs & Subsidies Estimate Cost Specify Services YES Does it work? NO Design Finance START

Private Finance What might be the potential sources of funding for a prvately financed project?

Private Finance What issues to consider when involving Private Finance? The way that the arrangement is designed, and the security offered against risks will affect the perception of operators, investors and lenders about the level of risks involved and ultimately the viability and cost of the project. This in turn will affect the level of investment cost, and in this in turn affects the cost of provision of service under the Private Participation arrangement [Risk allocation is an important subject dealt with in Module 6 ] - The cost recovery potential and tariff stability are issues that will have a direct bearing on this. Need to consider the views of potential lenders at the arrangement design and bid stages to ensure that a viable project can be put out to bid, and that investors will be interested to be involved The amount of investment required needs to be considered, to ensure that debt levels and risk are viable. The phasing and type of investment can be considered in order to rapidly increase cash flow, allow the operator to reduce costs and free up cash later for more investment.

A Development Agency Finance Arrangement One possible model for securing effective disbursement This figure illustrates one possible structure for incorporating government and development-agency financing in an arrangement, showing a public investment or subsidy fund established by Government and a development agency. It is not the only model, but gives some ideas of one approach. This incorporates two options: Investment lending : Finance from the public fund as a loan to the operator – to invest in infrastructure Payment per output: The subsidy fund would make payment when the operator provides specified services:

A Development Agency Finance Arrangement One possible model for securing effective disbursement This figure illustrates one possible structure for incorporating government and development-agency financing in an arrangement, showing a public investment or subsidy fund established by Government and a development agency. It is not the only model, but gives some ideas of one approach. This incorporates two options: Investment lending : Finance from the public fund as a loan to the operator – to invest in infrastructure Payment per output: The subsidy fund would make payment when the operator provides specified services: Example: Major investments needed to replace decaying pipe networks could be an unacceptable risk for the private operator if he had to provide the necessary investment himself. Example: Major investments needed to replace decaying pipe networks could be an unacceptable risk for the private operator if he had to provide the necessary investment himself. Example: The operator makes new connections as part of his contract. For those in low income areas he receives a specific fee – say, for example, $150 per connection Example: The operator makes new connections as part of his contract. For those in low income areas he receives a specific fee – say, for example, $150 per connection

In this Module we have considered the elements and process of establishing affordable Levels of Service, and some of the design and financing implications…. Set Tariffs & Subsidies Estimate Cost Specify Services YES Does it work? NO IMPLEMENT Design Finance START Reviewing Session 4.1

Checklist: Session 4.1 ……..and the process is detailed in this Checklist

Service Standards, Tariffs and Subsidies Sabino Escobedo, TAG Financial Advisors Best Practices in PPP Session 4.1 THANK YOU!

More Information: Session 4.1

Contacts For comments or further details contact: Junglim Richard Sabino Escobedo David Stiggers

Service Standards, Tariffs and Subsidies Sabino Escobedo, TAG Financial Advisors Best Practices in PPP Session 4.1 THANK YOU!