33110 UNDP-World Bank Water and Sanitation Program Considerations for Regulating Water Services 1 While Reinforcing Social Interests by Vivien Foster The purpose of the Working Paper Series is to share information in order to stimulate discussion, broaden thinking within the sector, and encourage dialogue among our clients in developing countries. These papers have not been formally published and your comments and feedback are welcome. Please send to: Water and Sanitation Program, World Bank, 1818 H Street, NW, Washington, DC 20433, or via email to: info@wsp.org. Copies of these papers are also available in French and Spanish and all versions are available on the Program website: www.wsp.org. October 1998 1Some of the material for these case studies were taken from internal World Bank memos (Back to Office Reports) rather than formally published sources, and are consequently not referenced in this paper. UES WORKING PAPER SERIES Forward It is widely believed that improvements in the supply to a promising Chilean approach, and for greater of water and sanitation can play a major role in sensitivity to the demands of poor customers. She improving the lives of the poor in developing cites evidence that the best use of extra resources in countries. In recent years, the potential value of developing countries is usually to increase the privatization and better regulation of water availability of basic water and, especially, sanitation companies have also been widely recognized. But services, rather than to increase their quality. The exactly what policies governments should introduce in case of condominial sewers in Brazil illustrates this the water sector--and precisely what rules they should approach. But a priori judgments about appropriate impose on private water companies--to help the poor quality need to be avoided: sometimes, as in the East remains controversial. Vivien Foster's "Considerations Javan case, the poor may be willing to pay for higher for Regulating Water Services while Reinforcing quality services than initially believed. Social Interests", the first version of which was prepared for a training program offered by the Vivien Foster, a Senior Consultant at Oxford Economic Private Sector Development of the World Bank, Research Associates Ltd. (OXERA) holds degrees in addresses this controversy. Philosophy, Politics and Economics from the University of Oxford and in Economics from Stanford. A Many governments aim to help the poor by imposing specialist in economic and environmental regulation of higher prices on middle-class customers of water privatized utilities, Foster has co-authored "Guide to companies in order to cross-subsidize the poor (in the the Economic Regulation of the Water Industry" and a jargon) and by requiring newly privatized water "Guide to the Environmental Regulation of the Water companies to quickly provide more poor customers and Electricity Industries. Her experience in the water with high-quality water-and-sanitation services. Some sector in developing countries includes having acted governments also prevent water companies from as economic advisor to the CRA (regulatory body for disconnecting poor customers when they fail to pay Colombia's water sector), as advisor on water to the their bills. As Foster's paper notes, the strategy can Bolivian Ministry de Capitalizacion and on water be counter-productive. Subsidies frequently fail to sector reform to the Panamanian Ministry of Planning reach the poorest since they remain unconnected to and Political Economy. She also consults with the Inter- the main network, even after its expansion. The American Development Bank and the World Bank extension of high-quality services is sometimes too where she lectures regularly on utility regulation. The expensive to be justified. And prohibitions on present paper is drawn from several of her lectures. disconnections encourage customers not to pay, lessening the water company incentives and financial Timothy C. Irwin ability to reach out to new, poorer customers. Economist What would work better than the traditional Private Sector Development approach? Among other things, Foster argues for The World Bank more-sophisticated approaches to subsidies, referring Washington, DC 1 UES WORKING PAPER SERIES Contents Forward 2 1. Introduction 3 2. Setting Quality and Output Targets 4 3. Determining Service Priorities 6 4. Monitoring the Delivery Outputs 7 5. Subsidizing Low-Income Consumers 7 6. Connections 8 7. Disconnections 10 8. Tariff Structures 10 9. Lessons 11 10. References 12 2 UES WORKING PAPER SERIES 1. Introduction Increasingly governments are moving away from the role of provider of urban services into a new role as regulator of private service delivery companies. In the case of water, developing countries are now learning the ropes of regulation, usually by reviewing costs and prices. However, it is the task of the regulator, not only to ensure that prices reflect efficient production costs, but also to determine the appropriate level of quality to be delivered to the customer. These `non-price aspects' of regulation encompass a wide range of considerations including securing quality standards and promoting universal access to the network, aion encompass a wide range of considerations including securing quality standards and promoting universal access to the network, ae delivery companies. In the case of water, developing countries are now learning the ropes of regulation, usually by review incentives for utility companies to go beyond the minimum levels of service which have been required. Quality-of-Service Regulation set standards monitor performance Þpenalise No levy compensation compliance? payments Þreward Yes use yard-stick regulation This paper provides a selection of brief case studies interests of low-income groups through a variety of which illustrate how regulators can protect the non-price mechanisms. 3 UES WORKING PAPER SERIES 2. Setting Quality Brazil: the condominial sewer and Output Targets Experience from Brazil suggests that it may sometimes be helpful to provide a range of There is a tendency for non-price regulation to focus quality of service levels for different consumer on the delivery and quality of water, without always groups, rather than aim for a universal quality paying a great deal of attention to the issue of how standard. The extension of urban wastewater systems targets for coverage and quality should be to shanty towns in Brazil has, in the determined. From an economic standpoint, it is past, been impeded by the relatively high cost important to consider the costs and benefits of of conventional sewerage systems. This led to the particular targets. However, in practice, the setting of development of an innovative low-cost approach, goals is often rather arbitrary and driven by political known as condominial sewers, which have been considerations. implemented in a number of Brazilian cities. The following examples illustrate the importance of: Condominial sewers have the following distinguishing features, which contrast them from conventional · considering the balance between costs and sewerage, as illustrated in Figure 2. benefits when determining the appropriate quality · Sewers are laid through the backyards of houses of service level for low-income customers; and instead of down the middle of streets. · Each household has a single point of direct · considering the effective demand for any planned outdoor access to the sewer, as opposed to pipes improvement in service quality. going into each house. · Households are required to maintain their own section of the sewer to ensure that blockages are avoided. Brazilian Condominial Sewers Condominialsewers Conventional sewers · innovative engineering · community involvement 4 UES WORKING PAPER SERIES These specific design features have the effect of · engaging a team of social workers and significantly lowering the cost of providing sanitation. sociologists responsible for managing the The reason for this is that they: community participation process, as a complement to the conventional engineering skills · reduce the length of pipework required to involved in designing a project of this nature; complete the system; · enable sewers not to be buried so deep; · establishing contact with community leaders as a · reduce the need to rely on remote maintenance point of entry into the local area, and organizing by the operator. subsequent meetings at the level of relatively small neighborhood groups of up to 50 families This comes as the expense of reducing the quality of as a means of promoting discussion; service that is offered, given that household connections are no longer interior to the household, · not proceeding with the construction phase of the and that consumer participation in infrastructure work until the selected project has received the maintenance is necessitated. endorsement of 70­80% of the local community, whether through personal signatures or the Consequently, a system of this nature can only agreement of community representatives. function if there is adequate community support from the outset of the project. Extensive experience in The advantage of this approach is that it ensures that mobilizing community participation in the design and the selected technology meets the needs of the implementation of water and wastewater systems in inhabitants, and that they will cooperate in its shanty towns has accumulated under the auspices of subsequent maintenance. Moreover, it is often the PROSANEAR project in Brazil, which was co- possible to incorporate hygiene education events with financed by the World Bank. the community participation process, or to link the sanitation project to wider social improvements. From this experience, it is known that the process of obtaining community participation for a sanitation The disadvantage of this approach is the additional project entails: cost implied by orchestrating the community participation. In most of the cases studied in Brazil, · allowing a period of 2-4 months (between the this cost was kept well below $20/capita. One initial project assessment and the commencement danger that has been noted is that of construction of construction works) for the purposes of delays which may undermine the initial community disseminating information to the community and support for the project. It is therefore important to organizing public meetings to reach community ensure that community expectations are kept in line consensus on the desired project design; with a realistic construction schedule. Table 1: Results of the East Java water survey Options for water services Public taps Private connections Rural views Low level of interest, given Noticeable willingness to pay presence of alternatives, (over 70% in some areas) unless within 20­30m radius Urban views Very low level of interest High level of demand (75% willing to pay) East Java water supply construction of piped water systems with public taps. Table 1 summarizes the main results of the survey. In East Java, a survey of 1,500 households in two large towns and eight villages was carried out in The survey showed that public demand in rural areas 1985, as part of the East Java Water Tariff Study, to for these improvements was low, given that most of determine willingness to pay for improvements in the the rural households relied on satisfactory alternative standards of water supply, achievable by the methods to obtain domestic water supply, mainly 5 UES WORKING PAPER SERIES through skillfully constructed shallow wells. In Where urban services are characterized by low particular, households stated that they would not make coverage rates and poor overall quality of service, the use of public taps unless they were located within a presence of capital constraints means that it is 20­30m radius, which was unlikely to be the case impossible to achieve everything at once. given the design standard. Moreover, the proposed Consequently, the authorities must set priorities both piped water scheme was not thought to be likely to between system expansion and improvement of contribute to significant improvements in public health, service to existing users, and between the different given that most people already boiled their drinking ways in which existing services might be improved. water. Finally, a significant proportion of rural households (over 70% in some areas) expressed the WASH study of urban water services willingness to pay for private connections as opposed to the cheaper public taps. A study by Water for Sanitation and Health (WASH-- now renamed Environmental Health Project (EHP)) Similarly, in urban areas, fewer than 10% of the provides some insight into the prioritization of different population wanted public taps. However, about 75% water services for the urban poor. expressed a desire for a private connection, signaling a widespread willingness to pay for a more expensive The WASH report considers three distinct ways in service, of a better quality. This is in spite of the fact which the water services to the urban poor might be that the cost of private connections exceeded the usual improved: cut-off threshold of 3­5% of household income. · provision of a plentiful and reliable water supply; The survey showed that the proposed piped water · improvements in the quality of drinking water; project was ultimately flawed, given the lack of · provision of basic sanitation facilities. adequate demand among both rural and urban households for the sThe survey showed that the In order to produce a prioritization ranking between proposed piped water project was ultimately flawed, these three investment options, the study reviewed given the lack of adequate demand among both rural over 100 pieces of research which study the causal and urban households for the service improvements it link between the availability of these different services would have produced. Moreover the survey indicated and incidence of the following six major water-borne that there appeared to be a substantive willingness to diseases: pay for a service quality higher than that which had · diarrhoea; originally been considered viable by the project · ascariasis; designers namely, private household connections. · trachoma; · hookworm; This example from East Java shows that careful · schistosomiasis; economic analysis of infrastructure projects, in general · Guinea worm. and of projects relating to the quality of service in particular, can lead to improved decisions, on the The main findings of the study were that: part of the planning authorities, in their choice of the appropriate level of quality at which to provide new · provision of basic sanitation was the most public services. effective intervention as far as health improvements were concerned; · the next-best step was to increase the quantity of 3. Determining Service water available for household hygiene, as opposed to increasing its quality. Priorities The authors note that this is somewhat at odds with Quality of service is not a one-dimensional parameter, conventional practice of prioritizing water supply over but covers a variety of aspects. The most basic issue is sanitation. The study is interesting in that it underlines whether the customer is connected to the service at the importance of understanding the relationship all. Once access has been provided, there are a between particular policy interventions and ultimate number of ways in which service could be improved social goals, as part of the process of prioritizing in terms of reliability, quality and customer interface. output targets. 6 UES WORKING PAPER SERIES 4. Monitoring the Delivery service. Thus, the resulting quality level is largely predetermined by the investment levels allowed in Outputs tariff-setting negotiations. At present, the regulatory agency has no direct interaction with Once targets have been determined, the regulator consumers, except in the event of disputes when it must establish a system for ensuring that these are is required to act as arbitrator. delivered. This will generally involve the collection and monitoring of information on quality standards, as Although this focus on the regulation of drinking water well as the provision of operator incentives for quality was undoubtedly an important starting point compliance. for quality of service regulation in Chile, the Superintendencia is now concerned to expand the scope of quality of service regulation to include other Chilean water sector aspects of quality, and in particular to ensure that The Chilean water sector falls under the jurisdiction of companies are giving adequate attention to consumer a central regulatory agency: the Superintendencia de complaints. Possible means of strengthening quality of Servicios Sanitarios (SSS). The agency is made up of service regulation are therefore being studied in the three departments, one of which has overall run-up to privatization. responsibility for setting and enforcing quality standards. Following the lessons of experience that moral suasion is not enough to make regulation work, 5. Subsidizing Low-Income the Chilean SSS has been studying the need to Consumers introduce fines. At present regulation of service quality is limited in scope and currently comprises the following elements. In most countries, part of the ideological legacy of public-sector provision of infrastructure has been an · With regard to clean water, drinking water enduring social understanding of the role of public quality is the primary regulatory focus. Each services. This involves a more or less explicit social operator is required to submit a monthly report obligation towards low-income groups, which is often and outside laboratories are contracted to reflected in the existence of subsidy or cross-subsidy provide spot checks. Although contracting systems aimed at certain categories of the domestic laboratory services allows the agency to have customer base. fewer staff, experience suggests that the supervision of outside However, such subsidy systems are not necessarily contracts can itself be a drain on staff time. A socially benign. On the contrary, there is evidence to major issue is that of penalties for non- suggest that the structure of subsidies is often highly compliance. There has recently been a move regressive, with substantial benefits going to middle- away from moral persuasion towards the and higher-income groups. This inequity is imposition of fines, where non-compliance can be exacerbated by the fact that the lowest-income groups directly attributed to negligence on the part of the will frequently lack access to the services altogether. operator. This means that, not only will they fail to benefit from the subsidy scheme, but they will also have to · With regard to waste water, companies are purchase the service from private vendors, often required to submit data on a quarterly basis. paying prices well in excess of those associated with However, only 10% of wastewater is currently supply from the public network. treated and no verification procedures are used. Two of the best examples of well-functioning, but · As far as quality of customer service is highly contrasting, subsidy schemes in the water concerned, there is no regular reporting sector are those provided by Chile and Colombia. mechanism, although companies are required to The first represents a system of direct subsidies, while notify the regulator in the event of interruptions to the second consists of an explicit and highly service. Investment plans include provision to transparent cross-subsidy built into the water tariff improve the continuity and pressure of the water structure. 7 UES WORKING PAPER SERIES Chilean direct subsidies Eligibility is reassessed every three years. Moreover, households failing to pay their own 15% share of the In 1990 Chile replaced its cross-subsidy system with a bill have their subsidy suspended. comprehensive direct subsidy scheme for low-income Initially, the onus of proof was laid on low-income households, which assists with the purchase of a households to come forward and claim the subsidy. variety of public services. Subsidies are financed by However, low take-up rates prompted the central government but administered through the collaboration of the water companies in identifying municipalities. The scheme is `direct' in as much as needy customers by examining tariff payment records. the government makes a direct financial contribution It is now believed that all eligible households in urban towards the water bills of low income households. areas are covered by the scheme, that is to say some 20% of the population. The subsidy law states that the scheme can cover up to 85% of the charges for up to a maximum of 20 The administrative organization of the scheme is cubic meters of consumption. In practice, in recent illustrated in Figure 3, which indicates that the years subsidies have been given for a maximum of 15 budgetary allocation is determined nationally by the cubic meters of consumption The goal of the scheme is Ministry of Planning, but that funds are subsequently to ensure that water and sanitation services do not allocated down to the municipalities, which act as the take up more than 5% of household income. There are local agents to determine the eligibility of specific multiple criteria for eligibility including: households. · region; The Chilean scheme provides an example of how · average cost of water; subsidies can be effectively targeted at essential · household income and wealth; consumption by low-income groups, if adequate · family size. consideration is given to the design and administration of the system. Chilean Direct Subsidies Ministry of Planning fund fund Regional Regional .... Government Government fund fund Municipality Municipality Municipality Municipality A Z A Z application application subsidy subsidy Users Users tariff tariff Regional Regional Company I Company III 8 UES WORKING PAPER SERIES Colombian cross-subsidies and then determine what percentage of subsidy can be afforded on the basis of the total funds collected. The new Colombian constitution promulgated in 1991 This confirmed a long-standing national commitment to the system of subsidies and surcharges is combined with a principle of social solidarity in utility tariff structures, rising-block measured tariff structure, although meter effectively requiring the incorporation of cross- coverage is not yet universal. subsidies. This commitment goes back to the late 1960s, when a 6. Connections customer-class tariff system was developed in order to implement this objective. An initial property value based tariff encountered problems because of the An important objective associated with privatization obsolescence of the data on which it was based. of public services is that of increasing connections Consequently, in the 1980s there was a move rates. However, this raises an important equity issue towards developing an alternative property-based with regard to financing. This is because those who indicator for wealth. A six-band nationwide do not have access to infrastructure networks are classification of all neighborhoods was finally typically those who are least able to pay for the adopted, according to the predominant physical connection to be made. This means that connection characteristics of the properties in the area subsidies or credit schemes may be required. (construction materials used for walls and the roof, number of floors, and so forth) and the neighborhood During the early 1970s, the Ivory Coast government itself (condition of roads, presence of garages, launched an ambitious national water program aimed lighting, public gardens and other local amenities). at the refurbishment and expansion of the existing The new taxonomy has operated successfully since network in urban areas, as well as the installation of 1983. boreholes to service rural communities. This program was financed by cross-subsidies on urban consumers The property-based indicator was ratified by the which were recycled through the National Hydraulic Public Services Law passed in 1994, which required Fund to provide free connections for the cross-subsidy element of the tariff to be clearly poor urban neighborhoods, and subsidies for rural identified in water bills and also set explicit ceilings supply. for the magnitudes of the cross-subsidies to be applied to each of the six strata. These new ceilings represent The scheme was successful in bringing about a major a significant reduction in the scale of cross-subsidies expansion in connections, which grew from 50,000 to relative to what has been countenanced historically in 140,000 over the period 1973­80. However, it came the country. They will be phased in gradually over a under increasing financial pressure during the period of five years and imply a period of substantial economic crisis of the 1980s. By 1984 a few hundred tariff rebalancing between socio-economic groups. industrial customers were funding 70% of the cross- Strata Legal limit subsidy for social connection. The high resulting bills 1 maximum subsidy of 50% led to a substantial decline in industrial water 2 maximum subsidy of 40% demand, partly as a result of industrial customers 3 maximum subsidy of 15% choosing to self-supply to avoid the high bills charged 4­6 maximum surcharge of 20% for public water supply. Since the late 1980s Commercial maximum surcharge of 20% connections are no longer provided free of charge. Indeed, the cost of a connection rose to a point where It is worth noting that these cross-subsidies are applied it was equivalent to half the minimum monthly wage. at the level of each individual company, with no cross- subsidies being permitted between regions. The Ivory Coast case illustrates the tensions involved in Consequently, the approach adopted by most funding social connections from surcharges on urban companies is to set the surcharges at the 20% limit, domestic and industrial consumers. 9 UES WORKING PAPER SERIES 7. Disconnections Finally, it should be noted that bad debtors are not always necessarily low-income consumers. In the Ivory Coast, the government failed to pay its water bills Once poor customers have been connected to the over the period 1990­94. In neighboring Guinea, network, there is still the problem that they may end- special care was taken to pre-empt such a situation: up being disconnected for non-payment. Countries the terms of the private operator's recently awarded differ widely in their social attitude to the legitimacy of contract explicitly empower the contractee to disconnecting households from public services in disconnect government agencies. However, this retaliation for non-payment. Two give two contrasting safeguard has not proved to be adequate in practice. examples: · Chilean law includes an explicit commitment to 8. Tariff Structures the notion that water cannot be regarded as a free good, thereby legitimizing disconnection of the service; A traditional approach to incorporating social considerations in public-service tariff structures has · Mexican law explicitly prohibits the been to rely on rising block tariffs. Such tariffs apply disconnection of water supplies from bad an increasing unit charge to successive blocks of debtors. consumption. Their purpose is to ensure that a basic level of consumption is affordable to all consumers, From the perspective of the private operator, while providing stronger incentives for conservation at disconnection constitutes an important sanction for high levels of discretionary use. As such, they non-payment. The Mexico City water franchises constitute a relatively simple and attractive basis for provide an interesting example of a mechanism for cross-subsidy to low-income customers. harmonizing social commitments with private-sector A recent field study in Ghana suggests that the provision. When the operators eventually take on full conventional wisdom about rising block tariffs may be provision of the water service, their contract allows for flawed in some instances. This is because rising block bills to be covered by the regulatory commission in tariffs are based on the assumption that each event of non-payment by the customer. The household has its own metered connection. In the case government is therefore effectively assuming collection of low-income consumers in shanty towns, this risk on behalf of the private operator. Since the assumption may sometimes be fallacious. The reason regulatory commission is financially dependent on is that such households may either: water tariffs, it retains an incentive to ensure that bad debts are ultimately paid. Whether this will prove · live as tenants in larger housing units, sharing a possible without recourse to the sanction of single metered connection with a number of other disconnection remains to be seen. families; Despite social views, the change to a private-sector operator will inevitably bring about a shift in the · (in the case of water) lack a connection culture of public-service provision. In Guinea, altogether and purchase a supply from following the introduction of private-water neighbors. concessions, consumers had major problems in managing their consumption of water. Metering and In both these situations, the effect of the rising block billing levels had been so low under public provision tariff is to increase the average cost of supply to low- that water was not regarded as an economic income households. In theory, this problem could be resource. A number of educational campaigns were remedied by applying adjustment formula to conducted, but these proved relatively unsuccessful. connections serving multiple dwellings. However, in Eventually, the private operator, SEEG, was forced to practice, such a system might prove too complicated rely increasingly on the ultimate sanction of to implement. disconnection. 10 UES WORKING PAPER SERIES 9. Lessons · In particular, the relative importance of From this brief survey of examples covering the non- expanding coverage and raising existing service price aspects of regulation, a number of lessons can levels needs to be assessed. be drawn out. · Subsidy systems should be designed to ensure · The setting of quality and output targets often that they genuinely target low-income households lacks a grounding in cost­benefit analysis. and avoid the creation of economic distortions. · A universal quality standard is unlikely to make sense where wide socio-economic disparities exist · Policy on connections, disconnections and tariff between customer groups. structures has important social implications in the context of public-service provision. Given the wide range of problems competing for investment funds, it is important for the regulator to set priorities. 11 UES WORKING PAPER SERIES 10. References Bakalian, A. and V. Jagannathan (1991), `Institutional Aspects of the Condominial Sewer System', Infrastructure Notes, W&S no. SW-6, Transportation, Water and Urban Development Department, The World Bank, August. Esrey, S.A., J.B. Potash, L. Roberts and Clive Shiff (1991), `Quantifying the Health Effects of Water and Sanitation Projects', Infrastructure Notes, W&S no. WS-4, Transportation, Water and Urban Development Department, The World Bank, February. Gomez-Lobo, A. (1997), `Are there alternatives to universal subsidies in utility industries? Some world experiences and recommendations for the United Kingdom domestic gas market, mimeo, Institute for Fiscal Studies. Mejia, A., L.C. Tavares, A. Bakalian and V. Jagannathan (1993), `Water and Sanitation Services for the Urban Poor in Brazil: The PROSANEAR Approach', Infrastructure Notes, W&S no. SW-9, Transportation, Water and Urban Development Department, The World Bank, September. Texeira, H.G.M. et al. (1995), Community Participation in Brazil's PROSANEAR Project. Oxford Economic Research Associates Ltd. (OXERA) is a leading firm of consultants specializing in the provision of economic advice to companies and governments. OXERA Blue Boar Court Alfred Street Oxford OX1 4EH Telephone +44 (0) 1865 251142 Fax +44 (0) 1865 251172 http://www.oxera.co.uk 12