Incentives – What are the ways to incentivize service expansion, performance and cost containment when a utility’s assets have not been maintained, cash flows are weak, and management is unresponsive to “traditional” penalties?
(Response by Sanford Berg, with input from Jemima T. Sy and Sara Ahmed)
Selected issues faced by Fragile and Conflict-Affected States (FCSs) in relation to developing and improving infrastructure regulation are discussed in this set of Frequently Asked Questions (FAQs). Fragility is different in every context. Context shapes the market, institutions and the actions that are possible to take. The FAQs present general principles, guidance, and examples; where possible, guidance have been distinguished for countries along a fragility spectrum using the following taxonomy: Crisis, Rebuild and Reform, Transition, and Transformation.
Relationship to other FAQs: Two other FAQs focus on collecting information for target setting and on how key performance indicators (KPIs), are the foundation for establishing incentives. Keeping track of KPIs over time enables decision-makers to clearly identify baselines, which can be used to evaluate the impact of regulations as the nation moves from a Crisis stage to later (more stable) stages, including Transformation.
In the Crisis or Rebuild and Reform stages, even if services are largely donor funded, with NGOs delivering some core services with government oversight, performance reports serve as the basis for determining where funds are utilized most effectively. As the intensity of conflict and political violence becomes manageable compared with earlier periods, policy-makers are able to put a development plan in place. Attention can begin to be given to incentives to make significant progress in the delivery of basic services.
Performance Challenges in FCSs
Setting tariffs and incentives is challenging in this context. The challenges are three-fold: obtaining funds for investments and operations; absorption/operational capacity, and balancing financial sustainability and affordability. In FCSs, there is an absence of financial institutions and markets that can provide funds for firms providing infrastructure and other services. Obtaining and monitoring funds for reconstruction and network expansion requires information/accounting systems that facilitate the collection and analysis of data, so the impacts of that funding can be documented. Yet, those information systems are unlikely to exist. The managerial talent for providing infrastructure services can range from local entrepreneurs to highly skilled engineers. Recruiting, training and retaining professionals is not easy. Finally, balancing revenue sufficiency with public acceptability and affordability presents, perhaps, the ultimate challenge. This is a significant problem since the majority of the public have minimal understanding of how political processes affect access to infrastructure. Furthermore, there is a widespread inability to pay for services. Establishing a “culture of payment” (even at only symbolic levels) is one step that must be taken if service providers are to begin to approach financial sustainability.
Some challenges faced by FCSs that affect service coverage and quality and financial performance are discussed below:
- Service Standard, Quality and Cost: Quality of service could include measures of continuity of service, system reliability, safety, meeting regular maintenance schedules, addressing customer complaints, and mean time to repair network failures, etc. There is an important trade-off between improving the service quality for current customers and expanding the network. This issue needs to be part of a public discussion, with input from local political leaders and consumer organizations. Measures of citizen satisfaction reflect perceptions regarding the mix of service coverage, tariffs and quality. Public information regarding service quality by geographic area is often woefully inadequate, limiting the ability of public input to put pressure on local infrastructure managers. Performance standards regarding service quality and reliability have cost and tariff implications because they involve resources. Consumers are willing to pay for a defined standard of service quality, and performance standards have implications for the cost of service and the utility’s financial sustainability. Monitoring the outcomes associated with these standards involves KPI benchmarking. The fundamental issue is whether incentives and disincentives are available to the regulator (and if so, which ones) if the performance standard is not met. The board of directors of an operator will put pressure on managers to meet targets. However, if the penalty for a state-owned or municipal organization is a price reduction, the impact on managers could be minimal. Current customers may be unaware of what is possible, due to lack of information about what comparable operators are achieving, and are happy to see prices fall. The losers are future customers and those who do not obtain access to the service because of the delay of network expansion initiatives. The case of the relatively young Rivers State Water Services Regulatory Commission (Obasiolu, 2015) illustrates the importance of stakeholder workshops and support from community leaders when using KPIs for incentives and for tariff setting. Of course, ability to pay is a serious issue in a FCSs, but establishing a culture of even “symbolic” payment is a foundation for future financial sustainability.
- Revenue Mobilization: Incentives to improve collections can directly increase the operator’s cash flows, even if these are a small proportion of total operating costs. Indicators for this aspect of performance capture the extent to which the utility has maintained the infrastructure network; generated service (and therefore, sales), reduced illegal connections, expanded access, and improved the percentage of bills that are paid. Politicians often do not want to tackle the politically sensitive issue of non-payment and theft. Some government agencies, such as defence facilities or hospitals, may not pay their bills, arguing that the money all comes from the same source and that their budgets are limited. Cutting off residential customers for non-payment raises public-health issues (in the case of water) and creates economic hardship for the vulnerable. Similarly, reducing water leaks and electricity-line losses requires funds for maintenance and problem identification, which implies either tariff increases or additional donor or government funding. Donors may respond to humanitarian appeals, but at some point, issues of cost-effectiveness affect the willingness of external groups to continue their support. Documenting good performance raises additional problems, some of which can be mitigated by having basic data collection procedures embedded in operating systems. Improved maintenance is not politically visible in comparison with inaugurating a new plant or adding new connections, which are clearly seen as benefiting potential voters. Reducing commercial losses (theft) raises further issues requiring community involvement and changing a culture that views illegal connections as acceptable, despite the fact that revenue burdens are passed on to others.
- Professional Service Providers: Smaller systems often depend on volunteer labor for some tasks. Local leaders are likely to be the ones performing managerial functions, though these activities are closely linked to the informal arrangements characterizing small organizations. The issue in small systems, therefore, is unlikely to be on “cost”, but on professional management. For example, the ability to perform basic accounting functions will be necessary to document how donor funds are used and the extent to which the local community is contributing to covering the cost of service. More entrepreneurial actors are likely to be needed to fill the gaps in service, in terms of geographical coverage and quality.
- Asset Development and Limited Public Funding: FCSs situations are characterized by weak public finance management, including procurement systems. Furthermore, with limited skilled personnel or systems in place, donors and development partners play an important role by promoting education for community leaders regarding infrastructure operation. In addition, local leaders are in the best position to identify geographic areas for service expansion. This is a challenge, since security forces or rebels sometimes plunder to obtain resources, damaging facilities and discouraging leaders who are attempting to give citizens a sense of local “ownership” regarding how things can look in the future. There are many other deserving claimants for public funds, so infrastructure performance needs to match promised outcomes, which donors and development partners can use to mobilize further resources.
Financial Sustainability and Affordability Central to this discussion is the fact that affordability of services and efficiency go hand in hand—greater efficiency allows for lower prices. However, sometimes network expansion and asset development, often the priority in the Rebuild and Reform stage, do not lead to affordable prices. Thus, for financial sustainability, prices could be set very high as operating costs increase and economies of scale are not realized. Cost-recovery calculations could also involve inappropriate depreciation formulas that yield high “accounting costs” in the early time periods, placing an excessive burden on current customers. On the other hand, unrealistically low depreciation rates result in price signals that are too low and reduce cash flows in the early stages. There is no simple way to balance the related objectives of financial sustainability, efficient cost management, and affordability. To clarify these matters, we define two objectives:
Financial sustainability: This can be viewed as the cornerstone for continuing operations. If total revenue, plus transfers from taxpayers and donors, is less than total cost, the operator will have to find some way to limit cash outflows. For example, managers could reduce maintenance expenditures, cut back on staff capacity building, or halt investments in information technology that would reduce future operating costs. None of these would necessarily lead to immediate reductions in service quality, but each has implications for future costs and service quality. For state-owned utilities, the periodic transfers of funds are often unpredictable, leading to erratic and sub-optimal business plans. For private infrastructure suppliers, managers will not expand operations if cash flows are inadequate. Collections are a key determinant of revenue sufficiency.
Affordability and public acceptability: The other key pricing objective involves citizens being able to understand and pay their bills. If the price signal is complicated, customers may misinterpret the price and make sub-optimal decisions. For low-income countries, public acceptance of price levels and structures involves affordability. This is difficult to define, but one rule of thumb used widely is that water bills should be less than five percent of a family’s income. Generally, bottled water is much more expensive than piped water from a network, and water from bore holes may not be safe. Similarly, electricity from batteries and small diesel or gas generators can be more expensive than from a grid. The price of alternative sources such as solar has come down rapidly. Thus, policy makers may need to educate members of the public regarding alternatives to networks, and in some cases, the service provision need not be through a local monopoly. Public acceptability contributes to the perceived legitimacy of the rate-setting process.
Modular service and planning. Given these related objectives, a large investment that cannot be maintained is going to stretch the available human and financial resources of the community and government. Thus, in FCSs more than in any other context, it is necessary to have a realistic long-term investment plan. In small towns, for example, given the rapid changes in their demographics, planning for 30-year systems may not be a smart strategy. It would be more sensible to have multiple flexible and modular five-year plans. This is not easy given the required investments in networks: planners need to understand the desirability of investing in “scrap and build” type of technology/assets, which usually have relatively lower standards but faster payback periods versus longer-lasting assets that require adherence to rigorous maintenance schedules, availability of expensive replacement parts, and scarce professional skills. Business planning and the associated incentives and pricing policies need to adapt to a rapidly changing market landscape in low-income countries and FCSs.
Establishing Incentives and Appropriate Rewards
Incentives can be internal to the firm: for example, offering a staff bonus pool for meeting targets or set by an external group providing oversight (such as a government ministry or a development partner). Internal rewards are not the responsibility of the external oversight agency and while the agency should not micro-manage operators, they can encourage managers to ensure that staff morale is high, recruit and retain excellent staff, and design internal incentives that reward strong performance. Input from local leadership on the reward is essential, because a “reward” that is not valued by the recipient is not a reward at all!
Regulatory performance monitoring is the foundation for establishing incentives. The external regulator should establish a system of regulatory accounts and assist in developing operators’ business plans. The plans serve as guideposts for the future. When the nation has moved to the Rebuild and Reform stage, oversight groups will be in a position to specify targets and develop incentives to motivate those producing and delivering infrastructure services. Such incentives can be as simple as bonuses when particular goals are met. These incentives could focus, initially, on restoring service and meeting basic health and safety standards. The incentives would also be directed at meeting goals for levels of output delivered to local constituencies.
Yardstick comparison can be an effective incentive to improve performance. To help managers gain the skills required to develop simple business plans, the appropriate Ministry (or regulator) could organize workshops that include presentations by managers of high-performing comparable utilities in that or neighboring nations. Similarly, a regulator can compile information on national and regional best practices and issue the reports to service providers as part of regular reporting initiatives. Such activities are not a form of micro-management, because they do not take away managerial accountability for local utility performance; rather, they serve as opportunities for capacity building at the utility. Additionally, simple data on trends and information on best practices can be used to educate consumers regarding the current situation, to set realistic targets, and to establish price trajectories that ultimately, promote financial sustainability. The oversight agency is not the company’s adversary: rather, the two need to be arms-length partners in promoting improvements in network expansion, service quality and better production efficiency.
Project Funding. For low-density or small-town systems, appropriate incentives need to be in line with local culture and customs. Usually, fairly small cash flows are involved, so a bonus that goes to a local manager (who is also usually a neighbor) may not be acceptable to other members of the community. However, those groups providing investment funds to small projects can make future funding for expansions and upgrades contingent on meeting targets that are identified in advance. The continued funding could be applied to a number of activities—network expansion, technical training, workshops, the acquisition of back-up equipment, or additional equipment for testing, etc. The local governing bodies will want to have access to additional funds and will put pressure on key personnel to meet the targets. The entire process reinforces the need for good data collection and authentication and documents the achievement of performance improvements. If poor cost containment, low collection levels, and other indicators of weak performance have no impacts on future funding, then funding agencies are throwing good money away. Positive incentives such as commitments for future funding promote changes in organizational cultures and reward local leaders who serve as catalysts for positive change.
Celebrations. When targets are met, the successes need to be celebrated and publicized. The event could be as simple as a staff party. Alternatively, a grander event for the entire community could be organized. Inclusive events can limit the social rivalries that sometimes contaminate local relationships, by serving as a reminder that the group is “in it together.” These events need not be highly elaborate, but the high-performing members of the staff need to be recognized, perhaps with certificates (and ultimately, with improved prospects for promotion). An operator could have a “worker of the year” award, with the entire family receiving recognition, given that spouses are often part of the reason for high performance. Local news coverage alerts the local population that things have been improving and that the money they pay is providing value to themselves and the community. One should not underestimate the role of the media, non-governmental organizations (NGOs), and social networks in increasing public awareness. Additionally, these stakeholder groups also tend to emphasize accountability—another element that promotes better infrastructure performance.
Promotions. When several projects are under way, there can be a competition among them for best performance on particular KPIs. Again, the key is to publicize the results. Winners get lots of attention, and those falling behind will be motivated to try harder next time. In Uganda’s National Water and Sewerage Corporation (NWSC), celebrations single out managers and staff of the best-performing utilities, and managers can submit bids to manage other (generally larger) utilities, for higher status and/or pay. Competition therefore exists among managers for important leadership positions. The performance of the utilities they managed in the past is part of the evidence put forward to document that they would do well in the new position. When money, status and positions are at stake, extreme care must be taken to ensure that selection processes are driven by well-documented evidence regarding performance and not by favoritism toward those who are members of particular groups.
The following cases, while focused on stable countries, provide illustrations of what incentives were introduced to catalyze performance improvement. Countries in the Crisis or Rebuild and Reform stages may not be in a position to adopt comprehensive performance reviews such as these. However, those with current operating and oversight responsibilities need to anticipate a time when their nation, too, can move to more sophisticated incentive systems.
Total Loss Targets—Oman Case Study: The Authority for Electricity Regulation in Oman establishes total loss targets for each of the three electricity distribution companies (Majan, Mazoon and Muscat) based on historical data, differences in service territories, and short-term projections. These targets are set for three- to five-year periods and carry financial consequences directly through the revenue requirement. If a company achieves lower losses than targeted, it receives a financial reward, pro-rated according to the magnitude of the losses. If the losses are greater than the target, they suffer a financial penalty, which is also pro-rated.
Multiple Targets and Incentives—Jamaica Case Study: In Jamaica, the Office of Utility Regulation (OUR) employs three different incentive systems for the Jamaica Public Service, a vertically integrated utility. The incentives are directed at different stages of production. First, for generation, a fuel adjustment clause weights the actual fuel expenditures according to both a heat rate and a loss target. If Jamaica Public Service (JPS, the electricity supplier) achieves a lower system average heat rate than the target, it receives a bonus proportional to the fuel adjustment. It receives a similar proportional adjustment for achieving line losses lower than the loss target. The implications of these target mechanisms is that JPS may recover more or less than its actual fuel costs through the fuel adjustment, and that this requires a relaxation of the “used and useful” standard, or at least a redefinition of this standard to encompass these quality metrics. Second, at the distribution level, the OUR uses a system of 12 overall standards, such as indices on system average interruption, billing punctuality, and call-center performance. Exceeding performance in these overall standards allows an increase of up to 0.5 percent in JPS’s annual price-cap formula, using a quality factor. Failing to meet these standards can result in a 0.5 percent decrease in the formula. Finally, the OUR uses a system of 15 guaranteed standards, such as time required to replace a faulty meter and the number of consecutive estimated bills, etc. Failing to conform to these standards results in a requirement for JPS to compensate affected customers.
In a FCS, the absence of basic law and order severely limits the scope of initiatives that can be reasonably undertaken by entities responsible for infrastructure oversight. The situation is such that weak and inadequate institutions deliver infrastructure services only sporadically. Funds to cover operating costs are often driven by humanitarian considerations, with efficiency given some attention—almost as an afterthought. Being open to entrepreneurial entrants is essential, if local needs are to be met. The system of governance is likely to be limited, since the basis for political, social and economic progress is often dependent on allegiances to an important figure. Similarly, institutional capacity is weak. That means that the national government may not be the source of creative initiatives to expand access to infrastructure or improve service quality. Often, international organizations and local civil society organizations (CSOs) are the primary groups engaged in emergency relief efforts, with some ministerial collaboration and (subsequent) oversight. When there is a lack of strong CSOs, local groups need to develop some long term plans for improving infrastructure performance. In such situations, capacity building for community leaders and local managers becomes a key task for oversight institutions. Basic data collection represents an essential foundation for identifying the impacts of later initiatives. The process is likely to be slow, but it can successfully move the nation toward a “Rebuild and Reform” situation. Once that stage has been reached, political leaders can set their sights on a time of transition, where institutions are in place to support dialogues among stakeholders and political parties – even if there is a lack of constructive cooperation (and consensus) required for long term decision making by operators. At least, the notion that “incentives matter” becomes part of that important dialogue.
Related FAQs on Targets and Incentives
- Challenges of incentive regulation—What are the key challenges that need to be addressed when introducing incentives?
- Promoting efficiency—To what extent do incentives actually lead to improved efficiency?
- Efficiency measures—How do you measure the efficiency of service provision?
- Efficiency targets—What are reasonable efficiency targets?
- Rewards for cost containment—What incentives should a regulator introduce in order to promote cost containment?
- Performance incentives—How can regulators encourage improvements in specific dimensions of performance?
- Penalties for noncompliance—What penalties are most effective when the operator is in noncompliance with regulatory rules (e.g., for providing data, setting prices, or meeting targets)?
- Incentives for improved performance—How can a regulator develop incentive to discourage energy/water losses?
- Promoting investments—How can regulatory incentives be introduced to promote investment?
- Coverage—How can regulators establish incentives for service expansion?
Berg, Sanford, Best Practices in Regulating State-Owned and Municipal Water Utilities, United Nations, 2013, ECLAC, 1-65.
Deo, Pramod, “Tariff Setting and Incentives—Indian Experience,” 2015.
Eisendrath, Allen, Water Utility Corporatization, United States Agency for International Development (USAID), 2013, (http://wwww.energytoolbox.org/)
Mugisha, Silver, Utility Benchmarking and Regulation in Developing Countries: Practical Application of Performance Monitoring and Incentives, 2011, International Water Association.
Obasiolu, Christopher, “Tariff-Setting and Incentives: The Case of Water Operators in Rivers State, Nigeria,” 2015.
Sigalla, Nahson, “Cases in Road Transport and Ports Sectors,” 2015.
World Bank, Operator Round Table—Study on Impact of Imperfect Data, Volume 1: Main Analysis, 2004 http://www.energytoolbox.org/library/good_practices_in_water+sanitation_utility_regulation/references/Study_on_Impact_of_Imperfect_Data.pdf.
 In the case of “light” infrastructure that serves relatively short-term objectives, the associated data collection and incentive issues are no less important. See the case of the Haitian “temporary” wastewater treatment facility built using Spanish money and catering to a temporary internally displaced persons (IDP) community. http://www.haitilibre.com/en/news-5685-haiti-environment-new-wastewater-treatment-plant.html