economic regulation of ppp contract in the water...

Economic Regulation of

PPP contract

in the water sector

Case study

Maria Salvetti

Sherer (1980):

A natural monopoly exists when economies of scale are so substantial

that a single firm can produce total market output at a lower unit cost,

and thus more efficiently than two or more firms.

→ Marginal cost < Average cost

Natural Monopoly Definition

Demand (water sold)

Mean cost

Marginal

cost

Price

Quantity (water volume, thousands m3)

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.

Natural Monopoly Characteristics

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)

Avoid abstraction of

monopoly rent and

allocative inefficiency

→ Public intervention is required to address this market failure situation and help

settle this pricing dilemma…

Why regulate NM?

Demand (water sold)

Mean cost Margin

al cost

Price

Quantity (water volume, thousands

m3)

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.

Why regulate NM?

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

Alternatives to Regulation

• 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

Economic regulation targets

Price Regulation

Cost-based, price-based,

revenue-based tariffs and

additional methodologies

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)

RoR = (Revenues – Opex)/K ≤ x%

price ≤ Opex + (x%*K)/volume

Revenues – Opex: net profit

K: capex or initial asset base (stock of capital)

x%: limit set by regulator

Regulating the price: 2 broad types of methodologies

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.

Pt = (1+ RPIt – X)*Pt-1

Price regulation

Additional price regulation methodologies

“Earning sharing”

Explicit sharing of extra-earnings

between operator & consumers above threshold

“Revenue sharing”

Scheme more incentive than earning sharing

“Hybrid model”

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)

Earnings = Revenues – Opex

Earning sharing = (Revenues – Opex)*rate (%)

Revenue sharing = (Revenues*rate %) – Opex

Price = č*(1+RPI-X) + Ř*Capex č : cost fct, average of costs

of companies in the sector

Ř: rate for RoR

Price regulation

Case Study – Contractual Regulation

SEDIF PPP contract

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

Responsible

authority

Private

company

operator

Water service customer

Investments

Operation

Invoice

Contract

• New contract signed with Veolia Water for 12 years

(2011-2022) to manage & operate SEDIF water service

PPP contract

• 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

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

Ind.1

Ind.1

0

Ind.2

Ind.2

0

Ind.3

Ind.3

0

Ind.4

Ind.4

0

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

CRTn = (1-Pn) x ( a + b + c + d + e )

Elements of economic regulation within the price revision formula

1) Coefficients and indexes should

describe & match the service

opex structure; hence price revision

& evolution will properly

reflect opex evolution control

over price evolution

Ind.1

Ind.1

0

Ind.2

Ind.2

0

Ind.3

Ind.3

0

Ind.4

Ind.4

0

Indexes Coefficient matching SEDIF opex structure

Coefficient proposed by Operator

ICHTTS 0.4 0.39

FSD3 0.3 0.25

EMT 0.04 0.06

TP10A 0.11 0.15

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


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


CRTn = (1-Pn) x ( a + b + c + d + e )

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

Ind.1

Ind.1

0

Ind.2

Ind.2

0

Ind.3

Ind.3

0

Ind.4

Ind.4

0


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 remuneration

Share in variable remuneration

Purpose of variable remuneration

Service quality 40% Performance

Opex management 40% Regulation, performance

Share on remaining operating balance

20% Incentive

Variable

remuneration

Operator remuneration

Opex management

“k” accounts for & reflects:

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

k>= k<

<0.9875

0.9875 0.99

0.99 0.9925

[…] […]

1.0075 1.0100

1.0100 1.0125

>1.025

Share o/

remuneration for

operator

Share o/

remuneration for

SEDIF

100% 0%

90% 10%

78% 22%

[…] […]

14.3% 85.7%

7.1% 92.9%

0% 100%

Remuneration is

shared between

SEDIF &

operator

depending on

the value of “k”


Cn

k=

(1-Pn) * [(CRCF réf * CFn) + (CRCV réf * CVn * (Vn/V0))]


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

CRTn = (1-Pn) x ( a + b + c + d + e )

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

Ind.1

Ind.1

0

Ind.2

Ind.2

0

Ind.3

Ind.3

0

Ind.4

Ind.4

0

Year Value for n Value for P

2011 1 0

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

remuneratio

n

Penalty

threshold

Penalty amount

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

within 8 working days

Monthly Yearly 99.5% 5 98% 1000€ per bracket of

0.1%

% of answers to written information

request on water quality within 48h

after reception


0.1%

Subscription/termination taken into

account within 24h on working days


0.1%

% of connection quote requests

answered within 8 working days


0.1%

% of water intake analysis results after

written claim within 48h


0.1%

% of emergency intervention within 2h

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

centre

Yearly Certification 0 Loss of

certification

500,000€ if loss or no

certification

Average rate of phone pick up (excl.

exceptional circumstances)

Monthly Yearly 40 sec. 15 60 seconds 1000€/sec.

Rate of unmissed calls (excl. exceptional

circumstances)

Monthly Yearly 90% 15 85% 10,000€/missing %

Rate of recall after message on Monthly Yearly 99% 10 95% 5000€/missing %

Thank you

[email protected]

economic regulation of ppp contract in the water...

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