In an industry where an aging network and generation capacity constraints lead to poor service delivery, to what extent should consumers contribute towards capital expansion?

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[Response by Sophie Trémolet and Diane Binder, June 2009]

Quality of service delivery is affected by the operator’s technical and financial capacity to properly maintain the infrastructure networks and make the necessary investments for rehabilitation and expansion. Sustainability1 of infrastructure service delivery is at risk if revenue cannot be generated at a sufficient level to cover all costs of service provision. While it is broadly acknowledged that consumers should finance regular operation and maintenance of the system through tariffs, financing of capital expansion appears more controversial, due to the large amounts of capital sunk and the related risk sharing issue between consumers and shareholders.

In rate of return (or cost of service) regulation, price levels are set according to the operator’s cost of capital2, allowing for a return on investments through depreciation and the allowed rate of return on the capital asset base3, so as to smooth out the impact on tariffs of financing new investments4.

However, there are certain exceptions where the costs of capital expansion may be covered from other sources than customer tariffs:

  • In a monopolistic situation5, the regulator needs to control market power of the dominant operator, notably through incentive and price (or revenue) cap regulations. Indeed, profit-maximizing prices of operators will tend to exceed their marginal cost of provision, due to the amount of capital sunk in the first place6. Yet, the regulator will not allow such price levels to be supported by the consumers. It is particularly the case when the investment is recognized as a public good (such as an investment in a wastewater treatment plant – see also the next point related to this argument).
  • In the case that investments serve some kind of social objectives. For instance, there are situations where price level is a hurdle because the overall costs of providing any level of service are high relative to what the consumers can afford. This is especially true when fixed costs of extending water networks or electricity grids into poor, rural areas are so high and capacity to pay of consumers so low that service extension is commercially unfeasible.

In such cases, there are alternative ways to cover the costs of capital expansion.

  • Transfers from international donors or government, in the form of grants or concessional loans may be considered. Those transfers include funds obtained at the national level or from dedicated agencies to reach social objectives and develop infrastructure in rural areas7.
  • Implementation of a connection charge, that recovers all or a substantial portion of the allocated cost of capital expansion, i.e. the costs of extending the network into a specific area and of connecting the final customer to the main network. However, in low-income areas, such a connection charge would constitute a substantial barrier to access the service.
  • A preferable alternative would be to spread the costs of capital expansion across the entire customer base, so as to cross-subsidize connection charges and maintain them at affordable level. In this scenario, existing customers contribute to paying the cost of connecting new customers.
  • Innovative payment schemes are developed in some countries to increase the capacity to pay of end-users while giving the operators an incentive to perform their duties efficiently. It is the case in Kenya, for example, where a donor project for community-managed water pipes system has been designed to use an output-based aid approach to leverage co-financing from a commercial micro-finance institution to facilitate capital expansion into rural areas8.

 

Resources

Natural Monopoly Regulation: Principles and Practice
Cambridge Surveys of Economic Literature Series, Cambridge University Press, 1988.
Berg, Sanford V., and John Tschirhart

The Economics of Regulation: Principles and Institutions
 Cambridge, MA: MIT Press, 1988, Reissue Edition, Chapters 2-7.
Kahn, Alfred

Impact of Market Structure on Service Options for the Poor
 Presented at Infrastructure for Development: Private Solutions and the Poor, 31 May – 2 June 2000, London, UK.
Ehrhardt, David

Taking into account the poor in Water Sector Regulation
Water Supply and Sanitation Working Notes, Note n°11, Water Supply and Sanitation Sector Board of the Infrastructure Network, World Bank Group, August 2006.
S. Trémolet & K. Hunt

Sustainability of Water Service Delivery in Rural Environment: Past Approaches and the Way Forward
Review of Literature, Emerging Markets Group, February 2008.
Binder, Diane

Microfinance for Rural Piped Water Services in Kenya
WSP, Policy note n°1, 2007.
Mehta, Meera and Kameel Virjee

Footnotes

  1. A sustainable infrastructure network is one that can meet performance requirements over the long run. Such systems have the following characteristics: a commitment to meet service expectations; the capacity to satisfy public health and safety requirements on a long-term basis; minimal assistance needed in the long-run; financing of regular operation and maintenance by users; continued flow of benefits over a long period. (Binder).
  2. See Cost of Capital.
  3. See Earnings Measurement.
  4. Refer to How can a regulator promote investment while keeping service prices affordable? for more details on price level regulation.
  5. See definition of a “monopoly” in the glossary.
  6. See What procedures should the regulator adopt in order to balance economic and social objectives (like efficiency vs. fairness)?.
  7. Readers should refer to Should social objectives be met through funds obtained at the national level and allocated to meet the objectives in each sector and region? and What are the advantages and disadvantages of creating dedicated agencies or « funds » to support the development of infrastructure services in rural areas? How should the regulator relate to such funds? for more details.
  8. In such a system, an OBA capital subsidy helped address affordability constraints. The subsidy reduced the total size of the loan to the operator and was only realized upon achievement of pre-determined objectives related to service extension. WSP, Policy note n°1, 2007