Toolkit: Approaches to Private Participation in Water Services

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: davidstiggers@comcast.net

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

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

5. 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? 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? Management Contract for What are the key areas of RISK associated with the responsibilities, and how can they be defined? Jordan Valley Authority, Irrigation Water Supply, may be the first of its kind. Plus! Additional Material: Tariff Reset Module 6 - What will we learn?

6. ANALYZING Responsibilities & Risks ANALYZING Responsibilities & Risks ALLOCATING Responsibilities & Risks DESIGNING Risk Allocation Rules EXAMPLES Allocation - Different PP Models Module 6 Allocating Responsibilities and Risks A big part of designing the PP Arrangement is defining and allocating the business responsibilities between the various parties. Risk associated with these responsibilities has also to be allocated between the parties, and this is also a key part of designing the Arrangement. • The basic process for allocating Responsibilities and Risks is: • Identify the main areas of Responsibility involved in delivering the services and the Risks associated with each Responsibility • Allocate each area of Responsibility and Risk to the party best able to manage it • Design the Arrangement to achieve the best allocation of risks and responsibilities

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

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

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

10. 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: COST OF RISK 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 through 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

11. Allocating RisksExample (1): Demand Risk “Example: 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

12. Allocating RisksExample (2): Currency Risk “Example: 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.

13. Allocating RisksExample (2): Currency Risk “..or, for this we example, can show graphically 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 Financing Risk Currency Convertibility Risk

14. DESIGNING Risk Allocation Rules Plus! Additional Material: Tariff Reset Module 6 Designing Allocation of Responsibilities & Risks “ The next step is to design the Rules that will allocate the risks and responsibilities” • Rules for adjusting Tariffs are an important mechanism for allocating Risk between the parties, including: • Cost Pass Through • Indexation • Tariff Resets • Other risk-allocating rules are also reviewed (e.g. Bonuses and compensation on termination) ANALYZING Responsibilities & Risks ALLOCATING Responsibilities & Risks DESIGNING Risk Allocation Rules EXAMPLES Allocation - Different PP Models

15. Module 6 Designing Allocation of Responsibilities & Risks “ We will consider two main subjects related to Risk Allocation” TARIFF ADJUSTMENT MECHANISMS ALLOCATION OF OTHER RISKS

16. 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…… TARIFF ADJUSTMENT MECHANISMS ALLOCATION OF OTHER RISKS • Cost pass-through • Tariff Indexation Formulas • Tariff Resets

17. Tariff Resets Tariff Indexation Cost Pass Through 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…… TARIFF ADJUSTMENT MECHANISMS ALLOCATION OF OTHER RISKS • Cost pass-through • Tariff Indexation Formulas • Tariff Resets

18. Tariff Resets Tariff Indexation Cost Pass Through Example: Why the need for Tariff Resets? Tariff Resets 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…… TARIFF ADJUSTMENT MECHANISMS ALLOCATION OF OTHER RISKS • Cost pass-through • Tariff Indexation Formulas • Tariff Resets

19. Module 6 Designing Allocation of Responsibilities & Risks “ In addition to Tariffs…………………………. important 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

20. 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: ALLOCATION OF OTHER RISKS • Bonuses and penalties • Government guarantees • Termination triggers and payments • Transition periods at commencement • Contract Duration

21. 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 “ 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 • 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 parameters 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

22. EXAMPLES Allocation - Different PP Models Different PP Models Allocating Responsibilities & Risks Module 6 • 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 EXAMPLES Allocation - Different PP Models

23. Operator Risks: Operational Technical Regulation Financial Forex Commercial Contract Form: Affermage - Lease     Concession       Service Contract (by comparison)  Management Contract    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” Risk Level: These are an indication of the level of Risk taken by the Operator for specific issues under the various PP models .

24. 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) Operator Risks: Operational Technical Regulation Financial Forex Commercial Contract Form: • Concession: • The Operator assumes full responsibility for service delivery, including: • Management • Operation • Maintenance of existing assets • New Investment Affermage - Lease     Concession       Service Contract (by comparison)  Management Contract    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”

25. Costs/Revenues Management Contract Tariffs don’t cover O&M costs Management Contract Lease/Affermage Tariffs cover O&M costs only Lease/Affermage Concession Tariffs cover total costs Political and Regulatory Risk LOW HIGH Operator willing to sink capital Operator willing to take operating and commercial risk only Operator will only take limited 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 ………….” “ …each model has a particular application to the balance between Costs and Revenues as well as Political and Regulatory Risks” 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.

26. Costs/Revenues Management Contract Tariffs don’t cover O&M costs Management Contract Lease/Affermage Tariffs cover O&M costs only Lease/Affermage Concession Tariffs cover total costs Political and Regulatory Risk LOW HIGH Operator willing to sink capital Operator willing to take operating risk only Operator won’t take any risk Different PP Models Allocating Responsibilities & Risks Module 6 “ ….but it may be necessary to adapt the standard models to meet particular needs” 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

27. Costs/Revenues Management Contract Tariffs don’t cover O&M costs Management Contract Examples; Risk in Hybrids - Amman (MC) - Cartagena Affermage/Lease Lease/Affermage Tariffs cover O&M costs only Lease/Affermage Concession Tariffs cover total costs Political and Regulatory Risk LOW HIGH Operator willing to sink capital Operator willing to take operating risk only Operator won’t take any risk Different PP Models Allocating Responsibilities & Risks Module 6 “ ….but it may be necessary to adapt the standard models to meet particular needs” 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

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

29. Checklist: Module 6 ‘……..and the allocation process is detailed in this Checklist”

30. More Information: Module 6

31. Supporting Material • The Toolkit Financial Model • Toolkit Case Study material • Toolkit Website: http://rru.worldbank.org/Toolkits/WaterSanitation/ • For comments or further details contact Cledan Mandri Perrott at cmandriperrott@worldbank.org

32. Toolkit: Module 6 End of Module

33. Toolkit: Module 6 Return to Start