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Toolkit: Approaches to Private Participation in Water Services

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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
1 ConsideringPrivate Participation 9 Selecting an Operator 2 Planning the Process TOOLKIT Appendix A Examples of PP Arrangements 8 Designing Legal Instruments 3 Involving Stakeholders Appendix B Policy Simulation Model Elements of the Toolkit: Toolkit is developed in ten main sections, two Appendices and Supplementary Material: Overview: Provides an overview of the approach taken in developing the Toolkit, discusses the key issues of providing water and sanitation services, the definition of basic principles and provides tools and options for planning and design of reforms to resolve the situation 1 Considering private participation: A review of the key issues that governments can resolve in order to introduce private participation, including resolution of policy problems, effects of privatization, making privatization work, the various private participation models, and how the Toolkit approach works. 2 Planning the process of introducing private participation: A four step process for developing policy, designing details of the arrangement, selecting the operator and managing the arrangements are reviewed. Key elements of the overall design such as stakeholder consultation, government institutions to manage the arrangement and key analytic and advisory work to support the arrangement are discussed. 3 Involving Stakeholders in the design of the arrangement: Discussion on ways of identifying and involving stakeholders in the design of the arrangements and of distributing the benefits and costs of private participation so as to increase support and long term sustainability. 4 Setting upstream policy: This considers some of the key reform choices for the water sector upstream of the design of the private participation arrangement, such as the allocation of responsibilities among different tiers of government, definition of the market structure for the water sector (including appropriate scale and scope for the water utilities) and establishing policies and rules governing competition. 5 Setting service standards, tariffs, subsidies, and financial arrangements: A section reviewing the key issues related to setting targets relating to coverage and quality; the implications of those targets for the cost of service; options for supplementing tariff revenue with subsidies; and some implications for design of the arrangement and its financing. 6 Allocating responsibilities and risks: Provides advice on the identification, assessment and allocation of risks and responsibilities among customers, the operator, and the government and how to design tariff-adjustment and other rules to achieve the desired allocation. 7 Developing institutions to manage the relationship: The choice and design of institutions—including courts, arbitration panels, independent experts, and regulatory agencies—that will interpret and apply the rules over the life of the arrangements. 8 Designing legal instruments for the arrangement: This section considers how the chosen arrangement can be embodied in legally effective documents (such as laws, contracts and licenses). It also describes how the government can retain legal power to implement the arrangement, how to check on potential constraints, and how to design legal mechanisms to enforce obligations and ensure successful provision of service. 9 Selecting the Operator: A review of the key issues to be addressed and steps involved in selecting an operator governments can use to select the operator. This includes detailed discussion on selection methods, selection criteria, managing the bidding process and some key bidding issues. Additional Toolkit material The Toolkit includes other supplementary material: Appendix A Examples of Private Participation Arrangements The Toolkit includes sixteen examples of arrangement designs in developed and developing countries. These highlight the specific design aspects following the sections in the Toolkit. Appendix B The Policy simulation model This is an Excel based policy simulation model. It illustrates issues discussed, suggests outputs that government’s modelers might produce and illustrates possible modeling approaches. It shows how the three key issues can be integrated: Stakeholder costs and benefits (Chapter 3) Setting tariffs, subsidies and coverage (Chapter 5) Allocating risk (Chapter 6) 7 Developing Institutions 4 Setting Upstream Policy 6 Responsibilities & Risks 5 Standards, Tariffs, Subsidy, Financials Additional Material CD-ROM

4 General Outline of Toolkit
Module 6 1 ConsideringPrivate Participation 9 Selecting an Operator 2 Planning the Process TOOLKIT Appendix A Examples of PP Arrangements 8 Designing Legal Instruments 3 Involving Stakeholders Appendix B Policy Simulation Model This presentation reviews Module 6 of the Toolkit ‘Approaches to Water Privatization’. Module 6, one of 10 related sections of the Toolkit, covers issues of Allocating Responsibilities and Risks in a Private Participation Arrangement Elements of the Toolkit: Toolkit is developed in ten main sections, two Appendices and Supplementary Material: Overview: Provides an overview of the approach taken in developing the Toolkit, discusses the key issues of providing water and sanitation services, the definition of basic principles and provides tools and options for planning and design of reforms to resolve the situation 1 Considering private participation: A review of the key issues that governments can resolve in order to introduce private participation, including resolution of policy problems, effects of privatization, making privatization work, the various private participation models, and how the Toolkit approach works. 2 Planning the process of introducing private participation: A four step process for developing policy, designing details of the arrangement, selecting the operator and managing the arrangements are reviewed. Key elements of the overall design such as stakeholder consultation, government institutions to manage the arrangement and key analytic and advisory work to support the arrangement are discussed. 3 Involving Stakeholders in the design of the arrangement: Discussion on ways of identifying and involving stakeholders in the design of the arrangements and of distributing the benefits and costs of private participation so as to increase support and long term sustainability. 4 Setting upstream policy: This considers some of the key reform choices for the water sector upstream of the design of the private participation arrangement, such as the allocation of responsibilities among different tiers of government, definition of the market structure for the water sector (including appropriate scale and scope for the water utilities) and establishing policies and rules governing competition. 5 Setting service standards, tariffs, subsidies, and financial arrangements: A section reviewing the key issues related to setting targets relating to coverage and quality; the implications of those targets for the cost of service; options for supplementing tariff revenue with subsidies; and some implications for design of the arrangement and its financing. 6 Allocating responsibilities and risks: Provides advice on the identification, assessment and allocation of risks and responsibilities among customers, the operator, and the government and how to design tariff-adjustment and other rules to achieve the desired allocation. 7 Developing institutions to manage the relationship: The choice and design of institutions—including courts, arbitration panels, independent experts, and regulatory agencies—that will interpret and apply the rules over the life of the arrangements. 8 Designing legal instruments for the arrangement: This section considers how the chosen arrangement can be embodied in legally effective documents (such as laws, contracts and licenses). It also describes how the government can retain legal power to implement the arrangement, how to check on potential constraints, and how to design legal mechanisms to enforce obligations and ensure successful provision of service. 9 Selecting the Operator: A review of the key issues to be addressed and steps involved in selecting an operator governments can use to select the operator. This includes detailed discussion on selection methods, selection criteria, managing the bidding process and some key bidding issues. Additional Toolkit material The Toolkit includes other supplementary material: Appendix A Examples of Private Participation Arrangements The Toolkit includes sixteen examples of arrangement designs in developed and developing countries. These highlight the specific design aspects following the sections in the Toolkit. Appendix B The Policy simulation model This is an Excel based policy simulation model. It illustrates issues discussed, suggests outputs that government’s modelers might produce and illustrates possible modeling approaches. It shows how the three key issues can be integrated: Stakeholder costs and benefits (Chapter 3) Setting tariffs, subsidies and coverage (Chapter 5) Allocating risk (Chapter 6) 7 Developing Institutions 4 Setting Upstream Policy Module 6 Allocating Responsibilities and Risks 6 Responsibilities & Risks 5 Setting Service Standards, Tariffs, Subsidies & Financial Arrangements Additional Material CD-ROM

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? What are the key areas of RISK associated with the responsibilities, and how can they be defined? Who is best able to manage these risks and responsibilities, and how best to allocate these? 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? By the end of this presentation we should have achieved understanding of the following: What are the key areas of responsibility for provision of the water services, and how can they be defined? What are the key areas of risks associated with the responsibilities, and how can they be defined? Who is best able to manage these risks and responsibilities, and how best to allocate these? 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? Is it possible to use a standard model of private participation for a specific case, or is some tailored or hybrid model required? Is it possible to use a standard model of private participation for a specific case, or is some tailored or hybrid model required?

6 Module 6 Allocating Responsibilities and Risks
ANALYZING Responsibilities & Risks ALLOCATING Responsibilities & Risks DESIGNING Risk Allocation Rules EXAMPLES Allocation Different PP Models The Module starts with a section ANALYZING key issues related to provision of water services: Key areas of RESPONSIBILITY and how can they be defined? Key RISKS related to these Responsibilities, and how can they be defined? We look at ways of determining the best ALLOCATION of Responsibilities and Risks between the operator and the contracting authority. Next we look at how DESIGNING rules and mechanisms can ensure that the allocations of Responsibility and Risk are carried out effectively. Finally we consider EXAMPLES of how we can Allocate Risks and Responsibilities under different models of PP arrangements.

7 Module 6 Allocating Responsibilities and Risks
Analyzing Responsibilities & Risks Module 6 Allocating Responsibilities and 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? ANALYZING Responsibilities & Risks ANALYZING Responsibilities & Risks ANALYZING Responsibilities & Risks ALLOCATING Responsibilities & Risks DESIGNING Risk Allocation Rules EXAMPLES Allocation Different PP Models ALLOCATING Responsibilities & Risks DESIGNING Risk Allocation Rules In this section we ANALYZE key issues related to provision of water services, looking at two main areas Key areas of RESPONSIBILITY and how can they be defined? Key RISKS related to these Responsibilities, and how can they be defined? EXAMPLES Allocation Different PP Models

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 Note: This slide is in two sections Responsibilities in any water or waste water utility can be considered in three main areas: MANAGEMENT OPERATIONS & MAINTENANCE INVESTMENT & FINANCE The following develop with three mouse clicks; We can describe certain main responsibilities in each key area, and although not exclusive, these include: Direct staff Set human resource Policy Establish or improve business processes Manage inventory Maintain assets Commercial responsibilities If current arrangements are unable to meet demand it will be necessary to provide investment and finance for new or improved assets, as well as any financing necessary for day to day utility operation: 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 In the Toolkit we review three main PPP models. Each covers a different allocation of risks and responsibilities. We look at this in more detail later, but here are the broad parameters for each arrangement: This slide reveals the three models through separate mouse clicks. The Management Contract is limited to aspects of Management responsibilities The Affermage & Lease arrangements are more onerous, and add Operations and Maintenance as well as the Management to the private operator’s responsibilities. The Concession & Divestiture arrangements are the most comprehensive, requiring the private operator to take responsibility for the majority or all of the utility activities, being responsible for Management, Operations and Maintenance as well as Investment and Finance.

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!!!!! “Risk is an unavoidable factor in provision of water and sanitation services” TWO MOUSE CLICKS ONE: 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. TWO: 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 Policy simulation: 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 Risks - Example: Demand Risk for Operator
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 Operator’s profits?” Risks - Example: Demand Risk for Operator “ What variation is likely in key project parameters?” Household demand (million m³) Year 250 200 150 100 50 ‘Good’ Forecast High demand Low demand 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: “ What variation is likely in key project parameters?” MOUSE CLICK 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 Operator’s profits?”

13 Risks Demand Risk for Operator
BEST FORECAST OF NPV OF CASH FLOWS TO OPERATOR 1,000 EXAMPLE: This shows about a 9.5 % chance (950 out of 10,000) that the Operator’s NPV will be between 0 and 20 million pesos (i.e. for the tallest blue bar here) 900 UPSIDE RISK DOWNSIDE RISK 800 700 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 Operator’s business, under different scenarios of Water Demand. The Y axis illustrates the ‘chance’ (or Risk) of achieving each level of NPV. 600 Frequency out of 10,000 500 EXAMPLE This shows about a 0.2% chance (20 out of 10,000) that NPV will be as low as -200 million pesos 400 Here we illustrate the way we need to model various risk scenarios to get an overview of the likely project risk profile under possible future situations. As an example, using the Toolkit Policy simulation model we can investigate the possible effect of unpredictable water demand on the Operator’s business. The model shows the varying Net Present Value of potential cash flow values of the Operator’s business, under different scenarios of water demand. The Y axis illustrates the ‘chance’ of achieving each level of NPV. MOUSE CLICK The heavy vertical red line at around 40 million pesos shows the best forecast of the NPV of cash flows to the operator The blue bars on the left indicate Downside risk, those on the right indicate Upside risk. To show the way that the chance of each scenarios is calculated we give two examples: Example 1: This shows about a 9.5 % chance (950 out of 10,000) that the Operator’s NPV will be between 0 and 20 million pesos (i.e. for the tallest blue bar here) Example 2 By the same method of calculation this shows (20 out of 10,000) about a 0.2% chance that NPV will be as low as -200 million pesos 300 200 100 - 200 - 160 - 120 - 80 - 40 40 80 120 160 200 240 280 320 360 400 Net Present Value (NPV) of cash flows to operator (million pesos)

14 Risks Responsibilities carry Risks
“Each area of responsibility for delivering water service carries risks” Examples: ASSET CONDITION Tender documents provide information on assets. The Operator uses this information to make his bid. The actual state and value of the assets is different from the assumptions, with a direct effect on operation and maintenance costs. COLLECTIONS Some customers will not pay. The Operator makes assumptions on levels of bad debts, varying with time. Economic conditions will vary, and so does the ability of customers to pay. CONSTRUCTION Construction 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 “Each area of responsibility for delivering water service carries risks” And this slide gives examples

15 Risks Links between Risks
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. Currency Risk Renewals Exchange Rates Interest Rates Permitting & Consents Cash Collected Regulation Tariffs Revenue Demand Economy Non 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. MOUSE CLICK THE DIAGRAM SHOWS AN EXAMPLE OF THE COMPLEX INTERLINKING OF VARIOUS RISKS AND RESPONSIBILITIES “ Many risks affect the water sector One risk is often a bundle of other more specific risks Risks are interrelated” Many risks affect the water sector One risk is often a bundle of other more specific risks Risks are interrelated

16 Example: Demand Risk & Cashflows
Currency Risk Renewals Exchange Rates Interest Rates Permitting & Consents Cash Collected Regulation Tariffs Revenue Demand Economy Non 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 Example – Demand Risk & Cash Flows 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 Allocating Responsibilities & Risks Module 6
A key aim of private participation is to allocate risks between the Operator and the Contracting Authority. ANALYZING Responsibilities & Risks ALLOCATING Responsibilities & Risks DESIGNING Risk Allocation Rules EXAMPLES Allocation Different PP Models ALLOCATING Responsibilities & Risks This next section deals with Allocating Responsibilities and risks A key aim of private participation is to allocate risks between the Operator and the Contracting Authority.

18 Allocating Responsibilities & Risks
Module 6 Allocating 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. A key question is “How can we best allocate Risks and Responsibilities between the Contracting Authority and the Operator” 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 Example: One party may be better able to predict non-payment Influence or control the risk factor Example: One party may be better able to reduce the number of non-paying customers through customer management Control the impact of the risk on the value of the water and sanitation business Example: One party may be better able to limit effects of non payment through better commercial management (eg different credit terms) Diversify or absorb the Risk Example: One party may be better able to absorb risks across a portfolio of projects 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 Operator’s 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 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 Operator’s 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. 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” THE SLIDE REVEALS THROUGH 4 MOUSE CLICKS: 1. Currency Risk affects the business value through several mechanisms: 2 Operational Costs e. g. Affects costs of imported inputs, such as energy costs 3 Maintenance and construction Costs e.g. Affects price of imported parts used in new construction 4 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……..” Operating & Maintenance Input Prices Total Costs Cash Flow Exchange Rate Risk New Investment We can show the effect of the Currency Risk example (from the previous slide) graphically; The risks and business elements affected reveal through 3 MOUSE CLICKS, showing how EXCHANGE RATE & CONVERTIBILITY ultimately affect COSTS and CASH FLOW Financing Risk Currency Convertibility Risk

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

23 TARIFF ADJUSTMENT MECHANISMS ALLOCATION OF OTHER RISKS
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 “ 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 Cost pass-through Tariff Indexation Formulas Tariff Resets Bonuses & penalties ALLOCATION OF OTHER RISKS Government Guarantees Termination Triggers & payments Transition periods at commencement

24 Tangiers Concession – Bulk Water Cost
Tariff Adjustment Rules (1) Cost Pass-Throughs Module 6 “ Cost pass-throughs should be considered for important costs over which the operator has no control” 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. 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 Tariff Adjustment Rules (1) Cost Pass-Throughs “ Cost pass-throughs should be considered for important costs over which the operator has no control” EXAMPLE ON MOUSE CLICK Tangiers Concession – Bulk Water Cost Bulk water is supplied to the Concessionaire by a Government owned body, and 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 Operator’s 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 utility’s 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 ) 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 Operator’s 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 utility’s 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 Operator’s 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? Tariff Reset Objectives & Risk Allocation Tariff Adjustment Rules (3) Tariff Resets – Objectives “ It is not possible to identify in advance all the factors that may affect an Operator’s 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

27 Objectives of Tariff Resets & Resulting Risk Allocation

28 Module 6 Other Mechanisms for Allocating Risk
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 Other Mechanisms for Allocating Risk Module 6 “ 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 Other Mechanisms for Allocating Risk “ It is not possible to identify in advance all the factors that may affect an Operator’s profits. Tariff Resets recognize that indexation cannot cover all cases” This slide looks at 5 other mechanisms for risk allocation, and details for each reveal on a MOUSE CLICK “Some other key risk allocation mechanisms include: 1. Bonuses and penalties 2 Government guarantees 3 Termination triggers and payments 4. Transition periods at commencement 5 Contract Duration” 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 Other Mechanisms for Allocating Risk “ It is not possible to identify in advance all the factors that may affect an Operator’s profits. Tariff Resets recognize that indexation cannot cover all cases” This slide looks at 5 other mechanisms for risk allocation, and details for each reveal on a MOUSE CLICK “Some other key risk allocation mechanisms include: 1. Bonuses and penalties 2 Government guarantees 3 Termination triggers and payments 4. Transition periods at commencement 5 Contract Duration”

30 Module 6 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. ANALYZING Responsibilities & Risks ALLOCATING Responsibilities & Risks DESIGNING Risk Allocation Rules The final section in the module looks at Different Private Participation Models and how they Allocate 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. EXAMPLES Allocation Different PP Models EXAMPLES Allocation Different PP Models

31 Module 6 Different PP Models Allocating Responsibilities & Risks
“ Each of the three standard models of private participation is defined by the allocation of responsibilities and risks” Operator Risks: Contract Form: Operational Technical  Management Contract  Affermage - Lease Concession Service Contract (by comparison) Regulation Financial Commercial Forex Different PP Models Allocating Responsibilities & Risks “ Each of the three standard models of private participation is defined by the allocation of responsibilities and risks” The slide gives Risks typically assumed under each of the three standard PP Models. The relative level of risk normally associated is indicated by the number of check marks against each of the three main PP Models: Management Contract Affermage/Lease Concession The main responsibilities are: Operational Technical Commercial Regulation Financial Foreign Exchange

32 Module 6 Different PP Models Allocating Responsibilities & Risks
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). 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) Different PP Models Allocating Responsibilities & Risks Module 6 “ Each of the three standard models of private participation is defined by the allocation of responsibilities and risks” Operator Risks: Contract Form: Operational Technical  Management Contract  Affermage - Lease Concession Service Contract (by comparison) Regulation Financial Commercial Forex Concession: The Operator assumes full responsibility for service delivery, including: Management Operation Maintenance of existing assets New Investment Different PP Models Allocating Responsibilities & Risks “ Each of the three standard models of private participation is defined by the allocation of responsibilities and risks” This slide gives further details on Responsibilities under each of the 3 PP models, each revealed through a mouse click Management Contract: The Operator fills the Key management oppositions in the water company. The publicly owned company continues to be accountable for other responsibilities (e.g. operating and maintaining assets, new investments) Affermage – Lease Responsibility for operating and maintaining assets plus commercial and management responsibilities, pass to the Operator The publicly owned company continues to be accountable for new investments) Concession The Operator assumes full responsibility for service delivery, including: Management Operation Maintenance of existing assets New Investment

33 Political and Regulatory Risk
Different PP Models Allocating Responsibilities & Risks Module 6 Affermage – Lease The risk transferred to the Operator is significant, but depends on the contract details and the way that the operator’s remuneration is determined. Affermage: the tariff adjustment rules relating to the Operator’s 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. “ Looking at the balance between Costs and Revenues and Political and Regulatory Risks for each model ………….” Political and Regulatory Risk Costs/Revenues LOW HIGH Operator willing to sink capital Operator willing to take operating and commercial risk only Operator will only take limited risk Tariffs don’t cover O&M costs Tariffs cover O&M costs only Tariffs cover total costs Concession Lease/Affermage Management Contract Management Contract Concession: The Operator takes the greatest overall risks or responsibilities of the three models 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. Different PP Models Allocating Responsibilities & Risks “ Looking at the balance between Costs and Revenues and Political and Regulatory Risks for each model ………….” This slide shows in diagrammatic form the level of some of the key risks typically associated with each of the three PP models: 3 MOUSE CLICKS REVEAL INFORMATION ON EACH TYPE 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 operator’s remuneration is determined. Concession The Operator takes the greatest overall risks or responsibilities of the three models

34 Political and Regulatory Risk
Different PP Models Allocating Responsibilities & Risks Module 6 “ Each model has a particular application to the balance between Costs and Rvenues as well as Political and Regulatory Risks” Political and Regulatory Risk Costs/Revenues LOW HIGH Operator willing to sink capital Operator willing to take operating risk only Operator won’t take any risk Tariffs don’t 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 Finally, the three basic PP models can be tailored to suit specific circumstances: “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 still protect the poor “

35 Political and Regulatory Risk
Different PP Models Allocating Responsibilities & Risks Module 6 “ Each model has a particular application to the balance between Costs and Rvenues as well as Political and Regulatory Risks” Political and Regulatory Risk Costs/Revenues LOW HIGH Operator willing to sink capital Operator willing to take operating risk only Operator won’t take any risk Tariffs don’t 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 Examples; Risk in Hybrids - Amman (MC) - Cartagena Affermage/Lease Finally, the three basic PP models can be tailored to suit specific circumstances: “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 still protect the poor “

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 REPRISE OF IINITIAL SLIDE: Setting Level of Service is an iterative process First this involves technical analysis and costing of the level of service and any related investment. The Government then has decide whether the cost of this level of service can be supported, what Tariff Levels need to be set for effective cost recovery and if any Subsidy has to be used to make an affordable service to the customer. We look at these elements, including types and use of subsidy Estimating the Trade off between Level of Service and Tariff/Subsidy is best done with a financial model such as the one provided with the Toolkit: If the cost of services proves too high then the process is iterated, amending the elements until a satisfactory balance between Level of Service and Tariff is found. When the balance between Cost of Service and Tariff is satisfactory, then we can proceed with the design and Implementation of the chosen arrangement. In the final sections we discussed Implication for design of PP Arrangements and looked at some guidance on Structuring Finance for the arrangement.

37 Checklist: Module 6 ‘……..and the allocation process is detailed in this Checklist” Finally, this Checklist gives a useful reminder of the detailed issues to be considered in this process, towards arriving at the final Arrangement Design.

38 More Information: Module 6
Finally, this Checklist gives a useful reminder of the detailed issues to be considered in this process, towards arriving at the final Arrangement Design.

39 Supporting Material The Toolkit Financial Model
Toolkit Case Study material Toolkit Website: For comments or further details contact Cledan Mandri Perrott at There are some supplementary materials that will help you understand this further. The toolkit includes a spreadsheet based financial Policy Simulation model that will assist in balancing tariffs, subsidies and coverage targets as covered by Module 5 [ as well as integrating with some of the other key financial issues covered in other Modules] There are 16 case studies, and some of these have been referred to in this module. The full toolkit can be read or downloaded from the website, and questions or comments made to the task manager.

40 Toolkit: Module 6 End of Module END OF PRESENTATION

41 Toolkit: Module 6 Return to Start END OF PRESENTATION

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

43 Event Based Reviews: Gambia & Gabon

44 Risk Share – Hybrids: Amman & Cartagena

45 Toolkit: Module 6 END OF PRESENTATION

46 Toolkit: Module 6 DO NOT MOVE or ERASE THE PREVIOUS SLIDES AFTER “END” OF MODULE END OF PRESENTATION


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