promoting efficiency in water services

PROMOTING EFFICIENCY IN WATER SERVICES: A SIMPLE MODEL Master thesis project in Finance (2010)

João Carlos Silva

9th IWA World Water Congress & Exhibition

Lisbon, September 2014

The issue in question 1

Results and conclusions 3

The proposed model 2

INDEX

The issue in question The proposed model Results and conclusions

Current framework

Water services in Portugal are

regulated by the application of a

model of cost of service (aka cost-

plus)

Capital base for the shareholders

remuneration

The regulation model focuses on

the net profit which means that the

financial operations are subject to

the regulator analysis

Shareholders remuneration is

guaranteed

Total costs, quantities and the

authorized rate of return are

estimated ex-ante; tariff is the model

output

Capital stock + legal reserve

(usually is used the operator RAB – regulated

asset base)

Absence of an incentive scheme for

cost reduction and efficiency

promotion

Due to these constraints it is not possible to transpose an incentive model from

another country or other different sector

Productivity gains

Definition:

• Extra remuneration that can be reached by the shareholders in addition to the

contractually established

• This amount is calculated every year and is divided in equal shares between consumers

(through tariff) and operators (surplus in dividends)

Current rule for productivity

gains calculation: comparison

between the budgeted unit cost

(ex-ante) and the effective one

(ex-post)

Problems:

• It is possible to obtain productivity

gains by just over-budgeting

• Operators can claim an efficiency

improvement without making a more

productive use of inputs

As requested by the Regulator, this rule was suspended in 2004 to prevent the distribution

of productivity gains calculated with 2003 figures. The aim of this procedure was to have

time to make a revision to this mechanism.

This procedure has been maintained since then.


Background

PROPOSAL RESULT

Two alternative proposals were presented to date by the Regulator in order to solve the

problem:

1) Different writing of the clause with

more accuracy that requiring the

demonstration of the productivity

gains calculation

2) Alternative model to promote

efficiency (MIE)

Combination in the same model of

shareholders remuneration and

productivity gains

Analytical model that introduces

risk – return on capital directly

linked with the operators

performance

Despite increasing the requirements,

it proved to be very difficult to make

this demonstration because there

were always different interpretations

between Regulator and operators

This model was not very welcomed

by the operators because the added

risk was disproportionate to the

potential gains

The shareholder remuneration would

no longer be assured and, in the

bottom line, could be cancelled due

to a bad performance

For these reasons the model was

abandoned


Model

Productivity Gains

Model (PGM)

Conversion

factors

INPUT OUTPUT

SUC

>

BMK

?

N

Costs

considered (C)

(current prices)

Standard

production (Q)

Standard unit

cost (SUC)

Y

Comparison with

the benchmark (BMK)

(constant prices)

Productivity

gains (PG)

No

productivity

gains

PG = (BMK – SUC) x Q (constant prices)

SUC = C / Q (current prices)

Conversion to

constant prices

In the end the result has to be

converted to current prices

BMK = Simple moving average of the best 3

observations in the last 5 years

BMKn =

( SUCt) - SUC Max1- SUC Max2n-5t=n-1

3


Operational expenditure (OPEX) considered

Amortizations and depreciation

Labour costs

Supplies and services

Cost of goods sold (COGS)

Taxes (except income tax (IRC))

Other operational costs

COSTS CONSIDERED

INCOME NOT CONSIDERED

Extraordinary income

Other operational income

Marginal activities with no expression or impact in

the operator core business

COSTS NOT CONSIDERED

Provisions

Financial costs

Extraordinary costs

The evolution of this kind of costs has a weak

correlation with the operators productivity

How to exclude these incomes from the model?

By deducting them to the costs considered.


Standard production

Operators

with one

activity

(Only water supply or

only wastewater

treatment)

No need for

standardization,

the production

comes directly

through the

measured flows

of the operator

(m3)

Water supply

Wastewater treatment

Total standard

production = Total volume of wastewater treatment

Total standard

production = Total volume of supplied water


Standard production

Operators

with both

activities

(Water supply and

wastewater treatment)

Water supply and wastewater treatment

Total standard

production = Activity

𝑖 x Conversion factor activity

𝑖

Opportunity cost

of wastewater

treatment

= Total income of wastewater treatment

Total volume of wastewater

= Wastewater tariff

Conversion factor ofwastewater treatment

in water supply

= Opportunity cost of wastewater treatment

Water supply tariff

=Wastewater treatment tariff

Water supply tariff


Volumes / quantities from different activities need to be standardized in order to be possible their

aggregation and consequently calculate the standard unit cost (SUC)

Productivity gains calculation

Why a benchmark for

each operator over a

global one?

• Geographical asymmetries;

• Investment asymmetries;

• Establishes an appropriate level of demand for

each operator.

How to divide the

calculated productivity

gains?

The same way as provided in rule of concession

contracts:

• 50% for shareholders (represents a higher dividend);

• 50% for consumers (through tariff reduction in the

following years).

How to calculate

productivity gains?

Each year, productivity gains are calculated by

multiplying the standard production and the

difference between the value of the reference unit

cost (RUC) and the standard unit cost (SUC).



Item Units 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008

Operational costs Current prices 16.940,4 € 17.448,6 € 17.972,1 € 18.511,3 € 19.066,6 € 22.119,8 € 24.677,9 € 29.767,0 € 27.908,8 € 30.587,0 € 29.986,4 €

Amortizations Current prices 19.644,4 € 20.233,7 € 20.840,8 € 21.466,0 € 22.110,0 € 22.809,2 € 24.101,8 € 22.604,5 € 25.310,7 € 27.733,1 € 29.119,8 €

Operational incomes not considered Current prices -302,7 € -311,7 € -321,1 € -330,7 € -340,6 € -370,7 € -396,6 € -587,5 € -982,8 € -2.597,7 € -2.727,6 €

Total costs considered Current prices 36.282,2 € 37.370,6 € 38.491,8 € 39.646,5 € 40.835,9 € 44.558,4 € 48.383,1 € 51.784,0 € 52.236,6 € 55.722,4 € 56.378,5 €

Water supply 000 m3 padron 40.227 41.434 42.677 43.957 45.276 47.994 49.469 50.629 52.382 52.758 54.446

Total incomes Current prices 18.949,7 € 19.707,7 € 20.496,0 € 21.315,9 € 22.168,5 € 23.169,5 € 22.043,4 € 20.788,2 € 22.799,4 € 23.432,3 € 24.603,9 €

Volumes supplied 000 m3 40.227 41.434 42.677 43.957 45.276 47.994 49.469 50.629 52.382 52.758 54.446

Unit income €/ m3 0,4711 € 0,4756 € 0,4803 € 0,4849 € 0,4896 € 0,4828 € 0,4456 € 0,4106 € 0,4353 € 0,4441 € 0,4519 €

Conversion factor m3/ m3 std 1 1 1 1 1 1 1 1 1 1 1

Total standard production 000 m3 std 40.227 41.434 42.677 43.957 45.276 47.994 49.469 50.629 52.382 52.758 54.446

Standard unit cost Current prices 0,9019 € 0,9019 € 0,9019 € 0,9019 € 0,9019 € 0,9284 € 0,9780 € 1,0228 € 0,9972 € 1,0562 € 1,0355 €

(€/ m3) Prices of year 2000 0,9476 € 0,9272 € 0,9019 € 0,8639 € 0,8331 € 0,8302 € 0,8532 € 0,8739 € 0,8272 € 0,8556 € 0,8168 €

Benchmark

Best 3 of last 5 years Prices of year 2000 0,8663 € 0,8424 € 0,8388 € 0,8388 € 0,8302 € 0,8369 €

Productivity gains

Best 3 of last 5 years Prices of year 2000 0,0362 € -0,0108 € -0,0351 € 0,0116 € -0,0254 € 0,0201 €

Current prices 0,0404 € -0,0124 € -0,0411 € 0,0140 € -0,0314 € 0,0255 €

Total of productivity gains Prices of year 2000 1.735,5 € 0,0 € 0,0 € 606,8 € 0,0 € 1.093,3 €

Current prices 1.940,9 € 0,0 € 0,0 € 731,5 € 0,0 € 1.386,1 €

(Values expressed in '000 Euros, except where indicated) TOTAL 4.058,5 €

Years


Results

000 € %

Operator 3 3.284,3 15,49% 116.186,6 2,83%

Operator 12 0,0 0,00% 269.586,1 0,00%

Sub-total Water operators 3.284,3 15,49%

Operator 9 6.233,7 29,39% 74.719,0 8,34%

Operator 23 2.400,9 11,32% 159.126,2 1,51%

Operator 2 0,0 0,00% 138.201,3 0,00%

Operator 6 0,0 0,00% 30.306,4 0,00%

Operator 31 0,0 0,00% 32.240,0 0,00%

Sub-total Wastewater operators 8.634,6 40,71%

Operator 18 2.579,6 12,16% 17.268,2 14,94%

Operator 22 2.883,4 13,60% 29.084,3 9,91%

Operator 25 3.147,8 14,84% 70.545,3 4,46%

Operator 27 678,0 3,20% 230.246,1 0,29%

Operator 1 0,0 0,00% 79.755,7 0,00%

Operator 7 0,0 0,00% 58.919,0 0,00%

Operator 8 0,0 0,00% 28.223,9 0,00%

Operator 13 0,0 0,00% 60.166,4 0,00%

Operator 14 0,0 0,00% 75.977,5 0,00%

Operator 19 0,0 0,00% 19.138,4 0,00%

Sub-total Water and Wastewater operators 9.288,8 43,80%

Grand Total 21.207,7 100,00%

Operator

Productivity gains

2003-08

(A)

Total costs

considered

2003-08 ('000 €)

(B)

PG share in

total costs

(A) / (B)


Conclusions

Main characteristics of Productivity Gains Model (MGP):

• More demanding – operators are stimulated to reduce their unit cost of production in order

to reach the benchmark and achieve productivity gains

• It can increase shareholders remuneration – productivity gains are a surplus in the

dividends without interfering in its calculation

• Productivity gains are shared between shareholders and consumers

• Incentive for continuous improvement, which is a motivation to elaborate more realistic

budgets

• Simple rules, using few variables and calculations easy to understand


Thank you for your attention!

João Carlos Silva [email protected]

promoting efficiency in water services

Government & Nonprofit