PPP International Best Practice and Regional Application

1. PPP International Best Practice and Regional Application Tegucigalpa, Honduras April 23 - 25, 2008 Sponsored by the Spanish Trust Fund

2. Government Readiness for PPP Session 6.1 Setting Upstream Policy David Stiggers & Sabino Escobedo

3. Session 6.1 Day 2 – Session 6 Readiness of Government Day 1: Session 1.1 Overview of PPP Private Sector View Day 1:Session 1.2 Challenges: Latin America Upstream Policy Day 2- Session 6.1 Setting Upstream Policy Readiness of Government Capacity Building For PPP Day 1:Session 1.3 Considering Private Participation PPP Approach Day 2:Session 5 Case Studies: (1)Highways (2)Water & Sanitation (3) Ports Day 1:Session 2.1 Planning the Process Day 1:Session 3 Case Study: Transmission Day 2 :Session 4.2 Selecting an Operator Day 1:Session 2.3 Involving Stakeholders Day 2 :Session 4.1 Standards, Tariffs, Subsidy, Financials Day 1:Session 2.2 Regulation & Institutions

4. What are the Responsibilities of other levels of Government? How do we DEFINE an appropriate Market structure for the Sector? Management Contract for How do we IDENTIFY the level of Government to be responsible for the particular services? Jordan Valley Authority, Irrigation Water Supply, may be the first of its kind. COMPETITION – how can we establish it? What will we look at?

5. Session 6.: Setting Upstream Policy • SETTING UPSTREAM POLICY • In this Module we look at the issues that Governments need to address to set Policy upstream from the design of the Private Participation Arrangement • This involves three broad topics • These steps do not need to be considered in sequence, as the results are often examined simultaneously as the reform strategy develops Identify the Reform Leader (Module 2) Introduce Private Participation

6. ALLOCATE Responsibilities to different levels of Government DETERMINE Market Structure ESTABLISH Competition Rules Session 6.: Setting Upstream Policy SETTING UPSTREAM POLICY Identify the Reform Leader Introduce Private Participation

7. Step 1. EXAMINE Responsibilities under current law & institutional arrangements Step 2. DECIDE Which level of Government should be responsible for service provision Step 3 DECIDE Which levels of Government responsible for tariff setting , environmental issues etc. Allocate Responsibilities at different Government Levels “Dividing up the responsibilities for water services is a three step process, ………” ALLOCATE (In 3 Steps) Responsibilities to different levels of Government

8. Step 1. EXAMINE Responsibilities under current law & institutional arrangements Step 2. DECIDE Which level of Government should be responsible for service provision Step 3 DECIDE Which levels of Government responsible for tariff setting , environmental issues etc. Allocate Responsibilities at different Government Levels “,……… then we need to set up the legal & institutional framework” • CREATE LEGAL INSTRUMENTS • These have to : • Be clear • Allocate appropriate responsibilities • Allocate adequate powers to each level of Government ALLOCATE (In 3 Steps) Responsibilities to different levels of Government

9. ALLOCATE (In 3 Steps) Responsibilities to different levels of Government Step 1. EXAMINE Responsibilities under current law & institutional arrangements Step 2. DECIDE Which level of Government should be responsible for service provision Step 3 DECIDE Which levels of Government responsible for tariff setting , environmental issues etc. Example: Question of Responsibility in Brazil Allocate Responsibilities: Step 1 – Examining existing “The first step is to identify current responsibilities of each level of Government, the legal and constitutional basis for these, and to identify any unclear areas” 3 Steps - ALLOCATE Responsibilities to different levels of Government

10. 3 Steps - ALLOCATE Responsibilities to different levels of Government Step 1. EXAMINE Responsibilities under current law & institutional arrangements Step 2. DECIDE Which level of Government should be responsible for water service provision Step 3 DECIDE Which levels of Government responsible for tariff setting , environmental issues etc. Allocate Responsibilities: Step 1 – Examining existing “The first step is to identify current responsibilities of each level of Government, the legal and constitutional basis for these, and to identify any unclear areas” • In many countries, responsibilities for services are spread between two or three levels of government. For Example • Federal states, like India, the constitution may assign roles to regional or state government, with some responsibility with central government • Local governments may be involved in reform at national level • Even in non-federal states the division of responsibility may not be clear • Example: Jamaica – water service provision is at national level, with small systems and standpipe payments at local level. However, legal and financial relationships between utility and local government is not clearly defined. • “Systems can work well with distributed responsibilities, but introduction of private • participation has to be done with care so as the change in roles does not cause • conflict.” 3 Steps - ALLOCATE Responsibilities to different levels of Government

11. Examining Responsibilities: Conflict “Brazil - unclear institutional structure led to legal questions on responsibility”

12. ALLOCATE (In 3 Steps) Responsibilities to different levels of Government Step 1. EXAMINE Responsibilities under current law & institutional arrangements Step 2. DECIDE Which level of Government should be responsible for service provision Step 3 DECIDE Which levels of Government responsible for tariff setting , environmental issues etc. Example: Economy of Scale -Small towns in France Allocate Responsibilities Step 2 – Choose Level “ Generally the tier of Government ( local, provincial or federal) responsible for service delivery should also be the Contracting Authority with the Private Operator”

13. 3 Steps - ALLOCATE Responsibilities to different levels of Government Step 1. EXAMINE Responsibilities under current law & institutional arrangements Step 2. DECIDE Which level of Government should be responsible for water service provision Step 3 DECIDE Which levels of Government responsible for tariff setting , environmental issues etc. Allocate Responsibilities Step 2 – Choose Level “ Generally the tier of Government ( local, provincial or federal) responsible for service delivery should also be the Contracting Authority with the Private Operator” • Although the tier of government responsible for service delivery should generally be the Contracting Authority, many factors influence the choice of tier: • Need for collective choice mechanism: in order to set an equitable service level and tariff, best if control is at a local level, representing the area of service. • Different capacities at different levels of government: For example, provision of water services needs specialized technical and commercial skills that may be in short supply, and perhaps only available at national level. • Economies of scale: It may be more efficient to have a single service provider serving several towns and villages rather than a number of smaller providers. • Dilemma of regional production and transmission networks: These may cut across several local areas. It may be possible to separate regional transmission systems from local distribution systems.

14. Step 1. EXAMINE Responsibilities under current law & institutional arrangements Step 2. DECIDE Which level of Government should be responsible for service provision Step 3 DECIDE Which levels of Government responsible for tariff setting , environmental issues etc. Step 3a DECIDE Which levels of Government responsible for tariff setting , environmental issues etc. Step 3b ESTABLISH Regulatory regimes and institutions Allocate Responsibilities Step 3 – ‘External’ issues “ Institutions and rules need to be set up to monitor performance, regulate contract obligations, set tariffs and regulation and compliance with relevant laws and codes (e.g. environmental , water resources etc.)” ALLOCATE(In 3 Steps) Responsibilities to different levels of Government

15. 3 Steps - ALLOCATE Responsibilities to different levels of Government Step 1. EXAMINE Responsibilities under current law & institutional arrangements Step 2. DECIDE Which level of Government should be responsible for water service provision Step 3 DECIDE Which levels of Government responsible for tariff setting , environmental issues etc. Allocate Responsibilities Step 3a – Monitoring/Tariffs “ Central Government can monitor contract performance and set tariffs. Difficulties may arise when Municipalities or states take on this responsibility” • In the case of municipalities or states there are three options for allocating responsibility for monitoring operator performance and adjusting tariff and quality controls: • Assign functions to the level of Government where services are provided: • Example: municipal contract supervision units for municipal contracts • ******PUERTO VALLARTA Waste Water BOT: Problem (1) Tariff set too high by Federal (2) Municipal Govt gave a very high minimum revenue guarantee. Municipal Government made massive annual expenditures for capacities not even treated and Federal Government revoked the BOT.********* • Establish a National Regulator: • Even if services are provided at municipal level, a national regulator can be established with responsibility for monitoring performance and adjusting tariff and quality controls. ****Example: Mexico water and waste water • Spread functions among various levels of Government: • The level to depend on who is best to perform particular functions.

16. 3 Steps - ALLOCATE Responsibilities to different levels of Government Step 1. EXAMINE Responsibilities under current law & institutional arrangements Step 2. DECIDE Which level of Government should be responsible for water service provision Step 3 DECIDE Which levels of Government responsible for tariff setting , environmental issues etc. Allocate Responsibilities Step 3b – Regulators “ A Regulatory institution or arrangement needs to be set up to monitor contract performance and set the tariffs. • There is a need to decide what are the best Regulatory arrangements, and at what level of Government it should be established. Should it be at national, state or local level? • Different mechanisms and Regulators for different tasks. Some of the key tasks include: • Contract monitoring & tariff setting • Example: municipal contract supervision units for municipal contracts • Environmental protection: • It is possible for services to be provided at municipal level, with responsibility for monitoring performance and adjusting tariff and quality controls. • Resource management: • The level to depend on who is best to perform particular functions.

17. ALLOCATE Responsibilities to different levels of Government DETERMINE Market Structure ESTABLISH Competition Rules DetermineMarket Structure SETTING UPSTREAM POLICY Identify the Reform Leader Introduce Private Participation

18. DETERMINE Market Structure Horizontal Structure Interaction between providers at the same level on the value chain Vertical Structure Interaction between providers at different levels on the value chain Cross Sector Structure Limits on ownership or other affiliations between utilities and companies in other sectors DetermineMarket Structure “ Market Structure refers to the number of service providers and their responsibilities. There are three main market structure models

19. DETERMINE Market Structure Horizontal Structure Interaction between providers at the same level on the value chain Market Structure:Horizontal “ Horizontal structures relate to service areas – and this section looks at decisions on selecting service areas” • HORIZONTAL STRUCTURE • Deciding on Service Areas • The options range from having a single provider responsible for the whole country, to allowing every town and village to have its own provider, and, in between, various groupings of rural and city areas. • Various issues are considered: • Environmental and Technical factors • Impact on Service Efficiency • Administrative boundaries & collective choice • Financial attractiveness and capacity • Transaction Costs Horizontal Structure Interaction between providers at the same level on the value chain Vertical Structure Interaction between providers at different levels on the value chain Cross Sector Structure Limits on ownership or other affiliations between water utilities and companies in other sectors

20. BOUNDARY Reservoir Village F Provincial Center Transmission Village A Village C Transmission Village E Town Capital City Village B Village D Treatment Plant BOUNDARY RIVER Secondary Town Bulk Supply Horizontal Structure:Environmental & Technical Single Utility? When areas are served by a single network (like Capital City and Villages C & D in the example) there may be an argument for a single utility covering this area ‘Technical & Environmental coordination can either be by awarding all responsibility to a single entity, or by ensuring adequate contracts or rules related to coordination’

21. BOUNDARY Reservoir Village F Provincial Center Transmission Pipe Village A Village C Transmission Village E Town Capital City Village B Village D Treatment Plant BOUNDARY RIVER Secondary Town Bulk Supply Horizontal Structure:Environmental & Technical Common resource? If areas compete for the same resource (for example abstracting from the same reservoir as Capital City and Provincial Center) it may make sense to have a single provider to resolve conflict ‘Technical & Environmental coordination can either be by awarding all responsibility to a single entity, or by ensuring adequate contracts or rules related to coordination’

22. BOUNDARY Reservoir Village F Provincial Center Transmission Pipe Village A Village C Transmission Village E Town Capital City Village B Village D Treatment Plant BOUNDARY RIVER Secondary Town Bulk Supply Horizontal Structure:Service Efficiency “Empirical research shows economies of scale in water services” Economies of Scale? As more customers are added to the service, generally the unit cost drops. This can be important in small towns and villages that lack the scale to employ specialist managers and staff There are limits to this. Utilities that are too large become difficult to manage

23. DETERMINE Market Structure Vertical Structure Interaction between providers at different levels on the value chain Market Structure:Vertical “ Vertical structure relates to the provision of water services from Source to Tap and beyond. There is the possibility of unbundling these water service components” Horizontal Structure Interaction between providers at the same level on the value chain Vertical Structure Interaction between providers at different levels on the value chain Cross Sector Structure Limits on ownership or other affiliations between utilities and companies in other sectors

24. Water Abstraction Transport Treatment Distribution Customers Collection Treatment Disposal Discharge Sludge Treated Water Vertical Market Structure:The Value Chain “Example: Water Services components can be shown as items on a Value Chain” ‘Unbundling’ ‘Unbundling’ is the where items on the value chain are given to separate service providers. More typical in the electricity sector, but still feasible in the water sector

25. Generation Distribution The Value Chain: Unbundling Example “Example: A proposal for improving Kenya Power & Light Company KPLC” • ‘Unbundling’ • ‘KPLC is the Kenya national power and distribution company. Quoted on the Stock Exchange, with partial private shareholding. The Government (2006) considered increasing effectiveness and Private Sector involvement through: • Increasing Private Sector Stockholding • Generation to be a separate business, unbundled from new separate private (a) Transmission and • (b) Distribution companies • Separating social (rural) from urban services Transmission Urban Customers Rural Customers

26. Vertical Structure:Unbundling Issues “When deciding whether to vertically separate services, consider several issues: ” • The current structure of the sector • How to ensure quality of service • Planning investment • Where new investment or management is needed • Taking advantage of scale and scope • Managing payment risk • Managing scarce resources (e.g. water, fuel, hydroelectric) • Promoting decentralized decision making “The issues and solutions will be specific to the particular case ”

27. DETERMINE Market Structure Cross Sector Structure Limits on ownership or other affiliations between utilities and companies in other sectors Market Structure:Cross Sector “ It is possible for utility services to be provided jointly with other utility services (for example water with power or gas). The issue is whether they should be separated or combined” Horizontal Structure Interaction between providers at the same level on the value chain Vertical Structure Interaction between providers at different levels on the value chain Cross Sector Structure Limits on ownership or other affiliations between water utilities and companies in other sectors

28. Market Structure:Cross Sector - benefits “ Grouping services can offer benefits…….” • Possible benefits of grouping services together include: • Economies of scope • Reducing payment risk • Financial sustainability and cross subsidy

29. Market Structure:Cross Sector - Disadvantages “ ……Grouping services can also pose disadvantages” • Possible disadvantages of grouping services together include: • Problems in cost allocation and tariff setting • Competitive distortions • Loss of management focus

30. Cross Sector:Gabon & Morocco “ These examples show how cross sector integrated schemes can work, for water and electricity, and also sanitation ”

31. ALLOCATE Responsibilities to different levels of Government DETERMINE Market Structure ESTABLISH Competition Rules Establish Competition Rules SETTING UPSTREAM POLICY Identify the Reform Leader (Module 2) Introduce Private Participation

32. ESTABLISH Competition Rules Competition for the Market Competition via Capital Markets Competition in the Market Establish Competition Rules “ Market structure is likely to evolve based on the rules established for competition as defined at the time of the Transaction”

33. ESTABLISH Competition Rules Competition for the Market Competition:For the Market “ Competition for the Market consists of re-bidding private sector contracts at regular intervals” Competition for the Market Competition via Capital Markets Competition in the Market

34. ESTABLISH Competition Rules Competition for the Market Competition:For the Market “ Competition for the Market consists of re-bidding private sector contracts at regular intervals” • Issues: • Bidding and Rebidding is an efficient way of maintaining competitive pressure to provide high quality service at reasonable price: because the contractor risks losing the contract at the next bid stage • Typically long term contracts (up to 50 years): necessary for the contract to mimic competition – such as price controls, based on competitive comparisons • Should firms be encouraged to bid for several projects? •  Firms can bid for several contracts; increase demand, spread overhead cost and benefit from economies of scale If firms are allowed to expand without limits, it may develop into a monopoly, making difficult for new entrants at re-bid stage. The issue of maintaining competition may limit the number of contracts an operator may be allowed to win, to prevent a monopoly. Example: Metro Manila – operators were not allowed to win both of the two Concessions for this major urban area In most developing countries, however, it may be necessary to allow operator to develop their demand base to gain economies of scale. Competition for the Market Competition via Capital Markets Competition in the Market

35. Competition for the MarketExamples: “ Competition for the Market consists of bidding private sector contracts at regular intervals. A great many PPP projects are in this form.” • A few Market Competition Examples: • Highways: • Mexico - a large numbers of PPI projects, under a new regulatory and contract mechanism. The are BOOT projects, generally very long term over 20 years. • Ports: • Djibouti - Doraleh Container Terminal –Development, financing, design , construction, management operation and maintenance of a container port.Concession, lasting 30 years • Power: • Bosnia Hydro Schemes: A multitude of small hydro power generation concessions. These are rebid every 5 years (profits of the new rebid are used to pay off the outstanding capital of the previous concessionaire) • Water: • Jordan – Amman: Management contract for major water and waste water utility for the country’s capital for 5 years. The operator brought some operating capital. The MC period was further extended by negotiation. Finally Government then took decision to consider not to rebid as MC, but new bids as either lease or corporatization.

36. ESTABLISH Competition Rules Competition for the Market Competition for the Market:Vietnam: Phu My 2-2 Power Project “ Competition for the Market consists of re-bidding private sector contracts at regular intervals” • The first international Competitively bid BOT power project in Vietnam • 715MW gas-fired plant sourced through domestic gas • Total project cost about $480m including $80 million • stand-by generation • IDA loan $75 million; Debt to equity ratio of 75:25 • Sponsors formed a project company MECO: • EDF International (56.25%) • Sumitomo Corp (28.125%) • Tokyo Electric Power Company International (15.625%) Competition for the Market Competition via Capital Markets Competition in the Market

37. ESTABLISH Competition Rules Competition for the Market Competition for the Market:Vietnam: Phu My 2-2 Power Project “ Competition for the Market consists of re-bidding private sector contracts at regular intervals” • BENEFITS: • Mobilized private investment for a country with untested legal / regulatory framework • Enhanced competition at entry and attracted strong bids • Shared risks with the private sector in infrastructure development (vs. all-risk pubic projects) • Increased Diversification of investment resources • Alleviated fiscal burden on budgetary resources Competition for the Market Competition via Capital Markets Competition in the Market

38. ESTABLISH Competition Rules Competition via Capital Markets Competition:via Capital Markets “ Competition via Capital Markets occurs when Operators can purchase their competitors through buying shares on the Financial Markets, or through mergers” Competition for the Market Competition via Capital Markets Competition in the Market

39. ESTABLISH Competition Rules Competition via Capital Markets Competition:via Capital Markets “ Competition via Capital Markets occurs when Operators can purchase their competitors through buying shares on the Financial Markets, or through mergers” • Issues: • Threat of Purchase: maintains competitive pressure on Operators, and an incentive to maintain the company’s financial health • When does this occur?: when company’s shares can be bought and sold (often for service providers, more restricted for asset owning companies) • Mergers & Acquisitions: Governments may want to restrict mergers and acquisition, as this would have similar issues to allowing a company to win multiple contracts, including difficulties of establishing competitive service benchmarks • Example: Mergers have been prevented in the UK Electricity, Gas and Water Services market to ensure sufficient Operators remain for comparative competition Competition for the Market Competition via Capital Markets Competition in the Market

40. ESTABLISH Competition Rules Competition via Capital Markets Competition:via Capital Markets “ Competition via Capital Markets occurs when Operators can purchase their competitors through buying shares on the Financial Markets, or through mergers” Competition for the Market Competition via Capital Markets Competition in the Market

41. Competition:Capital Markets - UK “England & Wales - Number of Competitors seen to influence effective competition”

42. ESTABLISH Competition Rules Competition in the Market Competition:In the Market “ Competition in the Market is when Operators are free to enter and offer services in a Market. More usual in consumer goods market; but has been used in Power Sector – sometimes with disastrous results.” Competition for the Market Competition via Capital Markets Competitionin the Market

43. ESTABLISH Competition Rules Competition in the Market Competition:In the Market “ Competition in the Market is when Operators are free to enter and offer services in a Market. In the Pakistan Power Sector an unregulated market created excess generation Capacity” • Exclusivity Issues: Often Exclusivity given to Operators, it limits competition, but may be needed to make the contract economic.  Liked by Operators - Protects Operator from competition and some uncertainty of future demand. Prevents inefficient duplication of distribution networks. Helps preserve cross subsidies (since high paying customers cannot change providers) • Customers may benefit from more liberal entry policies. • May prevent small scale Alternative Providers from offering services Competition for the Market Competition via Capital Markets Competitionin the Market

44. Example: Pakistan Power Sector “ The Pakistan Power Sector showed major problems with overexpansion of supply” • Promotion of massive investment in IPP: Following success of 1292MW HUB private power project, 1994 Government Power policy set to attract PPP generation projects • Overcapacity: With hindsight, estimated capacity needs were probably around 2,000MW. However, under this market approach 34 Projects were initiated, resulting in around 20 IPP’s with about 4,500 MW capacity reaching financial closure. This excess added to the later problems • Tariff ceiling: In an attempt to speed the process to financial completion, competitive bids were not required, instead a tariff ceiling was set, at a reasonable level at the time. However, this lack of competition resulted in public perception (unfairly) that private power was too expensive. • Market economy problems: a massive downturn in Pakistan economy resulted in rapidly increasing costs, particularly of foreign exchange components. IPP tariffs linked to the US $, and 45% rupee devaluation. For several reasons IPP power costs reached 50% of WAPDA operating costs. Revenues dropped with the economy, and poor WAPDA collection rates and crossubsidies • Government attempted to renegotiate (lower IPP payments) at the same time as sorting out cases of corruption. This led to foreign investor doubts about the economy, which reduced foreign investments to a trickle and worsened the wider economic crisis • With the help of World Bank, Pakistan established an Orderly Framework for IPP negotiation and a procedure was gradually established that regularized the situation. On average tariffs were decreased by 10%, in return for extension of power purchase agreements from 20 to 30 years

45. Competition:Alternative Providers

46. ALLOCATE Responsibilities to different levels of Government DETERMINE Market Structure ESTABLISH Competition Rules Reviewing Session 6.1 “The Session has looked the main areas of upstream Policy that should be established before developing PP design” Identify the Reform Leader (Session 3) Introduce Private Participation

47. Government Readiness for PPP Session 6.1 THANK YOU! Setting Upstream Policy David Stiggers & Sabino Escobedo

48. Session 6.1More Information “……..and further background information is available”

49. Contacts For comments or further details contact: Junglim Hahm jhahm@worldbank.org Richard Cabello rcabello@ifc.org Sabino Escobedo sescobedo@tagfinancialadvisors.com David Stiggers davidstiggers@comcast.net

50. Government Readiness for PPP Session 6.1 THANK YOU! Setting Upstream Policy David Stiggers & Sabino Escobedo