Economic Regulation of

PPP contract
in the water sector
Case study
Maria Salvetti
 Natural Monopoly Characteristics

Natural monopoly considered as a market failure

➢ How to organize natural monopolies market/companies to gain advantages of
production by a single firm (economies of scale) while minimizing the
disadvantages resulting from non-competitive market?
➢ Potential conflict between cost-efficiency and competition
More competition = more cost-efficiency but loss of economies of scale

Public intervention is required:

➢ on the ground of economic justifications
➢ on the ground of social/political justifications.
 Why regulate NM?
Monopoly price dilemma:
- Monopoly price is not efficient as it is set higher than the marginal cost which
leads to abstraction of monopoly rent
- Forcing the natural monopoly to sell at efficient price (i.e. marginal cost) leads to
negative profits (Cm<Ca)

Demand (water sold)

Avoid abstraction of Price
monopoly rent and Mean cost
allocative inefficiency Margin
al cost
Quantity (water volume, thousands
m3)

→ Public intervention is required to address this market failure situation and help
settle this pricing dilemma…
 Why regulate NM?

Other reasons justifying NM regulation

X inefficiency: internal efficiency, cost minimization.

In a competitive environment (pressure from competitors), incentive to reduce costs
to obtain higher profits. In a monopoly situation, lack of incentive.

Technical progress: no incentive to promote technical change and invest in R&D.

Due to its protected position, monopoly would not fear that a rival will promote
products and production methods and would therefore not be driven to innovation.
 Alternatives to Regulation

Competition for the market:

➢ Create competition between firms for the right of exclusive supply over a
limited period, namely a franchise solution (Demsetz).
➢ Such competition for the market (i.e., the right to be the natural monopolist)
may be an adequate substitute under some circumstances, where competition is
not possible within the market.
➢ Monopoly franchises could be auctioned off to the bidder offering the most
attractive terms.

Limits: advantages (experience, knowledge, reputation…) to the incumbent

compared to the outsider bidder
 Economic regulation targets
• Contract regulation: price & performance
– Set a price to avoid monopoly rent
– Set a level of performance/quality required to
avoid inefficiency

• Issues: asymmetry & capture of information

 Scope of regulation
Natural
Economic regulation
monopoly
Tariffs and service quality
Social
Competition regulation
Consumers protection
Politics

Information a
Health regulation
asymmetries
Drinkable water
Sanitation

Externalities Environmental regulation

Resource preservation
Discharge regulation
 Objectives of economic regulation
Balance interests: policy decision-makers, regulated
utilities, consumers
Create similar incentives as in the competitive market

Through regulatory framework

 Rules stated in laws, decrees and contracts
 Implementation processes of rules and regulations
 Credible, competent and independent institutions

Through regulatory tools

 Sticks (norms, standards, penalities, etc…)
 Carotts (benchmarking, tariff regimes based on
incentives, etc…)
 Market Failures
Remuneration
of shareholders

• Does not seek profit

Invest Operate Invoice • Seeks rent

• Insufficient • Low quality (losses) • Insufficient tariff (does not

maintenance cover costs)
• Inadequate customer
• Negative service • Tariff too expensive (not
environmental impact affordable)
• Focus on rich consumers
• Low access to service • Subsidies not properly
shared among customers

2 instruments: regulation of tariffs and quality

Price Regulation
Cost-based, price-based,
revenue-based tariffs and
additional methodologies
 Regulation by Agency
Regulating prices: cost-based or price based formula?

Difficulty with monopoly pricing results from:

→ problem of regulators not having access to good
information, regarding demand and best practice cost
conditions (Bradburd 1992).
→ designing a system of price controls that gives a strong
incentive for the regulated firm to invest more and to
improve its efficiency.
 Regulation
Regulating prices: cost-based or price based formula?
3 basic issues are involved:
1) the rate level issue—making sure that the total earnings of
the firm are appropriately related to the costs;
2) the rate structure issue—the determination of the
proportion of earnings between different customers;
3) the quality issue, to ensure that price controls do not
create incentives to reduce the quality of products and
services.
 Price regulation
Regulating the price: 2 broad types of methodologies

1) “cost-plus-fair rate of return” regulation method (cost based)

Tariff is calculated to cover the regulated firms’ operating costs, plus a
rate of return on the investment.
Prices are adjusted to keep the company’s rate of return on capital at a
constant level.
If the company’s rate of return falls below that level, the regulator allows
prices to rise.
Used in the USA & transferred to other countries (ex:
telecommunications sector in Philippines)
Revenues – Opex: net profit
RoR = (Revenues – Opex)/K ≤ x%
K: capex or initial asset base (stock of capital)
price ≤ Opex + (x%*K)/volume
x%: limit set by regulator
 Price regulation
Regulating the price: 2 broad types of methodologies
Pt = (1+ RPIt – X)*Pt-1
2) “price cap” regulation method (price based)
Prices rise according to “RPI-X” formula: tariff increases by the increase
in the retail price index adjusted by efficiency factor “X” to account for
expected productivity gains & other changes.
Company has incentive to lower costs, since it keeps the resulting
profits, at least for a designated period.
When tariffs are revised, a share of productivity gains can be passed on
to consumers.

It emerged during privatization of UK utilities in mid-1980s, also used in

countries such as Argentina, Brazil & Chile.
 Price regulation
Additional price regulation methodologies
“Earning sharing” Earnings = Revenues – Opex
Earning sharing = (Revenues – Opex)*rate (%)
Explicit sharing of extra-earnings
between operator & consumers above threshold

“Revenue sharing” Revenue sharing = (Revenues*rate %) – Opex

Scheme more incentive than earning sharing

č : cost fct, average of costs
“Hybrid model” Price = č*(1+RPI-X) + Ř*Capex
of companies in the sector
Ř: rate for RoR
Possibility to remunerate investment according
to their nature (supply or demand side) = use different rate Ř (rate for
demand investment > rate for supply investment, long term risk)
 Regulation
Promoting investments…

- Through tariff regulation.

- But also through regulation of service quality (performance indicators

definition, monitoring and improvement)

- And through stakeholder engagement and customer consultation

(achieving consensus, reaching common agreement…)
Case Study – Contractual Regulation

SEDIF PPP contract

 Contract Regulation
• Regulation by contract
– Most of the rules are fixed in advance in the contract between operator
& public authority. Limited discretion to adapt the rules
• Service standards & price revision formula in the contract
• Generic principal: maintain the financial balance of the contract
• Possibilities to negotiate between parties if any meaningful modification of
costs making the contract financially unbalanced
• Not very transparent, low incentive to improve efficiency
– Origins in France, adapted to French speaking countries (ex. Sénégal)
– Advantages
• Well adapted to certain cultural & law traditions
• Allows to minimize the cost of regulation
– Limits
• Contracts are uncomplete
• Institutional set-up for conflict resolution is often underdeveloped
Contract Regulation - France
 Syndicat des Eaux d’Ile-de-France
• Founded in 1923 to produce and deliver drinking water

• SEDIF today :
– Covers 142 cities located on the outskirts of Paris
– Supplies 4 million customers
– Produces 250 millions m3/yr (685 000 m3 distributed/day)

• Main assets :
– 3 water treatment plants
– 48 relay plants
– 8 700 kilometres of pipes
Delivery
territory
Primary
Network
 SEDIF organisation
• Committee with 142 representatives from municipalities
– Gathers 3 times/yr
– Elects a President and 11 Vice-presidents (The Board)

• Make decisions with regard to :

– The price of water: 1.74 € excl. taxes/m³ (2010)
– Budgetary allocations (581 M€)
o Investments scheduled : 200 M€/yr
o Operation and maintenance : 357 M€/yr
– Supervision of operator: 90 employees
– Operation (Veolia Water): 1,100 employees
 PPP contract
• Previous operating contract with Veolia Water
signed in 1962 ending on Dec. 31st 2010.

• Operator in charge of :
– Production and distribution
– Monitoring and maintenance
– Controlling water quality
– Customer service
 PPP contract

Sedif
Investments
Responsible
authority

Contract
Private Operation
company
operator

Invoice
Water service customer
 PPP contract
• New contract signed with Veolia Water for 12 years
(2011-2022) to manage & operate SEDIF water service

• Describe how economic regulation & performance have

been included in the contract
Through two examples: price revision formula
operator remuneration
 Price revision formula
Price revision formula: Rn = R0 x CRTn
R0: price on January 1st 2011
Rn: revised price
CRTn: price revision coefficient defined as follows
Ind.1 Ind.2 Ind.3 Ind.4
CRTn = (1-Pn) x ( a + b Ind.1 + c 0 Ind.2 0 +d Ind.3 0 +e Ind.4 0 )

a, b, c, d, e: coefficients with (a+b+c+d+e)=1 Pn: productivity

Generic comments:
➢ Reduced number of indexes compared to previous contract (8 to 4)
➢ Choose 4 indexes among the proposed ones: ICHTTS1 (wages), EMT
(electricity), TP10A (works in water/sanitation sectors), FSD3 (various costs), PCIB (chemical
products), EM (mechanic equipment)
➢ Indexes have to be easy to follow, long lasting
 Price revision formula
Ind.1 Ind.2 Ind.3 Ind.4
CRTn = (1-Pn) x ( a + b Ind.10
+c +d Ind.3 0
+e Ind.4 0
)
Ind.2 0

Elements of economic regulation within the price revision formula

1) Coefficients and indexes should Indexes Coefficient matching Coefficient proposed
SEDIF opex structure by Operator
describe & match the service
ICHTTS 0.4 0.39
opex structure; hence price revision
FSD3 0.3 0.25
& evolution will properly
EMT 0.04 0.06
reflect opex evolution control
TP10A 0.11 0.15
over price evolution

2) 9 price variation “meet up” clauses stated in the contract...

 Price revision formula
9 price variation “meet up” clauses stated in the contract :
• Every three years
• If the average water volumes sold over the past three years varies from
more than 4% (excluding bulk volumes)
• If the scope of the contract varies, as the operator remuneration formula
will have to reflect this change
• If applying CRT induces a variation of more than 4% of the water price
• If there is a substantial change in the infrastructure, in the water treatment
processes or in the service operation conditions
• If there is a substantial change in the service operation conditions due to a
change in legislation
• If there is a substantial change in the service statutory rules
• If one of the four indexes varies from more than 20%
• If the overall remuneration of the operator is caped according to the
present contract conditions for more than 4 years in a row
 Price revision formula
Ind.1 Ind.2 Ind.3
CRTn = (1-Pn) x ( a + b + c + d + e Ind.4 )
Ind.10 Ind.2 0 Ind.3 0 Ind.4 0

Elements of economic performance within the price revision formula

productivity gains required from operator

1) Pn = 0.75% from the 4th year of the contract onwards

2) Coefficient “a”
Neutrality coefficient used to neutralise a certain proportion of opex:
Former Sedif contract, “a” = 0.1 neutralisation of 10% of opex
New Sedif contract, “a” = 0.15 neutralisation of 15% of opex
 Operator remuneration
Operator overall remuneration: fixed part + variable part, caped at 9%

1) Fixed remuneration: 2% of revenues from water volumes sold (incl. bulk)

2) Variable remuneration calculated on basis of operation balance as follows:

“Operation incomes – opex – fixed remuneration”
= Operation balance - fixed remuneration
If balance is negative, operator does not receive any variable remuneration

Elements of variable Share in variable Purpose of variable

remuneration remuneration remuneration

Service quality 40% Performance

Variable Opex management 40% Regulation, performance

remuneration Share on remaining 20% Incentive
operating balance
 Operator remuneration
Cn
Opex management
k=
“k” accounts for & reflects: (1-Pn) * [(CRCF réf * CFn) + (CRCV réf * CVn * (Vn/V0))]
➢ Productivity gains (Pn)
➢ Control of variable & fixed costs evolution (CV and CF) compared to
variable & fixed reference costs (CRCV and CRCF) as defined in the contract
The formula takes into account a correction by the volumes (V) for variable costs
Share o/ Share o/
remuneration for remuneration for
k>= k< operator SEDIF
<0.9875 100% 0%
Remuneration is
0.9875 0.99 90% 10%
shared between
0.99 0.9925 78% 22%
SEDIF &
[…] […] […] […]
operator
1.0075 1.0100
depending on 14.3% 85.7%

the value of “k” 1.0100 1.0125 7.1% 92.9%

>1.025 0% 100%
 Operator remuneration
Service quality

3 elements of service quality performance taken into account:

➢ performance of the customer service

➢ performance of the technical management of service
➢ performance in terms of sustainable development

For each of these 3 elements of service quality performance:

➢ several indicators are defined & account for operator remuneration

➢ targets & thresholds are set for these indicators
➢ if targets not reached & thresholds not met by operator, penalties to be
paid
Indicators for performance
of the customer service
 Price revision formula
Ind.1 Ind.2 Ind.3 Ind.4
CRTn = (1-Pn) x ( a + b Ind.1 + c
0 Ind.2 0
+d Ind.3 0
+e Ind.4 0
)

Year Value for n Value for P

Pn = 0.75% from the 4th year
2011 1 0
of the contract onwards
2012 2 0
2013 3 0
2014 4 0.75%
2015 5 1.50%
2016 6 2.25%
2017 7 3%
2018 8 3.75%
2019 9 4.50%
2020 10 5.25%
2021 11 6%
2022 12 6.75%
 Customer service – Performance
indicators
Indicator - definition Period Target Points for Penalty Penalty amount
remuneratio threshold
n
Nb of written claims /1000 customers Monthly Yearly <3 5 5 1000€ per bracket of 0.1
(N/A if collective claim)

% of answers to letters/mails received Monthly Yearly 99.5% 5 98% 1000€ per bracket of
within 8 working days 0.1%
% of answers to written information Monthly Yearly 99.5% 5 98% 1000€ per bracket of
request on water quality within 48h 0.1%
after reception
Subscription/termination taken into Monthly Yearly 99.5% 5 98% 1000€ per bracket of
account within 24h on working days 0.1%
% of connection quote requests Monthly Yearly 99.5% 10 98% 1000€ per bracket of
answered within 8 working days 0.1%
% of water intake analysis results after Monthly Yearly 99.5% 5 98% 1000€ per bracket of
written claim within 48h 0.1%
% of emergency intervention within 2h Monthly Yearly 99.5% 10 98% 1000€ per bracket of
after customer call 0.1%
% of appointments within a 2h time slot Monthly Yearly 99.0% 10 95% 1000€ per bracket of
0.1%
Certification of customer service Yearly Certification 0 Loss of 500,000€ if loss or no
centre certification certification
Average rate of phone pick up (excl. Monthly Yearly 40 sec. 15 60 seconds 1000€/sec.
exceptional circumstances)

Rate of unmissed calls (excl. exceptional Monthly Yearly 90% 15 85% 10,000€/missing %
circumstances)
 Thank you

maria.salvetti@univ-paris1.fr
 Sénégal - Example
Indicators Penalties

Treatment efficiency Linked to price revision

Technical aspects
Level of water losses formula
Bacteriologic quality
Water quality Physico-chemical quality

Interventions < 1- 2 hours If unjustified interruption

Service quality Answer to complaints < 24 > 10h
hours
Number of connections
Network maintenance
km of network

Revenues collection Linked to price revision

Financial aspects formula
Payments to SONES
 Sénégal
• Affermage contract Sénégal signed in 1996
– Tariffs set by the Water Ministry on the basis of agreed principles and
financial model – increasing tariffs with social block (20m3/HH/ 3
months)
– Remuneration of operator/m3 sold was the awarding contract criteria
– Operator revenues are assessed on the basis of m3 sold adjusted by
performance
• Incentives to serve the poors
– “Social connections” financed by the government and implemented
by private operator (but the very poor, without property title, are
excluded)
– Private operator receive remuneration according to m3 sold,
whether water is sold at social or normal tariff (but social tariff
applies to all, not only to poor)
– If this generates a deficit in operation balance, SONES, the
infrastructure company, has to bear the difference
 GUIDELINES FOR PERFORMANCE-BASED
CONTRACTS BETWEEN WATER UTILITIES AND
MUNICIPALITIES

CONTRACT PREPARATION STAGE

‒Contract type and duration
‒Review of the existing legal and regulatory framework
‒Review of the utility’s assets and liabilities and restructuring of the utility
‒Preparation of the bidding and selection process
‒Accuracy of initial data and information

PERFORMANCE INDICATORS
‒Definition and selection of performance indicators
‒Definition of baseline scenario
‒Monitoring of indicators – the choice of a technical auditor
 GUIDELINES FOR PERFORMANCE-BASED
CONTRACTS BETWEEN WATER UTILITIES AND
MUNICIPALITIES
TARIFFS AND FINANCIAL OBLIGATIONS OF CONTRACTING AUTHORITY
‒Water pricing rules and principles
‒Types of tariff structures
‒Mechanisms for tariff adjustment
‒Financial obligations of the contracting authority

CONTRACT MONITORING, ENFORCEMENT AND DISPUTE RESOLUTION

‒Monitoring of contract implementation
‒Types of conflict resolution mechanisms.
‒Dispute settlement in the reviewed cases
‒Contract enforcement mechanisms

RISK MANAGEMENT
‒Types of risks
‒Risk allocation
 Exercise
• Propose 5 indicators for your water
service, including technical, economic and
customer aspects; set targets as well

• List all the information required to properly

design your contract and monitor it