Urban Water Strategic Management in 21st Century（III）

Urban Water Strategic Management in 21st Century[III]

7.7 PRIVATE SECTOR INVESTMENT

Many municipalities are considering various forms of financing sources. Private sector involvement has emerged as a viable strategy for infrastructure since it offers access to investment capital in addition to government expenditure. The PRC attracts a large amount of foreign direct investment in recent years, but the proportion of the foreign direct investment directed to urban infrastructure sector remains very low. A great potential of private investment can be tapped.

Developing private sector participation in urban infrastructure can improve access to capital funds, gain access to advanced technology and equipment, introduce new approaches to management that will increase production efficiency and financial performance and to upgrade technical skills and to create opportunities to reform tariffs. Efficiency improvements can occur if a competitive process is used by introducing the private sector option. The access to investment funds can improve because of the financial resources introduced by the private sector partner and a more rational cost based tariff introduced by the new arrangement. The use of governmental grants has increased to lever funding from the private sector in infrastructure and environmental projects.The objective of the private sector partner is a reasonable return on investment at an acceptable level of risk. The principal elements of risk for the private sector partner are: (1) changes in the fiscal, legal and regulatory regime; (2) failure to achieve performance standards for construction or operations; (3) failure to realize revenue requirements due to factors such as low sales volumes, low tariffs and exchange rate movements. The significance of these risks in a specific situation depends on the structure of the private sector option that is used and the contractual terms and conditions relating to the assignment and management of risk.

The ability to attract private sector partners will depend critically on future prospects for cost recovery including the recovery of a return on capital investments. Tariff reform and improved cost control are the most important changes that will improve profitability. Investment opportunities that will attract private sector funds must be comparable to alternative private sector investments in terms of return on investments and risk. Appropriate rates of return will vary over time and from one city to another depending on local risk factors. The regulatory process for tariffs must be sufficiently flexible to account for this variability. At the same time, it must prohibit excessive profits. National and provincial tariff guidelines should therefore establish clear but flexible rules governing allowable returns to investments.

In water supply sector, there have been several examples of this so far, including three projects in Shanghai and one in Chengdu. The Shanghai projects were initiated due to a projected need for ￥2 billion in capital funds for essential water supply facilities. Traditional funding sources were no longer available and WSC finances were such that they could not arrange financing themselves. The Raw Water Stock Company in Shanghai is a shareholder company owned by the municipal Construction Commission. It was established to allow funding to be obtained for a large raw water supply investment. The Lingqiao Company in Shanghai is another shareholder company that has issued and sold shares to finance the Lingqiao WTP. The Shanghai BOT project was used to build and operate a WTP that will eventually revert to the WSC. In each of these examples, the SMWC contracts to purchase water from the new company or agency at a stipulated volumetric wholesale rate that is set to fully recover project operating and capital costs. A new BOT project contract was finalized for Chengdu in 1998. It is being used as a test of this funding approach by the State.

There was some feedback on the alternative funding methods used in Shanghai and Chengdu. These methods are recognized as being successful in generating the needed capital funds. But it is not clear what other benefits they will bring. For instance, the BOT project can be used to introduce more efficient operating methods, but this does not appear to be the basis for the current BOT projects. WSC staff reported that water treatment plant designs in the PRC are at least as efficient as the approaches likely to be used by international consultants. Faster construction is also not expected from the BOT approach since water treatment plant facilities in the PRC can be constructed very quickly by western standards.

The alternate funding approaches do not change the ability of the WSC to pay the cost of capital works. In Shanghai, the WSC financial situation has deteriorated. The WSC is obliged to allocate funds to the independent wholesale water operations first. Since the retail water tariff is still inadequate to meet total costs, the coverage of the WSC‘s internal costs has deteriorated and this creates the need for larger subsidies. In 1996 these water supply operations supplied less than 10% of treated water needs and 2/3 of raw water needs, while receiving 64% of water sale revenues. Long-term debt approached ￥2 billion and accounts payable exceeded ￥1.2 billion. The use of shareholder financing dealt with the symptoms but did not deal with the fundamental problem, namely tariffs that are too low to generate the required funds. The alternative funding methods do fulfil the need for raising capital, but do not address the need for more financial self-sufficiency on the part of the WSCs.

It is still early to provide a definitive evaluation of the performance of WSC ventures involving the private sector, but experiences to date with the Shanghai BOT type project are informative. A WSC that is contemplating a BOT venture must carefully assess its own financial resources and technical skills in order to make sure that the BOT approach is likely to offer advantages that can not otherwise be obtained. A long term financial forecast that compares BOT costs with the costs of alternative approaches to developing capital works is an essential ingredient of this type of assessment.

8. FUNDING SOURCE DEVELOPMENT

Financing for major water supply investments has traditionally been provided by the State. With sources of funds under increasing strain, the approach is changing. Present fund sources for water supply projects are from governments, domestic loans and bonds, international loans, private investors and user charges. Savings of residents have increased at high rates and in 1998 savings residents in the PRC were 5,341 billion yuan, about 67% of GDP. More savings than capital investments in recent years means funds from domestic sources can meet the investment requirement of infrastructure. Since 1996, domestic interest rates have been lowed 7 times in order to encourage expenditure and investment. After June 1999, the one year term deposit in banks earns 2.25% interest and interest of one year loan is 5.85%. The low interest rates encourage funds flowing to investment. Water supply is surfacing out as a worth investment after interest in other investment phasing out.

8.1 GOVERNMENT

8.1.1 FUND SOURCES

To date, infrastructure investment has been financed almost entirely by Municipal, Regional, and State government grants supplemented by small amounts of internal financing.

A local government lending is another source for fund. At present 3-5 year loans are most common and 10 years is the maximum, but these are too short to cover the life of most assets of water facilities. Loans are frequently more acceptable where the project itself yields enough revenue to cover repayments or increases local tax revenue.

A local government lending is another source for fund. It becomes common in a share hold company which is acting as a project implementing agency. The government lends a fund to the company and charges interest.

As the capital market develops, and as the financial preparation and presentation of projects and credit-worthiness of local governments improves, there may be an opportunity that local government will be allowed to issue bonds. Enterprise bonds may also be able to have middle term and infrastructure funds may be established. They can be long-term and cost-effective method for funding infrastructure projects.

As such, where government financing of projects is necessary, the use of government loans (rather than grants) will increase the focus on cost recovery and the financial feasibility of projects. At the same time, government financing through loans will result in the eventual repayment of loans enabling government to re-circulate funds in the future.

Urban infrastructure financed by government grants results in low levels of concern for cost recovery or for issues of financial sustainability. Planning has generally followed a supply-side approach based on State determined standards of service. This trend is now changing to improve the utilization of limited financial and other resources. There is a shift from a supply-side to a demand-management approach and greater emphasis is being placed on a more rigorous economic justification for infrastructure projects.

Prioritization of projects for investment must place greater emphasis on financial and economic arguments. This includes improved efforts to achieve full cost recovery from the beneficiaries through user fees, and the use of government subsidization only where the economic benefits indicate subsidization is justified.

8.2 DOMESTIC LOANS AND BONDS

8.2.1 STATE DEVELOPMENT BANK

State Development Bank was established in 1994 and provides medium- to long-term funding to finance infrastructure projects selected on policy. In 1998, 55 % of its loan portfolio was for power, coal, and petroleum projects, 32 % for transport, and a small proportion for water and sanitation.

8.2.2 BOND

In PRC, the issue of debt for the infrastructure financing can be undertaken directly by the State government or a local enterprise while provincial and municipal governments are not allowed to issue their own bonds. PBC supervises the aggregate volume of enterprise bond issues. Enterprise bond issue quotas have been controlled. State owned enterprises are authorized to issue bonds by municipal planning commission and local PBC office, within the quota allocated to the municipality. Municipal governments do not have authority to change the issue quotas set by the State government. The allocation of the quota depends on financial needs and priorities of the development sector.

It is suggested that governments consider to support

8.2.2.1 State Infrastructure Bond

The PRC Ministry of Finance announced a 100 billion yuan short term lending program for infrastructure in 1998.

8.2.2.2 Enterprise Bond

The Baotou Water Supply Company issued bonds in 1997 to raise 100 million yuan for the Huajiangyingzi water supply project. The bond issue enabled the use of private funds for infrastructure development. Government guaranteed the bond to reduce the risk faced by investors and it offered an interest rate that was higher than that offered by the commercial banks. The 100 million yuan bond issue was offered to the public after approval by the People‘s Bank of China and it was completely sold out in 3 days. A second series of bonds are now under preparation to be marketed in 1999. Municipal bonds are therefore becoming an important financial option.

8.3 USER CHARGES

Water tariffs are required to be set to achieve the objective of full cost recovery in order to end WSC‘s reliance on governmental subsidies. Full cost recovery here means the recovery of all financial costs associated with the provision of water including direct and indirect operating and maintenance (OM) costs, depreciation, taxes, interest on debt and a return on equity. With the help of promulgated National Guidelines on Water Tariffs, WSCs are able to set the tariffs at level to recovery full cost.

The simple volumetric tariff structure is an effective structure for water conservation and it is easy to administer. The two-part tariff structure features a volumetric charge and a fixed charge. The advantages of two-part tariff, namely revenue stability and an enhanced incentive for water conservation, are significant improvements given the revenue recovery and water conservation objectives in the PRC. These advantages make this a somewhat better tariff structure. The final choice of tariff structure should however be based on local conditions. No single tariff structure will suit all needs.

A variety of additional charges are used by many WSCs. Many of them do not pass through the same review and approval process that water tariffs must pass through. Some WSCs incorporate these charges into their reported water tariff while others list them separately on the customers water bill.

Examples of non-tariff charges related to capital used by the WSCs are (i) capacity development charge that is a one-time development charge for non-residential customers. It is levied against the total annual customer demand of new customers and the increase in demand for existing customers who expand their operations. This charge is used to recover the cost of capital works. (ii) Connection charge which is also a one-time charge to new customers to recover the costs of connecting to the water supply system. And (3) Construction fee, a capital levy used to pay for WSC capital works. Funds are accumulated in a dedicated capital reserve.

Most of the non-tariff charges that are used to recover WSC costs should be eliminated and costs now recovered by these charges should be recovered by the water tariff. The non-tariff charges that should be retained are those that recover the direct costs of special services offered to individual customers, an example being the cost of connecting a new customer to a street main. It is not fair to recover these costs from all customers and it should be relatively easy from an administrative perspective to estimate an appropriate charge and bill the customer that received the service. The non-tariff charges levied to the customers who receive special services should be remained or developed in order to collect fund for constructing physical facilities to meet demand of the special services.

8.4 EXTERNAL ASSISTANCE

The State Development Planning Commission plays a central role in program formulation of external assistance, including review and approval of proposed projects. The Ministry of Finance is the key agency for the operations of the ADB, the World Bank and OECF; and the Ministry of Foreign Trade and Economic Cooperation for the United Nations Development Programme, the European Union and bilateral agencies.

8.4.1 MULTILATERAL LOANS

8.4.1.1 Asian Development Bank

As of August 1998, the ADB has provided 67 loans total of $8.15 billion. Since 1990s, the Bank has focused its operations and about two-thirds of the lending has been for infrastructure development. Water supply projects include Zhejiang-Shanxi Water Supply Project (Phase I), Fuzhou Water Supply and Wastewater Treatment, Dalian Water Supply with total of $362 million.

The operational strategy of Asian Development Bank (ADB) is consistent with the governmental development policy and emphasizes the broad objectives for the urban infrastructure and services sector which includes urban water to reduce existing bottlenecks; address urban environmental problems; and improve the living conditions and standards of residents. Because of the serious shortfall in urban infrastructure provisions and its negative effect on efficient growth and the environment, the ADB will focus on the infrastructure sectors including water supply to assist water supply development; reduce bottlenecks and support private sector investments.

The ADB involvement will focus on refining and promoting market-oriented reforms to enhance their operational efficiency. Important elements will include to promote the principle of cost recovery through user charges, greater autonomy of municipal governments in terms of revenue raising and allocation of expenditures, improved management and infrastructure planning, and encouragement of private sector involvement. Attempts will continue effort for establishing and implementing practical cost recovery strategies. The ADB‘s lending program is consistent with the governmental policy to promote infrastructure investments in underdeveloped provinces, more than half of the projects financed by the Bank have been in the interior and will continue to increase.

The ADB also provides technical assistance (TA) grants. More than 30 TA studies totaling over $23 million were provided to address issues such as water supply and environment. The ADB TA also addresses development management and governance issues, including improving the legal and regulatory framework, formulating water price legislation and regulations, strengthening the capacity of the executing and central agencies, promoting enterprise reform, and local government financing reform.

8.4.1.2 The World Bank

The World Bank‘s goal is to reduce poverty and improve living standards by promoting sustainable growth and investments in people. The World Bank provides loans, technical assistance, and policy guidance to help its developing-country members achieve these objectives. From the first loan to PRC in 1981 to the end of June 1998, the World Bank supported 199 projects in PRC, involving all the major sectors of the economy and most of the provinces, municipalities and autonomous regions across PRC. Total accumulative lending amounts more than US$30.4 billion. Since 1992 PRC has been the World Bank‘s largest borrower of investment loans, receiving US$2.5 - 3.0 billion for 14-18 projects every year. PRC is also one of the World Bank‘s best performing member countries in terms of project implementation. Lending in transport (22.92%), energy (19.46%) and industry (8.81%) accounts for more than half of the total portfolio, with agriculture (28.88%), environment/urban (8.49%), education and health (7.92%), water supply and sanitation (2.57%) comprising the remainder.

The World Bank supported 4 water supply projects, and most of them were for rural water supply. A number of environmental and urban development projects included water supply components, the Liaoning Urban Infrastructure Project, the Zhejiang Multicities Development Project, the Shanghai Environment Project, and the Liaoning Environment Project.

The most important objectives of the World Bank‘s assistance are to (1) ensure macroeconomic stability and maintaining the momentum of structural reforms; (2) reduce infrastructure bottlenecks; (3) enhance human development; (4) sustain stable growth in agriculture and ensuring food security; and (5) protect the environment.

8.4.1.3 United Nations Development Programme

The United Nations Development Programme focuses on environment and sustainable energy development, poverty alleviation, support to economic reforms, and sustainable agriculture and social development. During the period 1997-2000, the UNDP programme for Energy and Environment in PRC will focus on (i) environmental governance; (ii) sustainable energy development; (iii) pollution prevention and control; and (iv) natural resources management. Resource mobilzation target from 1997 to 2000 is of $188.9 million.

8.4.2 BILATERAL LOANS

8.4.2.1 Overseas Economic Cooperation Fund

The Overseas Economic Cooperation Fund (OECF0 is one the largest donor agencies in terms of net disbursement. OECF started to provide loans to P.R. China in 1979. As of January 1999, the total OECF loans to PRC reached ￥ 2,061 billion. OECF provided loans of total ￥ 99.6 billion to 12 water supply projects. The loan distribution among sectors is that railway accounts for the largest share (25.6%), followed by electric power (19.1), port (12.1%), commodity loans (5.7%), agriculture (5.5%), telecommunications (5.2%), airport (4.8%), mining and manufacturing (4.5%), water and sewage (4.5%), overall environmental conservation (4.1%) and others (9%).

OECF loans to PRC have an interest rate of 0.75 - 3.5% and a repayment period of 30 years and 40 years with a 10 years grace period. The disbursement period is usually 5 years. However, it may be longer if construction schedule is longer than 5 years. In general, all loans are untied.

OECF loans cover sectors which PRC needs. At beginning of OECF loans, railways, ports, electric power and telecommunications were predominant. It was diversified to include water supply sewerage and gas supply.

8.4.2.2 Other Bilateral Assistance

A number of countries including Canada, Australia, United Kingdom, France, Germany, Italy, Norway, Finland, Netherlands, Spain, Denmark, and Sweden are providers of bilateral aids to the urban sector, though loans on a smaller scale and TA more focused. Most of these aids concentrate issues related to urban environmental with an emphasis on water and wastewater treatment, and environmental study and pollution control. For example, Canada has been funding environmental study focused on water resources, wastewater and waste management, environmental pollution control and women in development; Australia is focusing on the environment and poverty reduction; the United Kingdom has been involved in environmental planning in the coastal development zones; Germany has participated in garbage disposal for Beijing; and Sweden has been funding in sewerage treatment.

9. STRATEGIC DEVELOPMENT OF COST RECOVERY

Full cost recovery is perhaps the most pressing issue facing WSCs. Other issues all relate directly or indirectly to the inability of water and wastewater companies to recover their costs and support investments in capacity, treatment and resource management. Thirty five percent of WSCs failed to make a profit in 1996. This high proportion is a clear indication of the state of crisis in the industry. But the crisis is not simply a matter of tariffs that are too low. There is certainly evidence of tariffs that are too low, but there is also evidence of a failure on the part of WSCs to control their costs. Moreover, the exact nature of finances in the industry is difficult to assess because not all water supply costs are reported in WSC books while costs and revenues not related to water production are included.

Full cost recovery must be established as the primary objective in tariff setting and approval in order to assure the long term sustainability of WSCs. Full cost recovery is interpreted in this section to mean the recovery of all financial costs associated with the provision of water including direct and indirect OM costs, depreciation, taxes, interest on debt and a return on equity. Full cost recovery must be the primary objective if water supply operations are to be organized and managed on a sustainable basis.

In the past, charges to customers have only covered a portion of water system costs. In recent years, a move to increase cost recovery has led to significant increases in tariffs and other charges. But many WSCs are still not recovering the costs that are reported in their books. They survive by virtue of government subsidies to cover operating deficits. This practice is not sustainable in the long run. Continued reliance on subsidies be ruled out because of changes in government policy.

Even if WSCs recover all of their reported costs from tariff revenues, tariffs will still be too low for WSCs who receive subsidies for capital finance or who omit capital costs from their accounts because these costs are paid directly by government.

Full cost recovery is required to sustain water supply operations but a quick transition to full cost recovery is not feasible. Social and political opposition to rapid tariff adjustments may be too great especially if the public believes that WSCs are not controlling their costs. The achievement of full cost recovery must be a gradual process that gains public approval through effective public communication and involvement and well documented efforts to control costs so as to minimize the need for tariff adjustments.

10. USER CHARGES

A variety of additional charges are used by many WSCs. Normally, such charges only require approval from the local government. Some WSCs incorporate these charges into their reported water tariff while others list them separately on the customers water bill.

Most of the non-tariff charges associated with water supply are structured as volumetric charges like the water tariff but there are others that use a different basis for charging the customer. Volumetric charges are recovered through the water bill. Typical non-tariff charges namely are capacity development charge, water conservation charges, connection charge, construction fee, booster fee, price adjustment fund fees, and water resource fee.

Together, these charges can represent a large portion of the total cost of water supply to the customer, especially the non-domestic customer. Aside from their obvious impact on revenue generation, the principle impact of these non-tariff charges is to complicate the revenue generation process and make it more difficult for the customer and others to understand WSC financing and the true cost of water supply. In addition, they add to administrative complexity and cost for both the WSC and the government. The principle merit of these charges from the perspective of the WSC is perhaps the fact that they are not subject to the onerous and time consuming review and evaluation process associated with the water tariff.

Most of the non-tariff charges that are used to recover WSC costs should be eliminated and costs now recovered by these charges should be recovered by the water tariff. The only non-tariff charges that should be retained are those that recover the direct costs of special services offered to individual customers, an example being the cost of connecting a new customer to a street main. It is not fair to recover these costs from all customers and it should be relatively easy from an administrative perspective to estimate an appropriate charge and bill the customer that received the service.

The main criteria for establishing non-tariff charges may be that the charge is associated with a specific service offered to a customer; that the cost for the service can be readily identified and billed back to the customer; and that it is cost effective to implement and administer the charge.

All other charges used to recover WSC costs should be folded into the water tariff so that the tariff becomes a measure of the true cost of water supply services. This should be done even if certain of these WSC costs are financed by government and not the WSC. As the water tariffs are adjusted to cover the full costs of water supply, these costs can be transferred to the WSC or revenues can be transferred from the WSC to government to cover the governments share of the WSC cost.

Charges that are used to recover other water resource management costs should remain under the control of government for a variety of reasons. Certain of the charges recover the costs of wastewater treatment and the revenues from these charges are obviously needed to pay for this service. Other charges, such as the water resource fee and the water conservation charges, actually serve as resource taxes and should not be linked to full cost recovery in the WSCs which is the role of the water tariff. Resource taxes can have several functions. Their most important function is to manage the use of the resource by giving users an economic incentive to use the resource efficiently. Resource taxes also capture the value of the raw resource and return this value to the state on behalf of the people. In economic analysis, this value is called the resource rent. Finally, resource taxes can be used to recover the costs of resource planning and management services that are incurred by government.

Since the water resource fee and the water conservation charges are resource taxes, the level of these charges should be based on the economic value of the raw water resource. Marginal cost analysis can be used to estimate this value. Marginal cost analysis is usually a forward looking analysis. For instance, the costs for an existing supply system will not reflect the economic cost of water if that system is not sustainable in the long run. The economic value of water is best measured as the cost of water from alternative sustainable supply schemes such as inter-basin transfer projects. The value of sustainable water supplies in water short regions is often two to three times larger than the cost of existing supplies for large cities. This cost is referred to as the marginal cost of water supply.

Revenues from charges that are resource taxes should remain with the government. They can be used to finance water resource planning and management activities or to help redress water supply problems that are beyond the scope of the WSC to handle. For instance the relocation of surplus WSC workers, the promotion of water conservation, and assistance to low income households and bankrupt SOEs that can not afford the cost of water supply.
11. CONCLUSIONS
Water supply needs to be improved greatly in order to sustain rapid development at a higher economic level. International experience provides lessons to be used for WSCs. By mobilizing various forms of financing sources and continuing institution and pricing reform, fund shortage will be overcome. As result, water supply services will be delivered at satisfactory level and full cost recovery of WSCs are expected in near future.

REFERENCES
1. Arriens, W.L., Bird, J., Berekoff, J. and Mosley P., Towards Effective Water Policy in the Asian and Pacific Region, Procedings of the Regional Consultation Workshop, Asian Development Bank, Manila, Philipppines, 10-14 May 1996.
2. Canadian Utility Profiles, American Water Works Association, 1995.
3. McIntosh, A.C. and Yniguez, C., Second Water Utilities Data Book Asian and Pacific Region, Asia Development Bank, 1997.
4. OFWAT, 1997. "Review of utility regulation - submission by the Director General of Water Services" 25 September. UK

Urban Water Strategic Management in 21st Century[I]