Viewpoint The World Bank Group September 1996 Note No.91 Regulating Water Concessions Lessons from the Buenos Aires concession Claude Crampes The public water and sewerage services for meters of underground tunnels, 9 pumping sta- and Antonio Greater Buenos Aires were privatized under a tions, 2 treatment stations, 370 kilometers of wa- Estache concession contract three years ago. Already, ter mains, and 19,000 kilometers of distribution there are positive results. Labor productivity pipes. Poor maintenance of the system had led has almost tripled, service coverage has in- to significant water losses-probably about 40 creased, reliability and responsiveness have percent, although no one really cared about improved, and the price of service has fallen. measuring them then. OSN produced 3.7 mil- But there are also some teething problems, es- lion cubic meters of water a day and served pecially in regulation. This Note discusses les- about 6 million inhabitants, about 70 percent of sons for policymakers contemplating a similar the area's population. Coverage for sewerage approach to water sector reform. was even lower, at about 58 percent. Strategy To avoid a prolonged process of privatization, the government opted to award the right to pro- Argentina privatized the water and sewerage ser- vide service under a concession rather than sell vices in the Buenos Aires metropolitan area in the utility, thus keeping the fixed assets under 1993. The assets of the public enterprise, Obras public ownership. Selling the assets would have Sanitarias de la Naci6n (OSN), included 77 kilo- required overcoming legislative hurdles, and the government feared that assessing the value of the underground pipes would be costly and time consuming. The government also decided not TABLE I IMPACT OF THE GREATER BUENOS AIRES to break up the utility. A single private firm WATER CONCESSION would operate the services for thirty years, a reasonable period in which to finance and com- Change from May 1993 plete the required investments. The concession hIdicator to Decemnber 1995 could be extended for one year, but at the end __ __ __ __ __ __ _ of the term, a new bid would be organized. increase in production capacity (pement) 26 The main objective of the reform was to reduce Water pipes rehabilitated (kilometers) 550( the cost to the government of operating the ser- Sewers drained (kiloneters) 4 800: vices while minimizing the price for service de- Decline in clogged drains (percent) 97 livery. Bidders would compete to provide services Meters upgraded and instaled f28,50D at the lowest price (the largest discount to the Staff reduction (percent) 47 public tariffs). No cash payments would be re- Residents witit new water comnectionts 64Z=quired. But the winning bidder, as the conces- Resident withtew sewer cwJnecfions 342,00D sionaire, would assume responsibility for Residents with new sewer connections 342,0operating and maintaining the fixed assets and would be obligated to expand coverage, guaran- tee water quality, and develop sewage treatment. The targets for coverage imply investments of Private Sector Development Department Vice Presidency for Finance and Private Sector Development Regulating Water Concessions about US$4 billion over the life of the contract, Competition with a large share to be disbursed at the begin- ning of the concession period. Pricing would be Water distribution and sewage collection are natu- governed by general tariff principles set out in ral monopolies, so the scope for direct market the concession contract, maintaining the cross- competition is lirnited to minor activities, such as subsidies that existed under public provision. The billing and revenue collection. In the Buenos Aires first price review would occur after five years. concession, competition was introduced through There would be some possibility for renegotiat- the bidding process. This process, which plays a ing the rules in the case of an unenforceable event critical role in drawing out enough information or new information, but any change would have to ensure that a concession is awarded success- to maintain the implicit rate of return proposed fully, generally worked well. by the winning bidder (that is, maintain consis- tency between the timing of costs and the evolu- The rules required potential bidders to prequalify tion of tariffs). The concessionaire would also be to limit the bidding to firms with strong technical responsible for negotiating the private labor con- and financial capabilities and to ensure that any tracts with the labor unions (since all workers foreign bidders would be the very top operators. ended up "privatized"). The call for bids went out in June 1992, request- ing two envelopes. The first, which determined Impact and lessons whether a bidder qualified, held technical offers (including legal features of the bidder, a mission The impact of the concession strategy has been statement, operational plans, proposed regula- generally positive (table 1). Since May 1993, the tions for users, and a US$3 million guarantee of first month of private operation, the maintenance commitment to the offer). The second envelope, system has been revamped and the backlog of opened if a bidder qualified, held financial and repairs significantly reduced. Rehabilitation has economic offers, including adjustments to the cut water losses to about 25 percent, according current tariff rate, indicators of financial strength to estimates by the concessionaire, allowing cov- and commitment, and an explanation of how the erage to increase by 10 percent with no increase bidder would operate with the new tariff. The in production. Coverage for sewerage services contract would go to the bidder offering the larg- is up about 8 percent. And prices were initially est discount to the public tariffs. The rest of the reduced by 27 percent. While they rose last year, information to be provided was essentially in- they are still 17 percent lower than those charged tended to demonstrate that the discount proposed by the public utility. would allow revenues consistent with the level and timing of expenditure commitments. But not all has been smooth sailing. Negotia- tions with the unions, for example, have been The concession contract was awarded in De- tense, though first impressions suggest a suc- cember 1992 (transfer occurred in May 1993) to cessful outcome. Most direct indicators of la- Aguas Argentinas, a consortium headed by bor productivity show dramatic improvements. Lyonnaise des Eaux-Dumez that offered a tariff And after a 48 percent reduction in staff in the discount of 26.9 percent. This result suggests first year of operation, the concessionaire is that the competition for the market has been now recruiting to keep up with the demand effective in reducing costs to users. To sustain for services. But indirect labor costs remain this gain, the national government is considering high, comparable to what they were under pub- yardstick competition when the price review lic management, as the concessionaire contin- comes due-possible now that some of the pro- ues to provide many of the fringe benefits vincial services have also been privatized un- traditionally available to civil servants (total la- der concessions. Yardstick competition is used bor costs are still about 60 percent of operat- effectively in the United Kingdom, where the ing costs). The most difficult adjustments, regulator calculates and widely publicizes wa- however, have been in the regulatory area. ter companies' comparative efficiency. Government as regulator rather than they need to recruit international experts-as service provider they did recently to assess a request by the concessionaire for an adjustment in the con- A key to the success of the bidding process has tractual investment plan. been its transparency. Just as important is trans- parency in the concession contract-clear and Adjustments and renegotiation unambiguous assignment and enforcement of the rights and obligations of the concessionaire. Soon after the concession had been awarded, The main regulatory instrument, this contract water quality problems revealed that the infra- spells out the rules of the game for the private structure was in worse shape than the govern- monopoly. But for the privatization to be effec- ment and the concessionaire had estimated. So tive, the Argentine government has had to rec- in June 1994, they agreed to speed up the deliv- ognize that once a private operator takes over, ery of some service requirements. The resulting it is in charge within the terms of the contract. cost increases triggered a contract clause (over That does not mean that the government has 7 percent) allowing an increase in tariffs, and no role. Because competition is limited to the Aguas Argentinas was granted a 13.5 percent tar- initial bidding and the rebidding at the end of iff hike. There was much public confusion about the concession (crucial to the effectiveness of this increase, and many users felt that it was un- the initial bidding), the government has a criti- fair. Poor explanation of the approval process to cal role to play as a regulator. But this is not a the users was partly to blame for this perception. day-to-day management role. Some argue that the level of detail in the Buenos Aires conces- This experience reinforces the need for rules sion contract reveals reluctance by the govern- allowing adjustment in the terms of conces- ment to give up management of the service and sion contracts when new information becomes that the contract focuses too much on processes available or circumstances change. It also shows and detailed targets. There may be some truth the need for regulators to ensure that the pub- in this, but it also reflects the lack of data at the lic understands their decisions and perceives time of bidding. Also true, however, is that pri- them as independent. This requires transpar- vate monopolies will try to keep regulators at a ency both in analysis and in decisionmaking. distance to make the most of their monopoly Although the concession contract should be power. The challenge is to design a contract prepared as if it were not going to change, that achieves the right balance. This requires under specific, limited circumstances, some good data, which can take time to collect. flexibility may be good policy. To ensure that the contract is a credible regulatory instrument, The government's new regulatory role is in the modifications should be arrived at through fair hands of a newly created independent regula- and workable renegotiation rules based on tory agency, Ente Tripartito de Obras y Servicios clear, preestablished criteria and agreed to by Sanitarios (ETOSS). The agency is financed by all parties. Fortunately, the Aguas Argentinas a user fee levied on consumers and governed contract included such a rule. by a directorate appointed to a six-year term, with the option of one renewable term. It moni- The challenge for policymakers is to find a tors the concessionaire, enforces the conces- transparent mechanism for modifying the terms sion contract and regulatory decisions, and of the contract without undermining investor levies fines when necessary. This new role may or consumer confidence. A renegotiation rule be the most difficult fact to accept for the newly should expose what changed unexpectedly. For created regulatory agency, as many of the example, if the assets deteriorated between the agency's employees had worked for the pub- time the bids were made and the transfer of lic water utility. Most recognize that they need the assets, what was the cause? Was it the new skills to be effective regulators and that weather? Or did the public operators stop main- when they lack the skills for a particular task, taining the assets? If the first, responsibility Regulating Water Concessions might be shared between the government and creates a complex system of cross-subsidies the concessionaire. If the second, the conces- between water and sewerage services. Although sionaire might have a fair claim for revising the water and sewerage charges are higher than the contract. The public policy criteria for test- operating costs, they do not fully cover invest- ing whether revision is needed must be pre- ment costs. The contract allows the conces- established and clearly defined. And any sionaire to use revenues from existing clients change to the contract that is warranted should to cover water system expansion costs not cov- be limited to the issue at hand: the entire con- ered by new customers. tract should not be renegotiated. Of course, unilateral modification of the rights defined in Conclusion the contract or the bidding documents-say, through a request to accelerate investment or As Argentina is finding out, regulating a private a move to impede tariff adjustments, without monopoly can be challenging. Its experience full compensation-is tantamount to expropria- suggests that to maximize the gains from water tion and defeats the purpose of reform. privatization, reformers in other countries should make the most of competition for the market, Investment and tariffs make sure that the government is comfortable with shifting its role from service provider to The design of the tariff formula is at the core of regulator, anticipate needs for renegotiating or effective regulation and critical to the sustain- adjusting the terms of the contract, and not un- The Note series is an ability of the reforms. The regulatory regime rec- derestimate the problems of tariff design. open forum intended to encourage dissemina- ognizes legitimate costs and allows an additional tion of and debate on profit margin (a loose form of cost-plus regula- The Argentine regulators, to their credit, are ideas, innovations, and tion, as information on cost is very approximate). aware of the tariff design problems and are deal- best practices for expanding the private There are about four different kinds of tariff ing with them systematically. For example, they sector. The views structures. Which structure is applied depends are commissioning a tariff study (from an inter- published are those of on the kind of building involved, and how the national consulting company) that should lead the authors and should not be attributed to the tariff is charged depends on whether the con- to marginal cost pricing and to a new tariff based World Bank or any of its sumer is metered. The design of this family of on metering. With the benefit of hindsight, many affiliated organizations. tariffs introduces a number of distortions. First, in the government may regret not having com- Nor do any of the con- clusions represent the metering incentive is in the wrong direc- missioned the study much earlier, when the sec- official policy of the tion. Consumers have an incentive to install a tor was being restructured. That would have World Bank or of its meter only if their consumption is small, but prevented the delay in implementing efficient Executive Directors or the countries they without meters it is difficult for the concession- and equitable tariff principles-and many of the represent. aire to track water losses. Second, average prices disagreements that have arisen among users, are lower for large users than for small users, providers, and regulators since May 1993. copies please call the yet for water, unlike for electricity, there is no FPD Note line to leave a technological justification for this. And third, the For mare on this topic, see A. Estache, F. Helo, and M. Rodriguez- message (202-458-1111) two-part tariff for metered customers leads to Pardina, "A Portable Description of Water Regulation in Argentina's or contact Suzanne cross-subsidy problems. The tariff has a fixed Main Concessions,' World Bank, Latin America and the Caribbean, G8105, The World Bank, part to cover the cost of infrastructure and a Country Departrnent 1, Washington, D.C., 1995; E. Idelovitch and K. Ringskog, 'Private Sector Participation in Water Supplv and Sanita- 1818 H Street, NW, variable part that is proportional to consump- tion in Latin America," World Bank, Washington. D.C., 1995; and Washington, D.C. 28433, or Internet address tion. But total connection costs are less than world Bank, "Argentina, Reforming Provincial Utilities: Issues, Chal- ssmith7@worldbank.org. total revenue from the fixed part of the tariff. lenges, and Best Practice," Report 15063-AR, Washington, D.C. Previous issues are also The resulting cross-subsidies lead to inefficient available on-line (http:II and often inequitable investment decisions. Claude Crampes, Professor of Economics, html/fpd/notes/ Institut d'Economie Industrielle, Toulouse, notelist.html). Another problem with the tariff formula is that France, and Antonio Estache, Latin America @Printed on recycled it provides little incentive to invest in expand- and the Caribbean, Country Department I paper. ing the sewerage system. The metered tariff (aestacbe@worldbank.org)