March 2006

Best Practice in Water and Wastewater Tariff Setting: Lessons for Water Systems in Transition Economies. Working Draft

PREFACE
This document was prepared for the DABLAS Implementation Working Group. Its purpose is to provide a basis for considering the ways in which tariffs, and tariff-related practices generally, might be incorporated more usefully and directly into the work of the of the DABLAS Task Force. Options for action range from development and distribution of a document like this through the Task Force to a dedicated Task Force program of tariff reform dissemination and training that is fully coordinated with the ongoing project identification and preparation programs of the Task Force.1 We offer this document as both a review of best practices in this area and to stimulate discussion of the role tariff reforms should play in the work of the Task Force.

The target audience for documents and capacity building in tariff reform is quite broad including: water

system managers, water associations, regulatory authorities, agriculture and environmental ministries, local government, and public and private financial institutions.

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TABLE OF CONTENTS

1. 2. 2.1.

Introduction ...................................................................................................... 5 Best Practices .................................................................................................... 6 Develop and maintain accurate and extensive accounts and records....................... 6 Acquire and maintain good customer records. ................................................. 6 Cost or expenditure records should be linked to tasks and activities. .................. 6 Establish and keep good capital accounts ....................................................... 6 Develop and maintain performance indices ..................................................... 7 Meter and Measure Water and Wastewater Flows and Quality................................ 7 Measure water and wastewater network flows ................................................. 7 Meter final users ......................................................................................... 7 Monitor water quality................................................................................... 7 Monitor wastewater quality........................................................................... 7 Establish Cost-Based Tariffs ............................................................................. 8 Establish full cost tariffs including proper account of depreciation ....................... 8 Establish cost-reflective tariffs ...................................................................... 9 Set tariffs with both variable and fixed charge components ..................................10 Beware of, and limit, the tariff burden on customers ...........................................11 There is no best practice level of affordable tariff .........................................11 Develop long term service agreements with key customers ..............................11 Provide incentives for good management ..........................................................11 Award contracts for system management on a competitive basis. .....................11 2.1.1. 2.1.2. 2.1.3. 2.1.4. 2.2. 2.2.1. 2.2.2. 2.2.3. 2.2.4. 2.3. 2.3.1. 2.3.2. 2.4. 2.5. 2.5.1. 2.5.2. 2.6. 2.6.1.

2.6.2. Provide pay bonuses to water system management and staff when performance targets are met. .....................................................................................................12 2.6.3. Provide incentives from the central government to the water system for taking the lead in improving water quality and/or reducing pollution or other externalities................12 2.7. Public Information Programs ...........................................................................12 2.7.1. Publish and regularly remind customers of the water and wastewater tariff schedule................................................................................................................12 2.7.2. Describe to customers policies that govern calculation of tariffs and the role of different costs in that calculation...............................................................................12 2.7.3. 3. Commission an external, performance audit...................................................13 Conclusion .......................................................................................................13

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1.

INTRODUCTION

There are a number of things to bear in mind when considering best practices in selecting and administering tariffs. First, that tariff best practices are not independent of other aspects of regional or local water system management2. Realization of the benefits of best practices in tariff selection depends on supporting practices in administration, financing, regulation, and technology. Thus, some of the best practices described here include aspects of tariff setting that overlap with many other aspects of water system institutions, management, and operations.

Second, a listing of the desirable attributes of water and wastewater tariffs commonly includes the following considerations. Tariffs should, it is said:

1. 2. 3. 4. 5. 6. 7. 8.

Be simple and easy for customers to understand; Produce a revenue stream sufficient to covers the cost of providing service; Provide a steady revenue stream that can be relied upon to pay long term debts and obligations; Discourage inefficient use of resources, including water resources; Support investments and operations that provide high quality service to its customers, Support investments and operations that protect the environment, Provide affordable service to customers, and Reflect the different costs of providing service to different customers.

These objectives are not all equally important. Moreover, tariff practice selected in pursuit of one objective will affect in diverse ways achievement of other objectives. The particular tariff practice may hardly affect some objectives, preclude pursuit of other objectives, substantially undermine yet other objectives, and even simultaneously both amplify and diminish different aspects of a single objective. Recognizing this, selecting best practices means selecting tariff and related policies that make advantageous tradeoffs and accommodations across the multiplicity of objectives. Finally, environmental protection may not be the primary consideration in selecting, or failing to select, a particular practice. The purpose of water systems is to efficiently provide safe and reliable drinking water and wastewater services on a sustainable basis. Tariffs policy, then, must give highest priority to providing a revenue stream that meets these minimal requirements. In the context of transition economies especially, tariff policies that provide a sustainable level of the most basic services are a pre-requisite of tariff practices that support improving environmental protection more generally.

The term water systems, as used here can includes wastewater systems and, sometimes,

stormwater systems. Likewise, the term municipal water system includes any organization, public or private, that provides water and wastewater services on a local or regional basis.

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2.

BEST PRACTICES

The following list of best practices comes from an variety of sources, including experience and practice in both developed and developing economies. They have, however, been selected with special consideration for the specific setting of transition economies.

2.1. Develop and maintain accurate and extensive accounts and records
Record keeping should meet local and international accounting standards, but this system should also be designed to support financial and management systems and decision making. Among the best and most supportive record keeping practices are:

2.1.1.

Acquire and maintain good customer records.

These records should include information on consumption, charges, and payments that are up to date and in a form suitable for supporting management of the water system. Such records, kept in a manner that is easily accessed and analyzed, have proved invaluable for 1) tariff studies, 2) payment recovery initiatives, 3) demand forecasting, and 4) demand management studies. All such studies and analyses are important in first developing better tariff policies and refinement of those policies over time.

2.1.2.

Cost or expenditure records should be linked to tasks and activities.

Cost and expenditure data are often organized only according to the good purchased or the sector in which the items are used. In transition economies, the need to develop in-house data systems to support broader policy and specific investment decisions are just now being fully appreciated. Best practice includes cataloging these data to particular activities, projects, or tasks that can, in turn, be linked to the output of particular changes or improvements in service. Classified in these additional ways, the purchases data can be used to support 1) development of full cost and/or reflective-cost tariffs, 2) maintenance, repair, and investment cost estimates, 3) estimates of cost-savings from automated operations, preventive maintenance and other interventions, 4) keep track of reserve funds and their disbursement, 5) a complete set of capital accounts, including estimates of replacement costs with new technologies and materials. All these applications are critical to improvement or refinement of analyses that support both management planning and the level and design of tariffs that support investment and operating decisions.

2.1.3.

Establish and keep good capital accounts

Capital accounts provide a basis for computing depreciation. Properly computed to conform as closely as possible to true, economic depreciation, these accounts support better valuation of capital stock and depreciation of that stock.3 Depreciation is often a key variable in determination of tariffs that will financially sustain a water and wastewater system.

Good practice often requires keeping several sets of depreciation accounts since tax laws and

accounting rules often diverge from market-based estimates of depreciation.

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2.1.4.

Develop and maintain performance indices

The records collected should include those data that can be used to construct performance indices that help measure changes in the effectiveness and efficiency or the water system programs and management. These can be used as important signals to the owners of the water system or those responsible for water system oversight. Financial and other indices are often used by lending organizations in their evaluation of water system management.

2.2. Meter and Measure Water and Wastewater Flows and Quality
Best practice includes not only development of better systems of accounts but good measurement systems in support of those accounts. These measurement activities support the design and effectiveness of tariffs in a wide variety of ways.

2.2.1.

Measure water and wastewater network flows

More extensive measurement helps establish the location and amount of water losses and infiltration and is a key to identifying the most cost-effective investments in the water and wastewater network.

2.2.2.

Meter final users

When final users are metered the tariff selected provides a direct incentive to conserve water resources. Metering also helps assure the customer that they are paying only for the water they use and this greatly aids acceptance of tariffs levels. This practice extends to retrofitting water meters in multi-flat buildings.

2.2.3.

Monitor water quality

These measures, taken at different points in the system, aid planning and resource allocation. When made available to the public they provide a strong incentive to water system owners and managers to maintain water quality and, at the same time, help assure customers that they are receiving good service. To be cost-effective, this monitoring is not usually continuous and can be enhanced by development of a well-conceived sampling program with both random and contingent components.

2.2.4.

Monitor wastewater quality

These measures help in a wide variety of management decision, including network and treatment designs that are optimized to wastewater composition and concentrations. They also provide a quantitative basis for wastewater tariffs that vary with the type and amount of wastewater produced by different customers. This monitoring is not usually continuous but based on a periodic sampling design that encourages positive adaptive behavior and is costeffective.

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2.3. Establish Cost-Based Tariffs

Cost-based tariffs are the sine-qua-non of cost-effective and efficient tariff design. Here we distinguish two aspects of cost that must be clearly distinguished as part of developing best practice, cost-based tariffs.

2.3.1.

Establish full cost tariffs including proper account of depreciation

Efficient resource allocation requires that service users pay the cost of providing that service.4 One implication of this requirement is quite clear and in widespread practice customers pay tariffs that are sufficient to cover the operating costs of the system. The need to set tariffs that also cover system depreciation is also widely acknowledged in principle, but the practice is often imperfect and, in some cases, results in divergence from the principles of efficient resource allocation. Some of the suspect practices encountered include: > > > > > Depreciation allowances in tariff calculations that are based on historic costs, Depreciation schedules that do not match up well with actual physical or technical conditions, Depreciation bases revised on arbitrary or economically inaccurate bases, Use of funds produced by depreciation allowances to support projects or cover costs unrelated to replacement of the system infrastructure. Failure to include in the asset base infrastructure that has been externally funded but which must eventually be replaced.

Good practice requires that the water system, its owners, and its customers have a clear vision of how they will finance the full costs of current service levels. In particular, they need to clearly decide whether to adopt as their primary approach to financing either borrowing (debt) or saving (local sinking fund) financing systems. Debt financing has current users pay principal and interest on past debt used to fund construction of infrastructure they are currently using. The use of a local sinking fund has current users paying into reserves that will finance infrastructure used by future users. Which is best depends on conditions in domestic and international capital markets, ones expectations regarding future incomes and prices, and, to a considerable extent, the perspective one adopts regarding what is fair to present and future customers.5

Formally, efficiency conditions require that the tariffs should equal long run marginal costs. In certain

circumstances, this may imply revenue streams which may be different from current system expenses. Such situations are not uncommon in the water industry but, with good management, they appear to be of small practical importance in most cases.
5

A bequest of state-owned infrastructure to municipal water systems as part of the devolution process

has provided water systems with a unique opportunity to make this choice. Deferring maintenance, repair, and replacement of water system infrastructure while keeping tariffs down is tantamount to choosing a debt system. Setting aside a depreciation allowance and limiting its use to repair and replace current infrastructure is a savings strategy.

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Full cost tariffs supporting current service levels should be in place before the water system commits to tariffs in support of new or expanded service levels. A water system risks serious problems if it commits tariff revenues to building or operating new or expanded services without first assuring that the full costs of its current services being met by current tariffs.

The differences between the term of a loan and the economic life of an asset purchased with the loan should be taken into account when considering the adequacy of tariffs. Accounting for this difference applies to either debt or saving financing, but is usually most critical to debt financing. Consider, for example, a water system that takes on a ten year debt to pay for infrastructure that, when properly cared for, should last forty years. Raising tariffs to cover the principle and interest on this debt would mean including costs in the tariff that exceed the costs of depreciation. In such cases, the water system should carefully consider other depreciation amounts included in tariff calculations and decide if some offset is appropriate. One can see clearly, in this instance, how important proper calculation of depreciation is to setting of tariffs, especially full cost tariffs.

2.3.2.

Establish cost-reflective tariffs

Cost-reflective tariffs not only reflect the full costs of providing service but also differences in the cost of servicing different customers. These cost differences can result from a wide variety of circumstances: the customers line of business, the effluent produced by the customer, the seasonality of water use, a customers remote location, etc. Whatever the reason, adjusting a customers tariff to fully reflect the actual cost of service is a necessary requirement for tariffs that properly conserve water and, more generally, valuable resources. Cost reflective tariffs require the ability to assign costs to particular customers or groups of customers. In this way, the book-keeping practices recommended in 2.1 are critical to the effective implementation of this practice.

Set water and wastewater tariffs to reflect the different cost of providing water and wastewater service. Many water systems in transition economies have data that allow them to distinguish between the costs of providing water and wastewater service and some have already set tariff based on this distinction. This practice, however, will likely be tested as the costs of wastewater start to accelerate as a result of service extension and environmental mandates. There will likely be pressure to spread these costs over more customers and as well as classes of service.

Set industrial and domestic tariffs to reflect the different cost of providing service. The historic practice in transition economies has been to charge industrial customers more than domestic customers. Many water systems in transition economies have narrowed the tariff differences but price discrimination on behalf of domestic customers is still a common practice. An unfortunate consequence of any tariff preference is that, over time, more and more customers get classified and approved for the preferential rate, eroding the revenue stream and further encouraging inefficient resource use.

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When large tariff adjustments are in order, spread the change in tariffs over time in smaller increments. While this practice seems like good common sense, some water systems are tempted to make up for years of constant prices and deferred maintenance in one shot. Furthermore, it is a good practice to provide advance warning to customers of a tariff increase and to explain the reasons behind the increase. When instituting reflective-cost tariffs, in particular, customers whose tariffs are increasing disproportionately should understand why they are being singled out for larger tariff increases.

In certain circumstances, set special fees and charges based upon costs of service. Many water systems assess special fees for special, one-time services such as connecting a new customer to the system or opening a new account. Like water tariffs, these fees should be based on the costs of this service, and should not be punitive. Some fees that have been used and should be considered as part of an emphasis on full cost pricing are: > > > > > Fees for late payment of bills, Deposits to assure payment, Initial fee when opening a new account to recover costs connected with introducing or closing the new account, Fees to cover the costs of extending or expanding system infrastructure to new customers, and Fees to cover storm water collection and/or treatment.

One has to be careful not to establish too many such fees. The more fees and the more complicated the conditions for computing the fee, the more confused both the customers and the water systems books become. If the fee does not yield much revenue in proportion to additional billing and bookkeeping costs, its better to recover the cost of the service with conventional tariffs rather than special fees.

2.4. Set tariffs with both variable and fixed charge components
Variable tariffs are denominated in monetary units per volume of water e.g., /m3. Fixed tariffs are denominated in monetary units per unit time e.g., /month. Since large parts of the costs of municipal water systems are composed of fixed costs, it makes economic and business sense to recover these costs through use of a fixed tariff and to recover operating costs that vary with the amount of water used with the variable tariff (sometimes called a commodity charge). Fixed fees are also attractive because they can stabilize revenue streams. Fixed tariffs are not standard but they are becoming more common in the water systems of both developing and developed countries. Where they are used, their design is carefully considered to prevent excess financial burdens on smaller users. Also, because fixed fees are a novelty to water systems in the transition economies of the Danube and Black Sea basins, their introduction may require changes in national laws or regulations.

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2.5. Beware of, and limit, the tariff burden on customers

Water systems have to protect their revenue stream and the financial viability of their customers. Tariffs that are too high can threaten the water systems revenue stream. When a water system selects investments and chooses financing mechanisms, it needs to anticipate the tariffs and financial burden the selections that would be imposed on customers. If customers respond by reducing or dropping service, by delaying or refusing payment, and by petitioning public officials for relief, the water system can face grave financial difficulties. Tariffs can be designed to help reduce financial burdens on the neediest customers, but these designs are imperfect. Moreover, such designs can get complex and have, in some cases, resulted in seriously undermining the water systems revenue stream and producing marked cross subsidies and inefficiency. While the water system may provide relief to some customers on a short term basis, the best practice is for the Central Government to determine who is needy and for assistance with payment for water and wastewater services to be delivered as part of general program of social protection.

2.5.1.

There is no best practice level of affordable tariff

Despite what has been written by some consultants, international financial institutions and serious minded economists have not sanctioned tariffs the keep average household expenditures on water and wastewater service within a specific affordable percentage of household income. Determining an appropriate burden for water and wastewater service rests on the value customers place on the service provided, including externalities such as environmental protection and public health. In practice, as well as in principle, the willingness-to-pay consumers demonstrate varies widely with national, community, firm and household circumstances and the level and type of service involved.

2.5.2.

Develop long term service agreements with key customers

These agreements set the terms of service, including tariff levels, for key customers. These agreements bind both the water system and the key customer together for an extended period. This protects the customer from unreasonable tariff increases and the water system from customer defections or sharp drops in service use. In most cases, this would include service a negotiated service agreement with the municipality and public institutions that are significant water users.

2.6. Provide incentives for good management

Provide incentives for a management that encourage reductions in the cost of service and/or improve the quality of service without increasing costs. If management is effective, and tariffs reflect the cost of service, these incentives will pay for themselves. Several possibilities are noted below.

2.6.1.

Award contracts for system management on a competitive basis.

The competition for the contract will encourage bidders to offer to keep water and wastewater tariffs low and for the winning bidder to aggressively cut costs if net revenues
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can be retained by the contractor. England and Wales and Australia are experimenting extensively with water and wastewater tariffs that are set under a price cap system with periodic re-determination of price based on recent costs.

2.6.2.

Provide pay bonuses to water system management and staff when performance targets are met.

The bonuses can be awarded when costs are reduced below recent levels. The performance targets can be based on the performance indices discussed above and costs-savings as measured by the extended book-keeping system (2.1.2). An apparent advantage of privatized systems, aside perhaps from access to capital, is their ability to more effectively and flexibly reward the best performing management and staff.

2.6.3.

Provide incentives from the central government to the water system for taking the lead in improving water quality and/or reducing pollution or other externalities.

Formally, this is not a current practice, but sometimes foreign or external assistance programs seem to be administered on this basis. The notion here (one validated on numerous occasions in our experience), is that it takes dynamic and aggressive local management and ownership to adopt and prove the most novel and risky technologies and investments. Properly measuring progress depends on the existence, once again, of good and extensive records. Rewards for progress can take many forms e.g., grants for special projects, preferential financing, special education or training programs. Administering such a program can be tricky and needs to be done in a way that doesnt seriously distort the incentives for efficiency built into the cost-based tariffs. By the same token, one should be concerned about assistance programs from any source - that are designed to help the most backward systems without qualification. Such a design encourages slack management and laggard investment.

2.7. Public Information Programs

2.7.1. Publish and regularly remind customers of the water and wastewater tariff schedule. Describe to customers policies that govern calculation of tariffs and the role of different costs in that calculation.

2.7.2.

The water system should alert customers in advance to upcoming investments, regulatory requirements, or other cost increases that will impact tariffs and compute the corresponding impact on typical customer bills. It is especially important to identify historic shortfalls in infrastructure investment or full costing of service that may have given the customer the impression that water service was less costly than it really is.

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2.7.3.

Commission an external, performance audit.

This audit will provide information that ownership and management can use to improve operations and reduce costs. Perhaps more importantly, an audit that certifies that the system is well and efficiently run will assure the public that tariffs incident to operating and maintaining the system are really necessary. Such assurance is especially important in transition economies where customers are skeptical of management claims and government oversight.

3.

CONCLUSION

Best practices in tariff setting and design will not realize their full potential or even, in some instances, constitute good practice, if they are instituted in isolation. The over-riding best practice is to design and implement record keeping, information, incentive, and cost-based tariffs concurrently. When carefully considered best practices are bundled together, the whole is much more than the sum of the parts.

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References page 14

REFERENCES
Clarification: this draft is not completely documented here or in the text. We drew on dozens of sources that are not listed below. Cadmus Group, et. al. A Study of Best Practices in the Water and Wastewater Sector for the Ontario SuperBuild Corportation. April, 2002. Morris, Glenn E. and Andrs Kis. Assessment and Development of Municipal Water and Wastewater Tariffs and Effluent Charges in the Danube River Basin. Volume 1: An Overview of Tariff and Effluent Charge Issues and Proposals. Danube Regional Project. September, 2004.