Consolidated Report on Urban Water Tariff Reform in Municipality of Shijiazhuang[II]

4. Pricing Strategies and Scenarios
4.1 Pricing Strategies
4.1.1 Marginal cost pricing

If resources are to be allocated in an 'economically efficient' manner (refer Section 2.1), prices must have regard to the marginal costs of supplying services. The 'efficient' price is not the cost of using the system now, but is the price which equals the supply cost of the next increment in the size of the system (marginal cost). Marginal prices are the key determinant of how much water is demanded and therefore how intensively existing water sector infrastructure is used. Responses to changes in usage charges are crucial in signalling consumer valuations of additional services and thus in guiding the timing of new investment. With marginal cost pricing, the revenue generated will cover the next step up in size, and until consumers are ready to pay for the next step up, they will not use the service in the volume necessary to trigger the next step.

Determining what constitutes 'efficient' pricing of water services raises conceptual and implementation issues. It is generally considered that price should be set equal to long run marginal cost (LRMC), including all capital, operating and resource depletion costs. This would ensure that the total economic cost of supplying an additional unit of water is met by the tariffs for consuming it. However, while marginal cost pricing has theoretical appeal, it has practical limitations. For instance:
- It is very difficult to calculate the LRMC due to the indivisibility associated with the large and long-term additions to capacity which generally occur in the industry.
- Marginal cost analysis does not consider costs associated with past investments in system capacity - however, these costs (eg. capital servicing costs) must be met by the water or wastewater enterprise.

In practice, 'efficient' (marginal cost) pricing regimes must invariably depart from some aspects of text-book rules and a significant element of pragmatism is called for. 'Efficient' prices should include usage prices based on marginal costs, but should also return over time the total revenue needed to remain in business.

'Efficient' pricing of water and wastewater services is about finding a system of charges which gives a reasonable prospect of cost recovery on sound investments, while at the same time signalling to users the 'opportunity cost' of additional water sector services. This strategy will provide adequate cost recovery to allow enterprises to operate on a self-sustaining basis, while promoting other tariff setting objectives such as conservation of water.

4.1.2 Cost recovery pricing

The issue of what costs should be covered by prices is best approached by asking what is the cost to an enterprise in the water sector of doing business. If these services were to be provided by a private sector operator, that operator would need to generate sufficient revenue to cover operating, maintenance and administration costs, depreciation of infrastructure, debt servicing requirements and pay a satisfactory return on equity funds invested in the business.

The need to recover operations, maintenance and administration expenses, depreciation and interest charges is widely accepted by government-owned water sector enterprises internationally. There is also general recognition that a return on government equity in fixed assets is a cost of making water services available.

4.2 Calculation of Costs To Be Recovered

Most water sector enterprises do not use marginal cost pricing, but concentrate on full cost recovery and financial sustainability as they move towards self-sufficiency. Tariffs are calculated from an analysis of the costs of service, for which there are basically two approaches:
1. Utility approach - this allows the enterprise to recover operating and capital costs as determined by generally accepted accounting principles, and to earn a return on its capital investments (ie. fixed assets). This return is used to fund the repayment of principal on debt service, to contribute to funding capital expenditure, to meet taxation requirements and to provide a dividend to the owner of the enterprise.

2. Cash needs approach - this allows the enterprise to recover its cash requirements, ie. user charges are structured to recover specific cash requirements for operating and capital.

The major difference between the two approaches is the way in which capital costs are calculated.
- Under the utility approach, depreciation, interest on debt service, and return on asset base provide the basis for calculating capital costs.
- Under the cash needs approach, debt service (principal and interest) and contributions to various cash reserve funds are typically included. Examples of reserve funds are capital replacement, capital expansion, insurance reserve and rate stabilisation.

The major advantages of the utility approach are that it provides a more rigorous methodology for identifying capital cost recovery requirements and it is more consistent with accrual accounting. Provided that a target rate of return on assets can be determined, tariffs can be set with less subjectivity than is involved in identifying the cash that is needed from annual revenue to support capital programs and related capital expenditures.

Internationally, there is strong support from water sector enterprises which are regulated by government agencies for the utility approach to calculating costs to be recovered. It permits a more comprehensive approach to capital financing than the allocation of unspecified amounts of revenue to special funds.

4.2.1 Asset Valuation

Given the objective of fully covering the costs of water sector services provision, proper asset valuation and provision for depreciation are crucial. Often fixed assets are grossly undervalued, being stated virtually at purchase price in balance sheets (commonly referred to as "historic cost accounting"). This creates a very distorted picture of the capital structure and of the revenue requirements necessary (through adequate depreciation) to cover system renewal and (by a reasonable rate of return) to provide for reasonable system expansion. The use of historic cost accounting to value assets is likely to underestimate the cost of capital employed in providing services.

Therefore, there is the need for revaluation of fixed assets in efficient pricing regimes where valuations of assets translate directly to the level of charges. However, there is no commonly agreed basis for valuing the sort of long lived assets that characterise the water sector or for setting depreciation charges. It is an issue on which much has been written but which has yet to be satisfactorily resolved.

In response to the deficiencies in historic cost accounting, many enterprises in the water sector have revalued their assets on the basis of current market values (commonly referred to as "current cost accounting"). The use of current cost accounting is often viewed as an essential prerequisite for setting efficient capital charges.

There are a number of alternative approaches to determining the current values of water sector assets. The simplest approaches are those based on replacement cost valuation. Assets are then valued at their written-down (depreciated) replacement cost for the purposes of calculating the return on asset base component of revenue requirements.

It is important to adjust for technological improvements in potential replacement assets which reduce the costs of providing services. This can be achieved by estimating the cost of replicating the service potential of an existing asset with the most appropriate modern equivalent asset. This technique results in a lower asset valuation than one based on unadjusted replacement cost.

It is therefore important that asset revaluations be undertaken periodically. However, to maintain the value of assets in current terms, it is necessary that interim revaluations be undertaken on an annual basis between the full revaluations. Indexation of an asset's most recent valuation (which may be its acquisition cost) is a useful approach to updating values between full valuations.

These interim valuations should use relevant official price indexes or other reliable measures that can be used to estimate the current values of major asset classes. Indices should take into account not only the effects of specific or general price levels, but also of technological change. Interim revaluations should also take into any other changes that have a material impact on the value of the asset.

Having achieved a figure for the (gross) current cost of an asset, it is necessary to then write down the value of the asset to reflect the remaining service potential, ie. current cost as determined must be reduced to reflect the already consumed or expired service potential of the asset. This can be achieved through the use of a conventional depreciation system, or renewals accounting as practised in the United Kingdom.

4.2.2 Rate of Return on Asset Base

There are three practical aspects associated with the rate of return on asset base:
- the method of measuring the rate of return
- setting an appropriate target rate of return
- determining what to include in the asset base

Each aspect is discussed separately below.

Rate of return measure

The rate of return target on an enterprise's asset base is a different concept from the required rate of return on new investments used in project evaluation. The former is a financial performance target based on the accounting rate of return method. The latter reflects the opportunity cost of capital or the rate of return that could be earned on an alternative investment of similar risk over the life of the investment; it is based on the discounted cash flow approach, where the cash flow numbers are different from the accounting figures used for financial reporting.

Accounting rate of return performance measures cannot easily be reconciled with project evaluation measures. It has been shown that there is no apparent compatibility between the annual rates of return, the average annual rate of return and the internal rate of return.

Target rate of return

The target rate of return needs to be set with regard to the circumstances of the individual water sector enterprise. The main factors to be considered are:

- impact on tariff levels and consumers' bills
- future capital expenditure requirements and the extent to which funding of capital expenditure relies on external borrowing (debt financing)
- financial viability implications including profitability, liquidity and cash flow position

Questions which arise in determining the appropriate rate of return are:

- Whether the rate is to be applied to assets valued on a historical cost basis or on current cost? The latter is the preferred basis for setting the return on capital objective, as it adjusts for the effects of inflation. This is consistent with the real rate of return concept.

- Whether different rates are to be set for existing assets and new investments (including renewals)? The existing rate of return could be applied to past investments, while a commercial return could be applied to new investments.

Composition of asset base

It is necessary to determine what asset base the target rate of return relates to. Possibilities are:

- total assets (net fixed assets plus working capital)
- original value of fixed assets
- net value of fixed assets (original value of fixed assets minus depreciation)
- equity capital (total assets minus total liabilities)

4.3 Cost Recovery Options

Four options generally reflect the range of cost recovery objectives, from recovery of operating and maintenance (O&M) costs to full cost recovery:

- all O&M costs;
- all O&M costs and depreciation;
- all O&M costs, depreciation and interest charges on debt;
- all O&M costs, depreciation, interest charges on debt and a specified rate of return on the asset base to provide for reasonable system expansion and to meet dividend and taxation requirements.

The second and third options reflect the concept of "full cost recovery" that would be expected from a water sector authority operating as a government department. The fourth option is more that which would be expected from an autonomous water sector company operating as a commercially-focussed enterprise providing a return on government equity.

4.4 Phasing-In of Tariff Increases

The setting of tariffs to achieve full cost recovery, including the required rate of return on asset base, will result in substantially higher water and wastewater charges.

How should the move to full cost recovery proceed? Perhaps the most practical approach is to consider recent local experience in tariff increases as a guide to consumer acceptability. Generally, there have been significant real increases in urban water tariffs since 1990. This provides reasonable opportunity for implementing a relatively small number of significant annual tariff increases to achieve the transition to full cost recovery and which would fall within the range of recent experience.

Consolidated Report on Urban Water Tariff Reform in Municipality of Shijiazhuang[Ⅲ]