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Toolkit: Approaches to Private Participation in Water Services Module 6 Allocating Responsibilities and Risks.

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Presentation on theme: "Toolkit: Approaches to Private Participation in Water Services Module 6 Allocating Responsibilities and Risks."— Presentation transcript:

1 Toolkit: Approaches to Private Participation in Water Services Module 6 Allocating Responsibilities and Risks

2 Introduction: Navigating through this E-Learning Module E-learning design:

3 Elements of the Toolkit TOOLKIT 1 Considering Private Participation 2 Planning the Process 5 Standards, Tariffs, Subsidy, Financials 4 Setting Upstream Policy 3 Involving Stakeholders 6 Responsibilities & Risks 7 Developing Institutions 8 Designing Legal Instruments 9 Selecting an Operator Additional Material CD-ROM Appendix B Policy Simulation Model Appendix A Examples of PP Arrangements

4 General Outline of Toolkit TOOLKIT 1 Considering Private Participation 2 Planning the Process 4 Setting Upstream Policy 3 Involving Stakeholders 6 Responsibilities & Risks 7 Developing Institutions 8 Designing Legal Instruments 9 Selecting an Operator Additional Material CD-ROM Appendix B Policy Simulation Model Appendix A Examples of PP Arrangements Module 6 5 Setting Service Standards, Tariffs, Subsidies & Financial Arrangements Module 6 Allocating Responsibilities and Risks

5 Module 6 - What will we learn? What are the key areas of RESPONSIBILITY for provision of the water services, and how can they be defined? Is it possible to use a standard model of private participation for a specific case, or is some tailored or hybrid model required? What are the key areas of RISK associated with the responsibilities, and how can they be defined? Management Contract for Jordan Valley Authority, Irrigation Water Supply, may be the first of its kind. What rules or mechanisms can be established to ensure that the allocation of risk is maintained in a clear and effective manner for the private participation arrangement? Who is best able to manage these risks and responsibilities, and how best to allocate these?

6 ANALYZING Responsibilities & Risks ALLOCATING Responsibilities & Risks DESIGNING Risk Allocation Rules EXAMPLES Allocation - Different PP Models ANALYZING Responsibilities & Risks Module 6 Allocating Responsibilities and Risks

7 ANALYZING Responsibilities & Risks ALLOCATING Responsibilities & Risks DESIGNING Risk Allocation Rules EXAMPLES Allocation - Different PP Models ANALYZING Responsibilities & Risks ALLOCATING Responsibilities & Risks DESIGNING Risk Allocation Rules EXAMPLES Allocation - Different PP Models ANALYZING Responsibilities & Risks Analyzing Responsibilities & Risks In this section we ANALYZE key issues related to provision of water services, looking at two main areas: Key areas of RESPONSIBILITY. How can they be defined? Key RISKS related to these Responsibilities. How can they be defined?

8 Key Areas of Responsibility MANAGEMENT OPERATIONS & MAINTENANCE INVESTMENT & FINANCE Direct staff Set human resource Policy Establish or improve business processes Manage inventory Maintain assets Commercial responsibilities (e.g. billing & collection Issue demand and capacity forecasts Arrange finance Prepare technical designs Construct assets

9 Responsibilities in the main PPP models Concession & Divestiture Affermage & Lease Management Contract MANAGEMENT OPERATIONS & MAINTENANCE INVESTMENT & FINANCE Direct staff Set human resource Policy Establish or improve business processes Manage inventory Maintain assets Commercial responsibilities (e.g. billing & collection) Issue demand and capacity forecasts Arrange finance Prepare technical designs Construct assets

10 Risks Forecasts and Variance Risk is an unavoidable factor in provision of water and sanitation services Important major project variables typically include: Demand Interest rates Foreign Exchange Rates However, while we know past and present values, we cannot predict future values with certainty. What we can do is to model various scenarios for each of the key project variables, and analyze the effects on the project outcomes for each of the scenarios. Example of forecasting issues: ANALYSIS OF DEMAND Demand depends on various parameters including : Growth in per Capita income Population Change in weather Preferences Technology …………….and none of these can be forecast with certainty!!!!!

11 Risks Forecasts and Variance Risk is an unavoidable factor in provision of water and sanitation services In the Toolkit we give a policy simulation model that treats Demand (and two other variables – Interest and Foreign Exchange Rates) as being subject to Risk. The use of such modeling techniques shows that: Risk is measurable (at least approximately!) Measuring Risk is a useful step to Managing Risk

12 High demand Low demand Risks - Example: Demand Risk for Operator Household demand (million m³) Year Good Forecast What variation is likely in key project parameters? Given the uncertainty in key elements affecting Demand, it is only possible to give a good forecast that will give the average or expected outcome: In addition to this good forecast, there are a range of different scenarios that will give higher or lower forecast levels of demand over time. There is a need to evaluate the potential effect of these on the project, for example: Are existing investment plans viable under all cases? What will happen to the Operators profits?

13 Risks Demand Risk for Operator Net Present Value (NPV) of cash flows to operator (million pesos) 1, Frequency out of 10, BEST FORECAST OF NPV OF CASH FLOWS TO OPERATOR UPSIDE RISKDOWNSIDE RISK There is a need to assess project Risks under different scenarios. This example shows the varying Net Present Value of potential cash flow values of an Operators business, under different scenarios of Water Demand. The Y axis illustrates the chance (or Risk) of achieving each level of NPV. EXAMPLE: This shows about a 9.5 % chance (950 out of 10,000) that the Operators NPV will be between 0 and 20 million pesos (i.e. for the tallest blue bar here) EXAMPLE: This shows about a 9.5 % chance (950 out of 10,000) that the Operators NPV will be between 0 and 20 million pesos (i.e. for the tallest blue bar here) EXAMPLE This shows about a 0.2% chance (20 out of 10,000) that NPV will be as low as -200 million pesos EXAMPLE This shows about a 0.2% chance (20 out of 10,000) that NPV will be as low as -200 million pesos

14 Risks Responsibilities carry Risks Each area of responsibility for delivering water service carries risks Examples: ASSET CONDITION oTender documents provide information on assets. oThe Operator uses this information to make his bid. oThe actual state and value of the assets is different from the assumptions, with a direct effect on operation and maintenance costs. COLLECTIONS oSome customers will not pay. oThe Operator makes assumptions on levels of bad debts, varying with time. oEconomic conditions will vary, and so does the ability of customers to pay. CONSTRUCTION oConstruction of new plant involves a series of risks. Labor costs, timing of equipment delivery and cost and need of permits can all affect project costs and construction times (positively or negatively

15 Many risks affect the water sector One risk is often a bundle of other more specific risks Risks are interrelated Risks Links between Risks Currency Risk Renewals Exchange Rates Interest Rates Permitting & Consents Cash Collected RegulationTariffs RevenueDemand EconomyNon Payment Labor Relations Existing Assets Environment Site Conditions Currency Convertibility Labor Costs Labor Force Wages Input Prices Operating Costs Maintenance Cash Spent Cashflow New Investment Financing costs Political Environment Risk can be divided into two categories; Operation related Risks Set of risks associated with Operation & Maintenance Investment related Risks Set of investment related risks, including new and renovated infrastructure as well as any other investment needs.

16 Example: Demand Risk & Cashflows Currency Risk Renewals Exchange Rates Interest Rates Permitting & Consents Cash Collected RegulationTariffs RevenueDemand EconomyNon Payment Labor Relations Existing Assets Environment Site Conditions Currency Convertibility Labor Costs Labor Force Wages Input Prices Operating Costs Maintenance Cash Spent Cashflow New Investment Financing costs Political Environment Returning to our example: A variation in any one parameter will flow through to a total increase or decrease in the value of the business. The blue shaded boxes show how, for example, variations in Demand have an impact on other areas of risk, and ultimately on the cashflow of the business

17 Module 6 ANALYZING Responsibilities & Risks ALLOCATING Responsibilities & Risks DESIGNING Risk Allocation Rules EXAMPLES Allocation - Different PP Models ALLOCATING Responsibilities & Risks Allocating Responsibilities & Risks A key aim of private participation is to allocate risks between the Operator and the Contracting Authority.

18 Module 6Allocating Responsibilities & Risks How can we best allocate Risks and Responsibilities between the Contracting Authority and the Operator? Some Guidelines: Each Responsibility is allocated to the party best able to undertake it Each Risk is born by the party best able to manage it, taking account of the parties ability to: Predict changes in the relevant factors Influence or control the risk factor Control the impact of the risk on the value of the water and sanitation business Diversify or absorb the Risk NOTE: Bearing Risk has a cost. If Risk is allocated to the Operator, he will generally expect to be able to recover the cost. Allocating Risk to the party best able to manage it helps to reduce costs to the contracting authority and customers. Example: One party may be better able to predict nonpayment Example: one party may be better able to reduce nonpayment thru customer management Example: one party may be better able to reduce nonpayment through ability to offer credit terms Example: One party may be able to diversify risk across a portfolio of projects

19 Allocating Risks Example (1): Demand Risk Demand Risk affects many elements of water and sanitation companies, it can have a significant impact on the business value, and fluctuations in demand can drastically affect investment needs. The extent to which Demand Risk is shared between the Contracting Authority and the Operator depends on the particular circumstances of the project including: Availability of good information on Demand Economic Stability The Operators willingness to accept Risk In practice the Operator will be reluctant to accept full Demand Risk, and will seek to pass it onto customers through: Tariffs or ……. Reduced Service Levels

20 Allocating Risks Example (2): Currency Risk Currency Risk is made up of Exchange Rate and Convertibility Risks. Exchange rate risks comes from unpredictable variation in Exchange Rate. Convertibility Risk comes from uncertainty as to whether the Government will restrict conversion of the local currency into foreign currency Currency Risk affects the business value through several mechanisms: Operational Costs e. g. Affects costs of imported inputs, such as energy costs Maintenance and construction Costs e.g. Affects price of imported parts used in new construction Finance Costs e.g If Loans in foreign currency but revenues from local currency, then exchange rate fluctuations will affect business profitability.

21 Allocating Risks Example (2): Currency Risk Or, we can show graphically at the how Currency and Convertibility Risks affect the value of the business through several mechanisms…….. Cash Flow Operating & Maintenance Currency Convertibility Risk Total Costs New Investment Input Prices Financing Risk Exchange Rate Risk

22 Module 6 ANALYZING Responsibilities & Risks ALLOCATING Responsibilities & Risks DESIGNING Risk Allocation Rules EXAMPLES Allocation - Different PP Models DESIGNING Risk Allocation Rules Designing Allocation of Responsibilities & Risks The next step is to design the Rules that will allocate the risks and responsibilities

23 Module 6 Designing Allocation of Responsibilities & Risks Rules for adjusting tariffs are the key mechanism for allocating risk among Customers, the Operator and the Contracting Authority, but mechanisms covering other risks must also be must be designed TARIFF ADJUSTMENT MECHANISMS ALLOCATION OF OTHER RISKS Cost pass-through Tariff Indexation Formulas Tariff Resets Bonuses & penalties Government Guarantees Termination Triggers & payments Transition periods at commencement Contract Duration

24 Module 6 Tariff Adjustment Rules (1) Cost Pass-Throughs Cost pass-throughs should be considered for important costs over which the operator has no control Rules for adjusting Tariffs often allow changes in the cost of certain inputs, that are then passed through immediately to the Customers. This effectively allocates the Risk to the Customers. Items that can be treated as pass-throughs include: Bulk Water price increases Costs of changes in sales or value added taxes Costs of changes created by regulations governing the quality of water or waste water Example: Tangiers Concession – Bulk Water Cost Bulk water is supplied to the Concessionaire, by a Government owned body. The bulk water prices are not in the control of the Concessionaire. If the price of bulk water goes up, then the Tariffs are increased by the same amount, and the Operator neither loses or gains from the change. Customers therefore bear the risk of bulk water costs.

25 Module 6 Tariff Adjustment Rules (2) Tariff Indexation Formulas Index formulas serve to adjust tariffs to reflect a change in an index of prices, rather than the Operators actual costs Tariffs are adjusted at regular intervals (example: every 6 months) rather than response to specific events. Indexation attempts to anticipate changes in certain determinants of the cost of service. Tariffs are automatically adjusted according to certain rules. Tariff indexation formulas provide different adjustment methods, including: Change in average level of prices (e.g. by the consumer price index) Customized price index related to changes in utilitys likely costs (e.g. a basket of prices, such as exchange rates and prices of specified utility inputs) No indexation ( as often happens in USA) but with a nominal rate set for the tariff, and all changes made during Tariff Reset ( as discussed in the next section )

26 Module 6 Tariff Adjustment Rules (3) Tariff Resets - Objectives It is not possible to identify in advance all the factors that may affect an Operators profits. Tariff Resets recognize that indexation cannot cover all cases Tariff Resets are used in long duration contracts (e.g. affermage–lease, concession or divestiture). Tariffs are Reset against a set of rules that allow tariffs to be adjusted in a predictable fashion. The rules are agreed before the arrangement. We should note that the Operator has to bear more risk: The longer the gap between resets The less that resets pass on tariff changes to customers Considerations in designing Tariff-Reset rules; What are the objectives of the reset If review shows new tariff needed, what is the method for setting the new tariff? What triggers the tariff review and any tariff reset? Event Based Reviews - The Gambia Lease - Gabon Concession Tariff Reset Objectives & Risk Allocation

27 Objectives of Tariff Resets & Resulting Risk Allocation

28 Module 6 Other Mechanisms for Allocating Risk Although Tariff adjustment rules are the main ways of allocating risks, other risks are allocated between Operator and the Contracting Authority by contract Some other key risk allocation mechanisms include: Bonuses and penalties Government guarantees Termination triggers and payments Transition periods at commencement Contract Duration Bonuses & Penalties Performance payments such as penalties and bonuses encourage efficiency gains by sharing some element of risk with the Private Operator The Contract may lay out a list of penalties if the Operator does not perform. The Contract may also include bonuses if the Operator exceeds certain targets Bonuses are the main mechanisms for transferring risk in a Management Contract. A management Contract without performance bonuses only gives an Operator weak incentive to improve performance Guarantees The Contracting Authority or a Government entity may provide guarantees to the Operator against certain risks, such as: Operating debt Exchange rate guarantees related to foreign debt This guarantees downside risk, making it more attractive to the Operator. Care must be taken not to included risks that the Operator might be able to cover by himself more effectively Termination triggers and payments An arrangement will usually set out a list of triggers that entitles parties to terminate early, for example: Requisition, expropriation or seizure of water systems by Government The occasion of force majeure that makes the contract unworkable If penalties exceed a certain threshold the Contracting Authority may have the right to terminate. Termination payments compensate the Operator for costs that would otherwise be lost under early termination (e.g. sunk investment costs by the Operator). The way that these payments are calculated and applied helps to determine the allocation of risk Transition periods Where information problems increase the risk a transition period can be built in at the commencement of the arrangement. This allows an initial grace period when the Operator to collect information needed to run the business on a commercial basis, without accountability for performance improvements. Terms can be adjusted to reflect any major differences from the initial assumptions The longer the Contract Duration the more difficult it is to predict the effect of various for the life of the contract. This may make the risks and the costs become unacceptably high to the various parties. Reset mechanisms can help reduce risks to manageable levels for long duration contracts, particularly where private investment is involved

29 Module 6 Other Mechanisms for Allocating Risk Although Tariff adjustment rules are the main ways of allocating risks, other risks are allocated between Operator and the Contracting Authority by contract Some other key risk allocation mechanisms include: Bonuses and penalties Government guarantees Termination triggers and payments Transition periods at commencement Contract Duration

30 Module 6 ANALYZING Responsibilities & Risks ALLOCATING Responsibilities & Risks DESIGNING Risk Allocation Rules EXAMPLES Allocation - Different PP Models EXAMPLES Allocation - Different PP Models Different PP Models Allocating Responsibilities & Risks In this section we look at the way that three standard PPP models deal with Risk and Responsibilities: Management Contract Affermage/Lease Concession Each of these models is defined by the particular allocation of Risks and Responsibilities. These models can be tailored to meet specific situations, or hybrid versions of these models used. In this section we look at the way that three standard PPP models deal with Risk and Responsibilities: Management Contract Affermage/Lease Concession Each of these models is defined by the particular allocation of Risks and Responsibilities. These models can be tailored to meet specific situations, or hybrid versions of these models used.

31 Module 6 Different PP Models Allocating Responsibilities & Risks Operator Risks: Contract Form: OperationalTechnical Management Contract Affermage - Lease Concession Service Contract (by comparison) RegulationFinancial Commercial Forex Each of the three standard models of private participation is defined by the allocation of responsibilities and risks

32 Module 6 Different PP Models Allocating Responsibilities & Risks Operator Risks: Contract Form: OperationalTechnical Management Contract Affermage - Lease Concession Service Contract (by comparison) RegulationFinancial Commercial Forex Each of the three standard models of private participation is defined by the allocation of responsibilities and risks Concession: The Operator assumes full responsibility for service delivery, including: Management Operation Maintenance of existing assets New Investment Concession: The Operator assumes full responsibility for service delivery, including: Management Operation Maintenance of existing assets New Investment Affermage – Lease Responsibility for operating and maintaining assets plus commercial and management responsibilities, passes to the Operator The publicly owned company continues to be accountable for new investments) Affermage – Lease Responsibility for operating and maintaining assets plus commercial and management responsibilities, passes to the Operator The publicly owned company continues to be accountable for new investments) Management Contract: The Operator fills the Key management positions in the water company. The publicly owned company continues to be accountable for other responsibilities (e.g. operating and maintaining assets, new investments). Management Contract: The Operator fills the Key management positions in the water company. The publicly owned company continues to be accountable for other responsibilities (e.g. operating and maintaining assets, new investments).

33 Module 6 Different PP Models Allocating Responsibilities & Risks Political and Regulatory Risk Costs/Revenues LOWHIGH Operator willing to sink capital Operator willing to take operating and commercial risk only Operator will only take limited risk Tariffs dont cover O&M costs Tariffs cover O&M costs only Tariffs cover total costs Concession Lease/Affermage Management Contract Management Contract Looking at the balance between Costs and Revenues and Political and Regulatory Risks for each model …………. Management Contract The risk transferred to the Operator depends on a performance bonus. The formula for the bonus sets how much risk is taken by the Operator. In general, the least amount of risk is transferred to the Operator under a Management Contract. Management Contract The risk transferred to the Operator depends on a performance bonus. The formula for the bonus sets how much risk is taken by the Operator. In general, the least amount of risk is transferred to the Operator under a Management Contract. Affermage – Lease The risk transferred to the Operator is significant, but depends on the contract details and the way that the operators remuneration is determined. Affermage: the tariff adjustment rules relating to the Operators tariff (or affermage fee) are the most important Lease: the Operator gets the customer tariff minus the lease payment. Tariff adjustment related to customer tariff are the most important. Affermage – Lease The risk transferred to the Operator is significant, but depends on the contract details and the way that the operators remuneration is determined. Affermage: the tariff adjustment rules relating to the Operators tariff (or affermage fee) are the most important Lease: the Operator gets the customer tariff minus the lease payment. Tariff adjustment related to customer tariff are the most important. Concession: The Operator takes the greatest overall risks or responsibilities of the three models Concession: The Operator takes the greatest overall risks or responsibilities of the three models

34 Module 6 Different PP Models Allocating Responsibilities & Risks Political and Regulatory Risk Costs/Revenues LOWHIGH Operator willing to sink capital Operator willing to take operating risk only Operator wont take any risk Tariffs dont cover O&M costs Tariffs cover O&M costs only Tariffs cover total costs Concession Lease/Affermage Management Contract Management Contract HYBRID MODELS In addition to the three basic PP Models, it is possible to design and implement hybrid structures that combine effective elements of different structures, balance risk, mobilize capital but protect the poor HYBRID MODELS In addition to the three basic PP Models, it is possible to design and implement hybrid structures that combine effective elements of different structures, balance risk, mobilize capital but protect the poor Each model has a particular application to the balance between Costs and Rvenues as well as Political and Regulatory Risks

35 Module 6 Different PP Models Allocating Responsibilities & Risks Political and Regulatory Risk Costs/Revenues LOWHIGH Operator willing to sink capital Operator willing to take operating risk only Operator wont take any risk Tariffs dont cover O&M costs Tariffs cover O&M costs only Tariffs cover total costs Concession Lease/Affermage Management Contract Management Contract HYBRID MODELS In addition to the three basic PP Models, it is possible to design and implement hybrid structures that combine effective elements of different structures, balance risk, mobilize capital but protect the poor HYBRID MODELS In addition to the three basic PP Models, it is possible to design and implement hybrid structures that combine effective elements of different structures, balance risk, mobilize capital but protect the poor Each model has a particular application to the balance between Costs and Rvenues as well as Political and Regulatory Risks Examples; Risk in Hybrids - Amman (MC) - Cartagena Affermage/Lease

36 Reviewing Module 6 The Module has looked at a whole range of issues for analysis and allocation of responsibilities & risks in PP design…………. ANALYZING Responsibilities & Risks ALLOCATING Responsibilities & Risks DESIGNING Risk Allocation Rules EXAMPLES Allocation – Different PP Models ANALYZING Responsibilities & Risks

37 Checklist: Module 6 ……..and the allocation process is detailed in this Checklist

38 More Information: Module 6

39 Supporting Material The Toolkit Financial Model Toolkit Case Study material Toolkit Website: For comments or further details contact Cledan Mandri Perrott at

40 Toolkit: Module 6 End of Module

41 Toolkit: Module 6 Return to Start

42 Toolkit: Module 6 DO NOT MOVE or ERASE THE FOLLOWING SLIDES

43 Event Based Reviews: Gambia & Gabon

44 Risk Share – Hybrids: Amman & Cartagena

45 Toolkit: Module 6

46 DO NOT MOVE or ERASE THE PREVIOUS SLIDES AFTER END OF MODULE


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