Promoting efficiency in water services: a simple model João Carlos Silva 9.º Congresso Mundial da Água Lisboa, 21-26 de setembro de 2014

1. 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

2. The issue in question
1
Results and conclusions
3
The proposed model
2
INDEX

3. 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

4. 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.
The issue in question
The proposed model
Results and conclusions

5. 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
The issue in question
The proposed model
Results and conclusions

6. 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 Max2
n-5
t=n-1
3
The issue in question The proposed model Results and conclusions

7. 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.
The issue in question
The proposed model
Results and conclusions

8. 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 standardproduction = Total volume of wastewater treatment
Total standardproduction = Total volume of supplied water
The issue in question
The proposed model
Results and conclusions

9. Standard production
Operators with both activities
(Water supply and wastewater treatment)
Water supply and wastewater treatment
Total standardproduction = Activity푖 x Conversion factor activity푖
Opportunity cost of wastewatertreatment = Total income of wastewater treatmentTotal volume of wastewater
= Wastewater tariff
Conversion factor ofwastewater treatmentin water supply = Opportunity cost of wastewater treatment Water supply tariff
= Wastewater treatment tariffWater supply tariff
The issue in question
The proposed model
Results and conclusions
Volumes / quantities from different activities need to be standardized in order to be possible their aggregation and consequently calculate the standard unit cost (SUC)

10. 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).
The issue in question
The proposed model
Results and conclusions

11. Productivity gains calculation
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
The issue in question The proposed model Results and conclusions

12. Productivity gains calculation
The issue in question
The proposed model
Results and conclusions

13. 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)
The issue in question The proposed model Results and conclusions

14. 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
The issue in question
The proposed model
Results and conclusions

15. Thank you for your attention!
João Carlos Silva
joao.carlos.silva@ersar.pt