Should social objectives be met through funds obtained at the national level and allocated to meet the objectives in each sector and region?

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

Special pricing and service arrangements for the poor are frequently developed to meet social objectives set by policy makers to improve service access1. When costs of providing service are high relative to what customers can afford, it may be necessary to provide external funding, such as subsidies.

Development of subsidies for service to the poor involves determining the amount and the funding of subsidy. Funding can be done through internal or external mechanisms. Internal mechanisms include cross-subsidization, increasing block tariffs2, fees derived from concession bidding, or taxes on operators’ revenue or profit. However, poor municipalities, especially in rural environments, may have difficulties to raise the necessary funding for service expansion in remote areas3: they could be hindered by a lack of fiscal capacity or the pitfalls of cross-subsidization4.

In such cases, funds obtained at the national level could be transferred to support the upgrade of services in under-served areas. Subsidy design and funding actually depend on market structure, and more particularly on the level of competition, of private sector participation, and of decentralization.

Several funding mechanisms may thus be considered:

  • The creation of a Universal Service Fund (USF), whose role would be to channel funding raised from various sources towards the achievement of social objectives. Sources include government general budget, industry levy and international donor funding5.
  • Transfers from central government to poor municipalities to carry out capital investments: this is the case in South Africa’s water sector, for example, where municipalities receive a Municipal Development Grant (MIG) from the government. The MIG includes grants for specific water infrastructure projects transferred by the central government to local governments to eliminate the backlog inherited from the Apartheid6. Another interesting example is the rural electrification program undertaken in Chile in the 1990s, where the central government allocated funds to regional governments on the basis of needs and their past performance in meeting needs, and regional governments in turn allocated funds in a form of a one-time direct subsidy to private companies to help cover investment costs.
  • Transfer payments from the government directly to the poor: while this avoids price distortions, a good targeting of customers can only be achieved at the expense of high administrative costs. A simulation performed in Panama in 1998 shows that administrative costs necessary to design a subsidy program, including poverty census, willingness to pay surveys and eligibility criteria design, absorbed 40% of the total value of the subsidy.

While transferring funds obtained at the national level appears to be necessary to support municipalities towards social objectives set by policy makers, such strategies, heavily dependent on external financing, may be unsustainable in the long run unless inter-governmental transfers are explicitly defined and secured over the investment planning horizon. Such funding is often not reliable as it is at the mercy of a shift in government and policy. Unlike cross-subsidization, it does not allow preserving the sector’s financial self-sufficiency. National government funding makes poor municipalities especially vulnerable in the case where such transfers actually finance operating rather than capital costs. Hence, transfers from national government should be coupled with other sources of funding and such transfers should not detract from the fact that tariffs should gradually move towards cost-recovery levels.
In addition, the need of public funding introduce a budget constraint for the government: in that respect, the choice of transfer mechanisms is crucial to limit the financial burden, by using mechanisms to increase private sector leverage such as Output-Based Aid (OBA)7.

Resources

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

Pricing energy in developing country
Report of the World Energy Council, June 2001.

Accounting for Poverty in Infrastructure Reform: Learning from Latin America’s Experience
Washington, D.C.: The World Bank, 2002.
Estache, Antonio, Vivien Foster, and Quentin Wodon

Designing Direct Subsidies for the Poor – A Water and Sanitation Case Study
Note no. 211 in Public Policy for the Private Sector. Washington, D.C.: World Bank Group, June 2000.
Vivien Foster, Andres Gómez-Lobo, and Jonathan Halpern

Financing On-Site Sanitation for the Poor A Six Country Comparative Review and Analysis
Water and Sanitation Program: Technical Paper. WSP Sanitation Global Practice Team, January 2010.
Trémolet, Sophie, Pete Kolsky, and Eddy Perez

Footnotes

  1. See In what ways, if any, should regulators treat SOEs differently than investor-owned infrastructure operators? for more details.
  2. IBTs provide two or more prices for water used, where each price applies to a customer’s use within a defined block. Price rise with each successive block. The first block tariff is deliberately set below cost. Much attention is therefore given to the size and price of the first block.
  3. See Pricing in Competitive or Partially Competitive Environments.
  4. Cross-subsidization may lead to “cherry-picking” behavior, where new competitors would chose to focus exclusively on rich customers at a lower price.
  5. USF mechanism is described at length in What is Corporatization?.
  6. See the South Africa Government Information Website for further information. However, available funding is not sufficient to cover operating expenditure, since MIG funding conditions expressly stipulate that it cannot be used to fund operations & maintenance of the infrastructure. As a result, the MIG may lead to an increase in the asset base without funds allocated to operate and maintain those new assets.
  7. “Output-Based Aid (OBA) is a strategy for using explicit performance-based subsidies to support the delivery of basic services where policy concerns would justify public funding to complement or replace user-fees. Affordability concerns for particular groups of users, positive externalities, or the infeasibility of imposing direct user-fees represent examples of the types of policy concerns that have motivated governments to use public funds to support the delivery of basic services”. Source: www.gpoba.org