WATER P-NOTES ISSUE 1 JUNE 2008 44719 Aggregation of Water and Sanitation Provision: Finding the Optimal Scale for Operations W hen several municipalities unite in a single · Scale. Most aggregations are formed by administrative structure--a process known neighboring towns. Some incorporate many as aggregation--they can lower the cost municipalities, and some all major urban cen- of utility services through economies of scale. Ag- ters in the country. It is important to identify the gregation of water supply and sanitation (WSS) aggregation's optimal size. Economies of scale services is established practice in some countries are powerful for utilities serving up to 125,000 and is likely to spread, as decentralization policies people, but can tail off above a certain point leave some service providers too small to be ef- (figure 1). ficient or sustainable. · Scope. Aggregated structures can provide one Aggregation offers returns such as shared or all water services, and execute few or all overhead and lower unit costs through bulk pur- functions. chasing and pooled operations, plus other benefits that lower costs to customers or improved service · Structure and process. Aggregations may be at the current cost. Other benefits include greater temporary or permanent. They may be formed access to financing, better distribution of skills, voluntarily based on mutual interests, or by more opportunities for cross-subsidization and ef- mandate from a higher level of government. ficiency, access to new water resources, and new They may be driven by government incentives-- solutions to pollution problems.1 for example, certain subsidies may be made available only to aggregated utilities. Munici- In 2005, we studied 21 instances of aggre- palities and the aggregated structure may share gation of WSS services aggregations, looking for responsibility for services and oversight in a innovative models and factors that contributed to variety of ways. In short, choices must be made success. The practices we identified may help other about the institutional form of the aggregation countries aggregate municipal utilities. and the procedures it will follow. Each type of aggregation is different; none can Characteristics of aggregation be applied to another situation without tailoring to schemes and structures Aggregation options range widely in scale, scope, 1Aggregation can lower costs to customers served structure, and process. by high-cost WSS systems through cross-subsidies from utilities in low-cost areas of the aggregation. This note reports key messages and findings from "Models of Aggregation for Water and Sanita- tion Provision," by ERM in association with Stephen Meyers Associates, Hydroconseil, and William D. Kingdom, published by the World Bank in January 2005 (Water Supply and Sanitation Working Note 1). Readers may download the complete paper from www.worldbank.org/water. WATER P-NOTES suit specific needs. Clear entry and exit rules can al- low the aggregation to resize as needed, but limits Figure 1. Returns to scale and scale on exit possibilities should be considered to avoid of service provision destabilization of any aggregated structure. Most of the innovation and success that we iden- tified came from seven aggregations: two voluntary Fragmented Optimal Too Scale Large (France, Philippines); two driven by incentives (Hun- gary, Brazil); and three mandated by government employee (Italy, the Netherlands, and England and Wales). per Scale The simplest structure may be a loose associa- to sold tion of municipalities, with one providing leadership water and resources. This model allows members to test eturnsR their willingness to collaborate before committing to a larger structure. volume. e.g A more permanent structure, such as the syn- Increased Scale of Service Provision dicate model in France, offers different services to e.g. Number of Municipalities, Population different towns. Some syndicates package disparate services. A Philippines syndicate provides tourism development, fish processing, health services, and local roads and railways for ten towns. When such entities become, in effect, a supra-level of local gov- be equitably represented in the agreement, and ernment, they may be criticized for undermining local lost advantages adequately compensated. If one democracy, because the utility's board is not directly member is much larger than the others, it may rea- accountable to citizens. If formal aggregation is not sonably seek a special position in the aggregated possible, aggregation can be achieved through the entity, such as heading up the board of directors. market, as when a water company achieves econo- mies of scale by serving several towns. Differing interests also can be addressed by al- locating shares in the aggregated utility and voting Aggregation often implies changes in over- rights on the board. Allocation creates multiple mi- sight. Utility services are usually overseen by local nority owners and limits the possibility of unilateral in- politicians who approve tariffs and monitor quality. fluence. Voting rights can be allocated in a variety of Aggregation raises the question of whether such ways; each has advantages and drawbacks (table 1). functions should remain in local hands or be aggre- gated along with the services themselves. The latter The utility's articles of agreement should in- course has advantages, although it may encounter clude precise rules about depreciation, accounting, local opposition. Decentralized services are subject pricing, water quality, continuity of service, and ex- to interference by local government; interference is tension of the network. Rule changes should require less likely when oversight is pooled in an aggregat- a strong board majority. A clear, data-based strat- ed entity. In Italy, a regional entity supervises smaller egy for keeping customers and community leaders service providers. In England and Wales, service informed may be necessary to parry opportunistic regions are self-monitoring--under the watchful eye criticism from politicians. of a central supervisor. Transfers of staff to the aggregated entity must be carefully planned. Technical continuity usually demands the transfer of some staff, transfer of an Governance, staffing, and condi- entire staff is typically neither necessary nor desir- tions for entry and exit able. Formation of the new entity presents an oppor- tunity to recruit innovation-minded new executives, To avoid conflict, aggregations must be governed to realize economies of scale by reducing staff, and in a way that represents all member municipalities. to adjust the staffing mix to fill gaps in skills and ca- Members may have differing interests and reasons pacities. The specialized skills required for effective for aggregating. Those differences can and should WSS services are scarce in highly decentralized en- ISSUE 1 · JUNE 2008 Table 1. Pros and cons of several methods for allocating voting rights Method of allocation Potential advantages Potential drawbacks By population of each member's Most democratic rule Small members may be deprived of service area voting rights By number of customers, number of Sound economic basis Varies from year to year connections, or asset value One member, one vote Simplicity May be unacceptable to larger members Specific powers for dominant entity, May be necessary to give domi- Small members have limited influ- if one exists nant entity confidence ence Combination of two previous meth- Acceptable minimum represen- May deter more powerful munici- ods tation for small communities palities from joining vironments. Larger, aggregated providers need more nicipalities? Local governments may be reluctant to of such skills and can better afford them. cede control of assets, and the process of inven- Other municipalities may seek to join the ag- torying and valuing assets can be complicated. In gregation--a sign of success. However, the impact many cases, asset transfer is effectively or explicitly of growth must be carefully considered so as to forbidden. But transferring ownership may make avoid costly or complex changes. When a member possible greater economies of scale while stabiliz- leaves the aggregation, the move may weaken the ing the aggregation by deterring exit. It may also be group's legitimacy, reduce its customer base, un- a precondition for investments by the aggregated dermine financial viability, and lead to higher tariffs. entity in shared facilities. (Such investments often The articles of association should establish strict exit make economic sense--but only when they are conditions--including advance notice of the intent made in services for which the aggregation is fully to separate and assumption by the exiting member responsible.) of attendant costs. To avoid conflicts, investments must be clearly Harmonization of tariff levels usually takes registered and compensation rules clearly defined. time, in part because aggregation may not in- There are three ways to pay for transferred assets: stantly improve service quality. Harmonization can (a) through shares in the new entity, (b) through be a unifying force, but it may also require one direct reimbursement by other members, and (c) member to cross-subsidize others. Uniform rates through payment of a lease fee. Every asset trans- can cause difficulties if one member believes that ferred should be independently valued and invento- it could achieve lower tariffs by leaving the group. ried upon aggregation, with depreciation schedules The aggregation process should include an inter- for future years. In the Netherlands, municipalities mediate phase, but harmonization should not be that transferred assets to an aggregated entity put off too long. were compensated for loss of future profits over 10 years. If wider aggregation of local services is under- way, WSS services aggregation should be coordi- Water rights, a special class of asset, represent nated with the process. a significant contribution that must be appropriately valued--a difficult task in view of the absence of a true market. Within aggregations, water rights Determining asset ownership can be converted into shares, sold by the owner, or leased. Conflicts often occur. In the Philippines, Should ownership of assets be transferred to the a water rights conflict led to the failure of the ag- aggregated entity or remain with the member mu- gregation. WATER P-NOTES Key policy lessons from global sistance from disinterested parties may also help the experience with aggregation process avoid political conflicts. Central governments can assist, mandate, or Aggregation can raise the efficiency of service de- provide incentives for aggregation. The ideal ag- livery through economies of scale and scope. Gains gregation process is voluntary. But national gov- may come from sharing overhead costs across a ernments can support and encourage voluntary wider customer base and reducing costs through aggregation by providing guidance on structures, bulk purchases, among other sources. The scope governance and management, tariff-setting, and of potential economies and the factors that account entry and exit rules. The government may also pro- for them always depend on local circumstances. vide a framework for evaluating costs and benefits. Aggregation can fail if benefits are not un- Tax or subsidy incentives for aggregated providers derstood or in the absence of an adequate imple- also help advance the process. In cases where the mentation process--due process and political will potential benefits of aggregation are large, gov- are essential. The benefits of aggregation may go ernments may mandate it. However, as mandatory unrecognized or ignored by local governments that action may appear as heavy-handed interference in put short-term interests ahead of long-term gains. local matters, incentives may be preferable. Because aggregation may have clear winners and As a final note, aggregation is often consid- losers and involve substantial transaction costs, the ered as a prerequisite for introducing private sector process usually requires strong leadership, either participation into the WSS sector. But the decision from individuals or an institution. Because each ag- to aggregate must make technical, economic, and gregation is unique, external assistance is usually political sense on its own--it should not be made required. Smaller municipalities that lack capacity primarily for the purpose of attracting private oper- in all of the areas covered by the aggregation may ators. Maximizing the efficiency of service provision be especially in need of outside help. External as- must always be the primary focus. The Water Sector Board Practitioner Notes (P-Notes) series is published by the Water Sector Board of the Sustainable Development Network of the World Bank Group. P-Notes are available online at www.worldbank.org/water. P-Notes are a synopsis of larger World Bank documents in the water sector. THE WORLD BANK | 1818 H Street, NW | Washington, DC 20433 www.worldbank.org/water | whelpdesk@worldbank.org