Philippine economy

The price of water: Areas of controversy

Lorna Paredes, Daniel Vincent Borja
The MWSS will announce new water rates on Sept. 12; How does the regulator compute a 'fair' rate of return for the capital Manila Water and Maynilad invested?

WATER RATES. The water regulator will decide on September 12 how it will adjust water rates in Metro Manila. Photo by AFP

MANILA, Philippines – Since the provision of water services in Metro Manila was privatized, the price of water is periodically set every 5 years using a financial formula, which allows the private concessionaires to recover the investment and operating expenses in running the water service, and earn a fair return on their investment.

This “fair” rate of return on capital invested in the water business is called the “appropriate discount rate” or ADR. The level of the ADR is determined by the cost of raising the capital needed for the business, which consists of equity and debt financing.

READ: MWSS, water firms and taxes: Big trouble, little impact

Since these costs (interest rates on borrowed money) change over time, there is a need to periodically adjust the ADR to the prevailing level of the cost of capital in a given time period.

This, plus the fact that the level of expenses for operations and the capital investments to maintain or expand service capacity, also change over time, is the reason that the price the concessionaires are allowed to charge for water, have to be reset every 5 years under the Concession Agreement.

The on-going negotiations between the Metropolitan Waterworks and Sewerage System (MWSS) and the two private concessionaires is a “rate rebasing exercise” to determine the ADR and the basic price to be charged for water by each of the two concessionaires in the coming 5-year period.

The principal controversies surrounding the ongoing rate rebasing exercise of the regulator and the concessionaires are the following:

1. Are the level of expenses and investments claimed by the concessionaires really justified?

Since the price of water must allow the concessionaires to recover the cost and investments in operating the business, it follows that these costs and investments should be “prudent” and “efficient” if the public is not to be burdened with high prices for water.

There are however many outlays possibly claimed by the concessionaires which should be questioned by the regulators. Below are some of the most important of these:

a. Exclusion of Financing Cash Flows

Capitalized interest included in the cost of long-term assets, guarantee fees and other financing costs may have been included in the computation of the Historical and Future Cash Flows and should be excluded and disallowed by the Regulatory Office.

b. Cash Flows outside the Geographic Scope of the Concession Agreement

Recently, the concessionaires have established service concessions outside the geographic area — like other regions, countries, etc — of the MWSS.

The Regulatory Office must also ensure that cash flows related to these other concessions are not included in the Rate Rebasing computations. Cash flows related to the other consulting projects of the concessionaires should also be excluded.

c. Prudent and Efficient Cash Flows

The Regulatory Office may consider expenditures as not “efficiently and prudently incurred” if actual cost exceeds bid levels or a benchmark whose value is based on appropriate cost drivers such as Billed Water Volume (BWV), Non-Revenue Water (NRW), number of connections, etc.

The Regulatory Office can also compare the performance of both concessionaires to determine efficiency.

Related party transactions are also scrutinized to check whether these are concluded at arm’s length. This evaluation is done also by looking at Key Performance Indicators (KPIs) and Business Efficiency Measures (BEMs).

d. Income Taxes

Much has been said regarding the inclusion of income taxes as part of the allowed expenditures. If the ADR, the required and allowable rate of return, is computed net of tax then it is appropriate to compute the relevant Cash Flows on an after-tax basis as well.

This argument qualifies Income Taxes as an allowable operating expenditure. Likewise, using an ADR computed gross of tax necessitate the use of before-tax Cash Flows. Either way, the exercise would result in the same rebased tariff.

e. Estimates of Future Expenditures

The MWSS Regulatory Office must ensure that the concessionaires do not overestimate their planned operating and capital expenditures since these will result in a higher water tariff for the current period and current consumers will suffer from these inaccurate estimates.

Although these are adjusted in the next rebasing period when the actual cash flows are determined, only future consumers will benefit from this adjustment. Unattained estimates of future expenditures may be a reason for penalties and disallowances since these may be considered as unmet targets and obligations.

2. Is the rate of return allowed the concessionaires (ADR) too high?

The ADR is the rate of return which allows the concessionaires not only to recoup their expenses and investments in operating the utility but also to earn fair return on their investment.

What is a fair return on investment is grounded on the notion that private capital will not be put in a risky business unless it is allowed to earn more than what can be earned from safe or riskless investments.

That is to say, the return on the investment in the water utility, a risky business, must provide for a positive “risk premium” over the return on riskless investments.

The application of this notion in practice, that is, the determination of what is the risk free rate and what is the appropriate risk premium, is neither easy nor straightforward however. The yield of a government-issued security is usually used as the proxy for the risk free rate.

It has been observed that in past rebasing exercises for water, and for other utilities, the bases for setting the risk free rate show no consistency across different rate rebasing periods and across regulated industries. Should the spot rate be used or a historical average rate?

The problem is compounded by other issues such as the choice of the government security, the length of the maturities of the securities and the averaging period, if historical rates are used. The pitfalls of using historical rates as a proxy for prospective rates is nowhere more evident than in the last two years when the yields on government securities fell to their historic lows.

Every method of estimating future yields on government securities can prove to be inaccurate. But there should perhaps be greater coordination and consistency among government agencies in the method for setting the risk free rate, to avoid public suspicion that the regulator is too accommodating to the entities it regulates.

Determining the level of the “risk premium” above the risk free rate is another major bone of contention. The risk premium should be higher the higher is the riskiness of the business and vice versa.

Many argue that the risk premium allowed the water concessionaires are too high since water is a stable and non-cyclical business. Moreover, the concessionaires are insulated from many of the other major business risks, like fluctuations in the exchange rate and inflation.

The concessionaires, on the other hand, may argue that, unlike unregulated businesses, they continuously face “regulatory risks.” The validity of the latter argument is questionable since the variables used for estimating the risk premium for the water business are market-based.

Markets should and do already reflect the risks inherent in regulated industries In the previous two rebasing exercises, the ADRs allowed by the regulator were as follows: 

2002 and 2007 ADRs

2002 2007
Gearing ratio 60/40 50/50
Real risk-free rate 7.4% 6.3%
Debt premium 1% 1.5%
Real cost of debt 8.4% 7.8%
Real cost of debt, net of tax  8.4% (0% tax rate)  5.38% (31% tax rate)
Equity beta 1 1
Market risk premium 6% 7%
Real cost of equity 13.4% 13.3%
Weighted average cost of capital (ADR used)  10.4% 9.3%

The most recent ADR is currently being deliberated by the MWSS and the two water concessionaires.

In the current rebasing exercise, Manila Water Company, Inc. (MWCI) is asking an increase of P5.83 per cubic meter and Maynilad Water Services, Inc. (MWSI) is seeking a P 8.58 per cubic meter increase in the price of water.

Does this mean that they are arguing for a higher ADR than the previous years? If so, what could be the basis for such given that the risk free rate must surely be lower now (compared to 7.4% and 6.3% in 2002 and 2007), and given that concessionaires’ experience in the business over the past decades must have already removed many of the uncertainties in the business which they initially faced thus lowering the riskiness of operating the water utility going forward?

Surely, ADR should be lower than 9.3% as determined in 2007. Are the proposed rate hikes due to significant increases in operating and capital expenditures? If so, did these translate to a wider coverage and improved services to consumers?

Are forecasted expenditures based on the level of expenditures needed to accomplish the targets and obligations of the concessionaire? Or are these excessive?

These are the questions the regulators need to address in order to ensure that the concessionaires charge a fair price for the consumption of water.

Addressing these issues ensures that the process of rate-making is all the more consistent with the goal of privatization that is to provide a more efficient and better service to the consumer. –

This was presented at the forum on Pricing in Regulated Industries; Water, Power and Telecom, sponsored by the U.P. Cesar E.A. Virata School of Business and the Development Center for Finance (DCF), on July 19, 2013 at the University of the Philippines-Diliman.

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