ROI: What is the appropriate Return on Investment for a SOE?

[Response by Sanford Berg, May 2009]

The cost of capital for SOEs is a complex topic. First, we need to know how the Return on Investment (ROI) is to be used for decision-making. Is it a purely an accounting item, with the funds going to pre-determined projects? Or is it a hurdle rate used to screen projects based on net present value criteria?

Funds as a Subsidy: If the ROI is only a financial technique used to account for funds provided the SOE, then the number might be viewed as somewhat arbitrary. The State (through taxes on citizens and economic activity or through the issuance of national bonds) provides funds for network investment or to cover operating costs. Some bookkeeping liability is entered in the SOE’s balance sheet, but this might be written off later on if future cash flows are unable to provide regular interest payments and return the principle when the bond has matured.

There is an initial opportunity cost to providing the SOE with funds (since they are unavailable for building hospitals, schools or roads), but political priorities resulted in some funds being allocated to the SOE at various points of time. If past investments do not yield cash flows sufficient for interest payments, the funds still may have resulted in positive benefits to the economy via improved citizen health (in the case of access to clean water) or through economic linkages that stimulated economic growth (as with electricity to rural areas). Thus, ROI as a monetary measure could be modified to include non-cash returns that benefitted society.

Financial Sustainability: On the other hand, if the SOE is corporatized, it is expected to be financially sustainable. Interest payments on bonds issued by the SOE need to be paid to those investing in those bonds; otherwise, investors are not going to continue to be willing to own the bonds. Zero cash-flows to investors imply zero value for their bonds. Similarly, if dividends are to be paid to the Ministry of Finance, then the mix of debt and (government-owned) equity determines the weights assigned to each source of financial capital. The interest cost is fairly straightforward—at a minimum, it would be the cost to the nation of raising funds in international capital markets through issuing debt. The cost of equity would have to include the added risk associated with the particular types of projects associated with the sector. Of course, nations with poor credit ratings (or whose borrowing is constrained by conditions imposed by international organizations such as the IMF) may not be in a position to raise debt or equity capital from international financial markets.

ROI as a Hurdle Rate: This point gets us back to the question: how is ROI utilized? When it is used for decision-making, the ROI becomes a hurdle rate. High risk projects should face high hurdle rates. Then managers can compare alternative projects that relate to the service or geographic area on a common basis; in the case of mutually exclusive projects, the use of the required ROI results in cost-effective use of scarce funds. Managers select the project with the higher net present value (calculated using the appropriate ROI).

A closely related issue is whether existing rate structures and implicit cross-subsidies mainly benefit those who are well-off. Since cash flows determine ROI, under-pricing the infrastructure service results in lower realized returns. If social objectives are met, then the lower financial ROI may not be a problem: achieving greater network coverage and serving low income households have social value. In addition, other national objectives might be met: projects supporting regional development or projects with linkages to key industries. So the Social ROI may be acceptable. However, there is evidence in developing countries that pricing below cost leads to inadequate maintenance (reducing service quality). In addition, the operator will lack the funds to expand service coverage, so those without service remain unserved, where the substitutes (such as water tanker service and bottled water) are very expensive.

As Eberhard (2006, p. 21) has said, “If the utility is state -owned and operating under non-commercial conditions, with tariffs below costs, then it may be politically unrealistic to expect an independent regulator to be successful in moving tariffs quickly to revenue sufficient levels. The initial focus may need to be on building political and regulatory commitment with parallel work on commercialization reforms coupled with diminishing subsidy support.” The ROI then becomes an internal hurdle rate used to allocate limited funds to the most productive investments.

Resources

A re-assessment of independent regulation of infrastructure in developing countries: improving performance through hybrid and transitional models
Prepared for the Annual World Bank Conference on Development Economics, 2006.
Anton Eberhard

Regulatory Risk and the Cost of Capital: Determinants and Implications for Rate Regulation
New York: Springer. 2006.
Pedell, Burkhard

The Regulation of Investment in Utilities: Concepts and Applications
Washington, D.C.: The World Bank, 2005.
Alexander, Ian, and Clive Harris

Accounting for Infrastructure Regulation: An Introduction
World Bank, 2008.
Martin Rodriguez Pardina, Richard Schlirf Rapti, and Eric Groom