Failures in water reform: Lessons from the Buenos Aires's concession

Utilities Policy 15 (2007) 234e247 www.elsevier.com/locate/jup

Failures in water reform: Lessons from the Buenos Aires’s concession Ariel A. Casarin a,*, Jose´ A. Delfino b, Marı´a Eugenia Delfino a a

IAE Escuela de Direccio´n y Negocios, Universidad Austral, Mariano Acosta s/n y Ruta Nac 8, Casilla de Correo 49, B1629WWA Pilar, Buenos Aires, Argentina b Department of Economics, Universidad Nacional de Co´rdoba, Co´rdoba, Argentina Received 31 August 2006; received in revised form 13 February 2007; accepted 16 February 2007

Abstract This paper examines the performance, until the cancellation of the contract, of the Buenos Aires sanitation concession in relation to privatization objectives of expanding coverage, reducing consumers’ tariffs and increasing service standards. The evidence shows that, despite a noteworthy increase, coverage rates remained significantly behind goals and that several contract renegotiations came along with significant tariff changes that turned an initial access problem into an affordability one. The analysis indicates that the concession’s high profits originated almost exclusively from tariff increases, as the contribution of total factor productivity improvements and of changes of input prices have been negligible. A good number of the concession’s failures seem to have been explained by the presence of a weak and inexpert regulator. The evidence also points out that regulators should consider protecting the interests of consumers by setting capital requirements. Ó 2007 Elsevier Ltd. All rights reserved. Keywords: Privatization; Sanitation services; Universal service; Regulation

1. Introduction During the past two decades, countries worldwide have made pioneering efforts in the design and implementation of reform plans in infrastructure services. These so-called first generation reforms encompassed restructuring, privatization and deregulation in the telecommunications, energy, water, and transport industries. Private sector participation has been accomplished in a variety of forms, ranging from management contracts to concessions and full privatization. These reforms have led to a reallocation of the conflicting roles of governments as owners, operators, and regulators, with private firms and regulators undertaking important roles in these functions. The evidence shows that privatized enterprises have on average delivered superior performance across a wide range of performance indicators (see for example Megginson and Netter, 2001). It also shows that reforms have proved successful in

defining suitable environments attracting private and mostly foreign investment. A main reason for the superior performance of privatized firms seems to be that, under a strong institutional environment that facilitates regulatory commitment, privatization makes it difficult for government and politicians to intervene in the operation of firms and to behave opportunistically, taking actions that expropriate rents once costs are sunk.1 Weak institutional environments, on the contrary, might allow not only governments but also private operators to behave opportunistically. Indeed, fragile institutions and inexperienced regulators could facilitate powerful firms to shape the rules of the game to their own advantage at a high social cost. This might result in increased tariffs, lower service standards or coverage levels, or in the provision of contract clauses transferring all risks to the state. The political pressure exerted by groups

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* Corresponding author. Tel.: þ54 2322 481000; fax: þ54 2322 481050. E-mail address: [email protected] (A.A. Casarin). 0957-1787/$ - see front matter Ó 2007 Elsevier Ltd. All rights reserved. doi:10.1016/j.jup.2007.02.004

Post-privatization performance is also affected by technological change and the extent of liberalization and competition introduced into markets previously dominated by state-owned firms.

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that have lost advantages during the reform may then induce the government to renegotiate the rules of the game. Properly used, renegotiation can increase welfare. However, failed renegotiations may end up in litigation or, ultimately, in the abandonment or cancellation of concessions. This would bring back the low-level equilibrium position that motivated privatization in the first place (Savedoff and Spiller, 1999). The Buenos Aires water concessiondthe world’s largestdappears to be a paradigmatic case of a concession failure. Transferred to private operators in 1993, the main objective of this 30-year concession was expanding coverage while achieving both quality of service standards and universal service. However, the decade that followed privatization witnessed several contract renegotiations, which gave rise to opposite views on the concession’s performance. Some observers argued that privatization brought about large benefits to consumers’ welfare (Alcazar et al., 2000), while others emphasized that goals have not been fully achieved because of the firm’s opportunistic behavior and the regulator’s limited ability to protect the interest of consumers (Water and Sanitation Program, 2001). These positions have become more conflicting since January 2002, when a macroeconomic crisis led the government to suspend utilities’ contractual procedures and to call for a full renegotiation of all franchise contracts. In 2004, following several failed renegotiation attempts, the concession owners filed an international arbitration case for indirect expropriation and warned that they would abandon the concession. Probably in anticipation of that event, the government cancelled the firm’s contract in 2006. This paper examines the performance of the Buenos Aires sanitation concession throughout the period of private management. The analysis concentrates on the evolution of the sanitation system performance as it relates to the privatization objectives of expanding coverage, reducing consumers’ tariffs and increasing service standards. The Buenos Aires concession illustrates the very rare event of an outright contract cancellation.2 It also highlights several issues that may help explain the lack of consensus about how to best organize the sector, a fact that seems to be reflected in the various extents to which the private sector has been involved in water supply and sewerage (see OECD, 2000, pp. 14e18). In short, our analysis suggests that a significant number of the concession’s failures seem to have been explained by the presence of a weak and inexpert regulator, which had to confront several issues not clearly addressed at the moment of privatization. These all seem to have favored an opportunistic behavior of the licensee. Contrary to privatization objectives, several contract renegotiations turned an initial and still unsolved access problem into one of affordability. The rest of the paper is organized into seven sections as follows. Section 2 reviews the literature on regulatory capture, regulatory failure, and renegotiations. Section 3 concentrates on the concession, examining the completion of the contract’s

targets as they relate to service coverage and investment outlays. Section 4 describes the taxonomy of tariff reforms. Section 5 overviews the financial performance of the licensee and uses a simple model of index numbers to provide a comprehensive assessment of the concessions’ economic performance. The analysis in Sections 3e5 concentrate on the post-privatization period until the suspension of contract procedures that took place in January 2002. Section 6 briefly examines the developments that led to the cancellation of the contract. The last section concludes.

2 Harris et al. (2003) estimate that the cancellation rate in water (at 3.5 percent) is only second to that of toll roads.

3 Alternatively, the agency might simply adopt inefficient policies for various non-economic reasons.

2. Regulation, capture and renegotiation Potable water services are a critical part of the urban fabric of all societies, as they influence health conditions, land prices, manufacturing costs and daily comfort. Potable water services share many of the characteristics of private goods that are bought and sold in any private market. It is a commodity for which demand is normal with fairly stable and predictable elasticity in prices and income. Still, and like other utilities’ sectors, water markets are not free from failures that make it difficult to provide the service through more competitive markets. The combination of large sunk costs, economies of density and massive consumption can be so severe as to merit regulation despite its attendant costs. Market failures in the water industry can also lead to significant politicization of the sector’s pricing and operations. Sunk costs may tempt governments to adopt administrative measures aimed at the appropriation of firms’ rents, taking advantage of the fact that firms will operate as long as operating revenues cover operating costs. The fact that water services are massively consumed creates an opportunity for politicians to use pricing as a political instrument. As a result, the particular features of the water sector make regulatory credibility a necessary ingredient for solving a key contracting problem between the government and the utilities by restraining the former from opportunistically expropriating the firms’ quasi-rents (see Levy and Spiller, 1994). But regulators can fail as well. Agencies can be corrupt or inefficient in setting or enforcing standards. The regulator is also unlikely to possess the same information that firms have about the technologies and costs involved in the operation of the firm; this information asymmetry could lead to regulatory capture, with the agency siding with the interests of the regulated firm.3 It is also possible that the lack of strong and credible regulations could make it easy for firms to shape the rules of the game to their own advantage, at a high social cost. Firms could try to hedge against this poor definition and take advantage of their bargaining strength vis-a`-vis the government. This could result in increased end consumer prices, or in the provision of contract clauses transferring all risks to the state, yet yielding handsome profits. The political pressure exerted by groups that have lost in the reform may then induce the

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government to renegotiate the rules of the game (Basa~nes and Willig, 2002). Renegotiation occurs when a concession contract undergoes a significant change or amendment not envisioned or driven by stated contingencies in tariffs, investment plans or levels, exclusivity rights, guarantees, annual fees or lumpsum payments, service standards or concession periods (Guasch, 2004). Renegotiation can thus be seen as resulting from incomplete contracts. Tirole (1999) summarizes the main three reasons that could generate incomplete contracts. The first is inability to account for all possible contingencies in contracts during their execution. Second, even if parties could anticipate all the possible contingencies that should be included in the contract, they may be so numerous that the costs of describing them all can be prohibitive. Third, the contract can only be contingent on variables that could be verified by a third party, usually a regulator. In the case of concession contracts, it is also possible that renegotiation may reflect a change in government objectives. Finally, the degree of government commitment helps determine the nature of contracts and influence the probability of renegotiation.4 Several renegotiation models have been developed. Hart and Moore (1988) model renegotiation in the presence of incomplete information assuming that actions and future contingencies are all ex post observable, though not verifiable by a third party. In that case, they show that the parties cannot achieve an ex ante optimal level of investment, and renegotiation is used to achieve ex post efficiency. Aghion et al. (1994) argue that the assumption of unverifiability is not enough to explain under-investment. Very often, this problem can be overcome with an appropriate ex ante design of the renegotiation process itself. In their model, playing with the default option and the bargaining power at the renegotiation stage restores efficiency even when actions are not verifiable. In the more specific case of utilities, Jeon and Laffont (1999) model a government regulating a firm under some uncertainty conditions on the demand faced by the firm and its fixed cost. They assume that both the government and the firm are myopic, not being able to anticipate future renegotiations. Ex post, if the profit of the firm is negative, the regulatory contract is renegotiated. In this context, renegotiation occurs more often when the firm is inefficient. Kartacheva and Quesada (2000) assume a government auctioning the concession of a utility. Firms anticipate that renegotiation will occur if demand is low and take this fact into account at the auction stage. Firms know that if profits are negative, the government will prefer to renegotiate rather than to stop production and they will face no competition at that point. As a consequence, the announced bid will be biased downward given that a firm expects renegotiation if it makes losses. Furthermore, different firms can have different degrees of bargaining power at the renegotiation stage. Both effects give 4 Bidders have often anticipated the possibility of renegotiation and based their bids not only on their costs, but also on the costs of securing the concession. Then, underbidding increases the probability of winning the auction and the possibility of renegotiation reduces the losses associated with it.

incentives for firms to announce a bid lower than the one that would have been announced without the possibility of renegotiation. This implies also that the ex post possibility of renegotiation is higher. More recently, Guash et al. (2003) have developed a theoretical framework that examines the impact of institutional constraints on the incidence of renegotiation. Their model predicts that the probability of renegotiation augments when the level of state capture, the costs of enforcing the contract and the magnitude of committed investments are high and the quality of enforcement is low. They also expect that the existence of formal arbitration rules increases the probability of renegotiation, since arbitration rules help settle disputes, making renegotiation less costly. On the other hand, their model predicts that the probability of renegotiation decreases with the existence of a regulatory body at the time of a concession award and with the presence of a good institutional environment. To sum up, most economists agree that most concession contracts are incomplete and that renegotiation is one way to redress inefficiencies caused by incompleteness. Incomplete contracts can lead to inefficiencies that are exacerbated by weak enforcement and in some cases can also lead to ex post inefficiencies that can be resolved through renegotiation. Properly used, renegotiation can increase welfare. Failed renegotiations, however, will most probably end up in the abandonment of concessions, government take-over or court arbitration or litigation. A non-credible regulatory framework eventually creates the conditions for the government to become the owner and operator by default. Then, government ownership represents neither the best way to promote the public interest nor the most efficient way to provide services, but simply the failure to develop institutions that set limits on the temptation of opportunistic behavior.

3. The Buenos Aires water concession Sanitation services in Argentina were traditionally provided by a national state-owned utility until 1982. In that year, the national government transferred the responsibility for service provision to local governments except in the city of Buenos Aires and a few adjacent districts (jointly forming most of the Buenos Aires metropolitan area), which remained under the control of the Obras Sanitarias de la Nacio´n (OSN). The performance of the sanitation system resulted in reduced network expansion, too little innovation, poor service quality and utility operating deficits, which were originated by the difficulty in passing infrastructure costs to new users, the persistence of cost unreflective tariffs and poor collection rates, and the little autarky of the firm’s management. Coverage rates declined, the rate of spilled water increased, pressure and service quality deteriorated and summer shortages abounded (Artana et al., 1999). General discontent with the system’s performance and ever-increasing pressures to enhance service provision and to ease the burden for financing underperforming assets led the way to private sector participation in the industry.

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The Buenos Aires water concession went forward as part of the block of privatization transactions carried out by the Menem administration since 1989. The franchise was awarded to the consortium offering the largest reduction over the prevailing public firm’s tariffs. OSN’s responsibility for Buenos Aires’ sanitation services was thus handed over to the Aguas Argentinas consortium in May 1993.5 Since privatization, the government’s regulatory role has been in the hands of the Ente Tripartito de Obras y Servicios Sanitarios (ETOSS), a regulatory agency responsible for monitoring the concession’s owner and enforcing the contract and regulations, which were established by a presidential decree.6 The ETOSS is governed by a board of six full-time directors appointed in equal parts by the National Government, the Government of the Buenos Aires Province and that of the City of Buenos Aires; the members are appointed by the executive branch of each jurisdiction without legislative intervention. The funding of the regulator’s budget comes from a fee levied on users’ tariffs. Prior to privatization, only 70 percent of the population in the metropolitan area was connected to the water system, and 58 percent to the sewerage system. The shortfall was in the poorer, suburban areas, which had been growing very rapidly prior to the concession and totaled 5.6 million people at the time of the transfer. Only 55 percent of the population in these areas had access to water and 36 percent to sewerage. In contrast, almost all of the 3 million inhabitants in the Capital District had access to both services. The concession was granted under a thirty-year concession contract with the main objectives of reducing the government’s funding and expanding system coverage according to a thorough schedule of precise coverage targets, disaggregated at the district level into six five-year periods. The concession was to achieve both quality of service standards and universal service by the end of the concession period. Coverage targets specified that system expansion largely had to be directed towards low-income sectors located in marginal areas, as central regions were already connected to the network. System expansion was mandatory. This therefore entailed that, once the network was made available, residents in the new service areas must join the system. Table 1 summarizes both coverage expansion targets and outcomes for the first two five-year periods of private management. The data show that population served increased significantly following the reform, though not as laid down in the contract. Expansion of water and sewerage services did not surpass the contract’s targets in 1998. The analysis for the 1993e2003 period indicates that 1270 and 605 thousand new users were added to 5 The consortium was led by Lyonnaise des Eaux, which subsequently became Suez. Lyonnaise des Eaux was one of the three firms serving the French sanitation market, where foreign entry is not allowed. Other firms with stakes in the consortium were Sociedad Comercial del Plata, Sociedad General de Aguas de Barcelona, Meller, Banco de Galicia y Buenos Aires, Compagnie Generale des Eaux, and Anglian Water. Only 10% of equity remained in the hands of employees. 6 ETOSS objectives as established in the regulatory body consist of monitoring the concession’s five-year investment plans, determining tariff provisions and investigating customer complaints.

237

the water and sewerage system, respectively. Despite the increase of new users, by the end of 2003 coverage rates for water and sewerage were still behind the contract’s targets, implying failures to comply of about 47 and 70 percent, respectively. The data in Table 1 also show that the completion of the first module of a new sludge treatment facility and the increased capacity of another existing unit proved insufficient, as the firm was unable to comply with targets. By 2003, the total number of new users with sludge treatment facilities added up to 751 thousand people, 42 percent behind the goal. The renovation of pipes followed a different pattern because the replacement of water and sewerage networks was 9 and 17 percent ahead of targets, respectively. The increase in population served followed a 17 percent increase in water production (from 3.65 in 1993 to 4.27 million cubic meters per day in 2003), an improvement that essentially resulted from better operation of existing facilities. Despite the limitations that a non-metered usage system imposes on unaccountedfor-water estimates, the figures indicate a decline in spilled water from 1.45 to 1.23 million cubic meters per day between 1999 and 2003. The failure to comply with expansion targets was uneven across districts. The data reveal that expansion of water services surpassed the contract’s targets in ten of the eighteen districts, though the firm underperformed in the remaining eight.7 Most noticeably, the data show that sewerage coverage was clearly behind the goals in all districts but one.8 It could a priori be expected that the likelihood of the firm’s failure to comply with expansion targets in a specific district should be positively related to the magnitude of investments required for system expansion, but negatively related to the potential revenue to be earned from households residing in such an area. It is possible to examine these hypotheses by means of a simple discriminant analysis to determine the factors that best separate districts where the firm had complied with the franchise’s targets and those where it did not. The dependent variable is binary taking the value of 1 if the firm fulfilled the contract’s water targets in district i by 2001, and 0 otherwise. Several independent variables were used as discriminants. It is expected that system expansion to larger and more densely populated communities would be less costly, all else being equal. Therefore, the population of each municipality was used as a proxy of system size. Similarly, population density was also included because the density of an area should relate inversely to the cost of service provision because of the presence of economies of scale or output density. Finally, as it is also expected that areas closer to existing pumping stations and treatment plants would be less costly to connect; a variable capturing the mean distance of each district from treatment plants was included. The impact of economic factors 7 The failure was mostly due to the delays in network expansion in La Matanza, the municipality with the largest population in Buenos Aires. 8 Data on coverage targets and outcomes by district are available from the authors upon request.

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Table 1 Coverage expansion targets and outcomes: Aguas Argentinas Concession Contract 1993e2003 Indicators

Initial level 1993

1993e1998 a

Target

1993e2003 b

Outcome

Target

Outcomeb

Target vs outcome (%) 1089 14 1058 1389 10 1370

Population served (000s) Potable water City of Buenos Aires Municipalities Sanitation services City of Buenos Aires Municipalities

6007 2931 3092 4978 2931 2024

1331 45 1328 929 15 903

949 37 897 279 48 254

2359 60 2268 1994 60 1949

1270 46 1209 605 50 578

Sludge treatment facilities Secondary treatment

343

805

696

1301

751

550 (42)

10970 7210

987 343

1286 498

1318 588

1428 689

112 (9) 101 (17)

Renovation of pipes (km) Water mains Sewerage network

(46) (23) (47) (70) (17) (70)

a

Expansion targets for the first five-year plan should be reduced by 15% for water and 13% for sewerage according to a 1997 contract renegotiation. Outcomes were adjusted by subtracting 464 and 308 thousand people served with water and sanitation services from the Municipality of Quilmes and other districts that became part of the franchise area from 1995 on. Source: Own elaboration based on Concession Contract and Aguas Argentinas Customer Reports. b

was proxied by the extent of poverty, as measured by the proportion of households with unsatisfied basic needs.9 It is expected that the population, density and distance variables would be positively correlated with the probability of service coverage, while the poverty variable would be negatively correlated with coverage. The discriminating power of the independent variables was examined in a stepwise procedure. After entering all explanatory variables individually, poverty seems to be the best single discriminating variable. Matching poverty with the other variables, it appeared that a solution that used population, density and poverty as explanatory variables offered the best discrimination between groups. The statistics suggest that the discriminatory power of the discriminant function was statistically significant.10 The coefficients indicate that districts with high population, low population density and high levels of poverty are more likely to be in the group of districts for which the contract’s water targets had not been fulfilled. In other words, the results seem to suggest that the licensee did comply with the targets in those districts for which the costs of service expansion seemed to be low and the economic well-being of users offered the most attractive income stream. The contract’s targets were also spelled out in monetary terms, which resulted in a total investment plan for the whole concession of $4 billion, disaggregated into six five-year periods. Table 2 displays investment targets and outcomes for the first two periods. The data show that the firm invested $1033 million throughout the first five-year period, a figure slightly above the $1025 million established

in the contract. The analysis for the whole decade is more troublesome because investment targets for the second five-year period of about $700 million were increased up to $1100 million in January 2001, when a contract renegotiation introduced an Improvement and Service Expansion Plan (PMES). The renegotiation covered capital expenditure categories that deviated from those considered in the concession contract.11 Despite the fact that the resulting reclassification of targets make difficult both the aggregation of investments over time and the consequent comparison of targets and outcomes, a computation of accumulated investment targets for the 1993e2003 period indicates that they should have totaled $2126 million, a figure that exceeds by $486 million, or 23 percent, the amount of $1640 million of accumulated investments recorded by the firm until the end of 2003. 4. The taxonomy of unforeseen tariff reforms The concession contract established that the firm’s tariffs would be regulated by a hybrid regime that combined elements of cost-plus and price cap schemes. Initial tariffs were to be adjusted when the variation of a composite cost index exceeded the 7 percent threshold, in which case the firm was allowed to request a tariff revision. Price cap’s typical incentives to improve cost efficiency were thus limited to the period for which annual cost increases did not surpass the 7 percent threshold. However, the tariff regime would resemble a costplus regime if variations in the cost index exceeded frequently such a threshold. The contract also stipulated ordinary tariff

9

Household income was unavailable at the district level. The coefficients of the discriminant function were: Z ¼ 0.456 þ 0.002(population)  0.363(density) þ 1.797(poverty). The canonical correlation coefficient (0.682) indicates a strong association between group membership and the discriminant function. Wilks’ lambda (0.535) shows that the difference between the centroids of the two groups is significant at the 5 percent level. The classification matrix indicates that the discriminant function correctly classified 89 percent of observations. 10

11 New outcomes resulted in new planned investments of $474 million for service expansion in suburban areas and the adjustment of water treatment plants, $318 million for the renewing of pipes, $190 million for the program aimed at recovering Buenos Aires riversides and $124 million for the updating of the information technology, the maintenance of buildings and the renovation of equipment.

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Table 2 Investment targets and outcomes: Aguas Argentinas Concession Contract 1993e2003 (million US dollars)a Service

1993e1998 Targets

Outcomes

Targets

Outcomes

$

%

Total investment

1025

1033

2126

1640b

486

23

Water services Water mains Water treatment plants Water supply booster stations

474 328 37 109

491 400 76 15

958 812 37 109

864 700 113 50

94 59 76 59

10

Sewerage services Sewerage network Sewerage pumping stations Sludge treatment facilities

551 206 100 245

212 138 19 55

855 510 100 245

443 312 32 99

412 198 68 146

48

330 93

411 125 189

333 145

19 21 189 66 122

6

Other investment Computers, maintenance, repairs Comprehensive sanitation plan Buildings, structure, machinery Works in progress

1993e2003

52 185

Realization 93e2003

66 122c

a

Investment data for 2002 and 2003 (of 42.4 and 60.2 million pesos, respectively) are measured in 2001 real prices. Based on 2001 Annual Report data plus 2002 total investment as available from 2002 Annual Reports. c It includes 2003 total investment as available from 2003 Annual Report to ETOSS. Source: Own elaboration based on Concession Contract, Aguas Argentinas’ Annual Reports and 2003 Annual Report to ETOSS. b

revisions every five years to examine and update the five-year investment plans. One striking flaw of the concession was the decision to leave the existing inefficient tariff regime unchanged. According to the contract, basic bimonthly tariffs for non-metered customers were determined as: BBTij ¼ TGij ,K,Z,ðSC,E þ 0:10,STÞ

ð1Þ

where BBTij is the tariff for the ith type of service (water or sewerage) for the jth customer category (residential, nonresidential, and land lot), TGij is a general tariff unrelated to consumption for each service and customer category, K is an adjustment factor used to implement tariff changes originating in cost revisions, Z is a coefficient that varies with property location, E is another coefficient related to the type and age of the property and SC and ST are the dwelling’s total built size and lot area. Naturally, this tariff structure ignores efficiency goals, as consumers’ marginal cost of water consumption is zero. Minimum tariffs are established for each customer category. Metered customers pay for their use of each sanitation service according to a two-part tariff. The first component is a fixed charge equivalent to half the non-metered tariff, while the second relates unit prices with total water usage (over a monthly free consumption threshold of 15 cubic meters). Both the licensee and consumers enjoy the right to request a move from the non-metered to the metered regime, though at their own cost (i.e. the party requesting the change has to pay for connection and meter reading costs). Privatization came along, however, with the introduction of newer access costs. Newcomers were required to pay access costs that put together an infrastructure charge (IC), payable in installments once the works were finished, with connection fees (CF). The former would be used to fund the expansion of the secondary network and the latter to pay for the right to

connect to the grid. Table 3 depicts the evolution of access costs. The table shows that initial access costs to the water and sewerage network totaled $1120, as ICs stood for $785 and CFs for $335.12 These figures, to which the cost of internal dwelling plumbing installations should be added, were well beyond the monthly income of poor households (see Table 5). Furthermore, in June 1994 ICs increased 57 percent for water and 65 percent for sewerage, while minimum CFs increased 42 percent for both services. In May 1995, ICs were reformulated as a function of land and dwellings’ features in order to reduce access costs for the poorest newcomers; they only decreased in July 1995 after an extraordinary tariff revision induced by lower social security taxes. This decline notwithstanding, access costs increased 33 percent in the two years following privatization. High access costs raised generalized discontent among newcomers and refusal to pay. By the end of 1996, arrears in the collection of access costs had soared to about $30 million (or 8% of revenues), which led the concession’s owners to halt system expansion to poorer areas. In February 1997, Aguas Argentinas began a contract renegotiation with the ETOSS. Soon afterwards, however, the regulator was bypassed by two federal agencies, the Secretariat of Public Works and the Secretariat of Natural Resources and Sustainable Development, which reached a direct agreement with the licensee made official in November 1997. The renegotiation introduced key changes in the terms of the license. On the one hand, ICs were replaced by a one-off service integration charge (CIS) and a permanent universal service (SU) fixed charge. The CIS consisted of a lower fixed charge of $120 per service payable by new entrants in 30 bimonthly

12 Estimations for the US indicate that the average cost of basic water and sewerage infrastructure is about $200 (Chisari and Estache, 1999).

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Table 3 Pre-tax access costs: Aguas Argentinas (US dollars)a Access cost componentb

May 1993

June 1994

July 1995

Nov 1997

May 1998

Jan 1999

Jan 2001

Jan 2002

Infrastructure charge Water Sewerage

785 325 460

1271 511 760

1021 415 606

e e e

e e e

e e e

e e e

e e e

Service integration charged Water Sewerage

e e e

e e e

e e e

240 120 120

253 126 126

253 126 126

265 133 133

277 138 138

Connection feese Water Sewerage

335 135 200

476 192 284

501 202 299

501 202 299

526 212 314

549 221 328

c

Price index Consumer price index Wholesale price index

1.00 1.00

476 192 284 1.04 1.00

476 192 284 1.08 1.07

1.08 1.10

1.09 1.07

1.10 1.02

1.07 1.06

1.05 1.00

a

The VAT rate should be added in all cases. This rate was 18% until May 1995 and 21% thereafter. Newcomers also incur in dwelling’s internal connection costs of about $50 for water and $400 for sewerage (Mazzuchelli et al., 2001). c Payable in 12 bimonthly installments. d Payable in 30 bimonthly installments. e Connection fees vary according to the diameter of pipes; these are minimum values. Source: Own elaboration based on ETOSS Resolutions, Aguas Argentinas’ Annual Reports and INDEC price data. b

installments, while the SU resulted in a fixed charge of $2.01 per service applicable to all users. In practice, the introduction of the latter was translated into an implicit cross-subsidy from existing to new customers. On the other hand, the ‘‘integral sanitation plan’’ (PSI), as outlined by Aguas Argentinas, was introduced into the license, modifying the original sewerage disposal program established in the contract. The funding of the PSI resulted in the addition of an environmental improvement (MA) fixed charge of $1.04 per service, which became effective in 1999.13 The introduction of these fixed charges, several adjustments in basic tariffs and marginal tax changes not only increased the household’s cost of sanitation services significantly, but they also distorted the nature of the propoor cross-subsidies specified in the concession contract, as they affected lower tariffs more severely. Table 4 illustrates the impact of those changes because it summarizes the evolution of the bimonthly bill for an average water and sewerage residential consumer.14 Privatization came along with a tariff reduction, since Aguas Argentinas won the bidding process by offering a discount of 26.9 percent over prevailing tariffs, thereby setting the initial value of the K factor at 0.731. Consequently, the total bill for an average user totaled $17.57. Only a year later, however, the regulator authorized an increase in the K factor of 13.5 percent, which added to the more significant adjustment of access costs discussed above. The table also illustrates the inclusion of the SU that resulted from the contract renegotiation of 1997.

Soon after the renegotiation of 1997, the regulator authorized an extraordinary tariff revision that in May 1998 led the way to another increase of 5.31 percent of the K factor. Shortly after, in January 1999, the MA fixed charge to finance environmental improvements was also added to the bill. Additional annual tariff increases of 4.9, 4.4 and 3.9 percent were adopted since 2001 through adjustments of the K factor, which in all cases were aimed at compensating for past inflation. The cost of each service was further increased in January 2001 by the introduction of two new fixed charges: a charge for connection maintenance (CMC) of $0.43dwhich would account for the eventual replacement of connection devices and metersdand another of $0.25 named access imputed charge (CIA), which was added to the SU in order to finance works of the PSI.15 Overall, Table 4 shows that adjustments in basic tariffs, the inclusion of fixed charges and marginal tax changes caused the real bill (see price index data in the table) of an average residential consumer to increase significantly throughout the period.16 The changes in both the level and the structure of tariffs may have affected some consumers more severely than others. We therefore used household level data to examine the impact of tariff changes on household welfare. The data used in the estimates come from the household expenditure survey (EGH) carried out by the National Institute of Statistics and Censuses in the Buenos Aires metropolitan area between March 1996 and March 1997 (INDEC, 1998).17 This is the

15

13

The CIS, the SU and the MA are all adjusted by the K coefficient and subject to the VAT rate. The ETOSS fee is not levied on these charges. The restructuring of tariffs brought about a significant increase in revenues. Prior to the renegotiation, annual revenues collected from the ICs totaled about $14 million while by 2001 total revenues provided by the CIS, the SU and the MA had increased to $104 million. 14 The average consumer as defined by both the firm and the regulator.

From January 2002 and throughout 2003 these fixed charges would be adjusted with changes in the K coefficient. From 2004, the CMC would be established in five-year ordinary revisions. 16 A computation of tariff changes under two scenarios that capture the dwelling’s features of a rich and a poor household, respectively, show increases of 33% for the former but 135% for the latter. 17 This survey contains expenditure and socioeconomic data of about 5000 households. This sample is statistically representative of a population of 12 million people.

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241

Table 4 Water and sewerage bimonthly bills: Aguas Argentinas’ average customer (US dollars) Bill component

May 1993

June 1994

Nov 1997

May 1998

Jan 1999

Jan 2001

Jan 2002

% increase 1993e2002

17.57

19.95

25.42

26.77

29.34

32.46

33.88

93

Tariff and fixed charges Basic bimonthly tariff

14.56 14.56

16.53 16.53

20.55 16.53

21.65 17.41

23.73 17.41

26.25 18.26

27.40 19.07

88 31

Fixed charges Universal service (SU) Environment imp (MA)b Connection (CMC)

e

e

4.02 4.02

4.24 4.24

6.32 4.24 2.08

7.98 4.44 2.68 0.86

8.33 4.64 2.80 0.90

e e e e

Total bill (W þ S) a

ETOSSc

0.39

0.44

0.55

0.58

0.63

0.70

0.73

e

VATd

2.62

2.98

4.32

4.55

4.98

5.25

5.77

e

Minimum bill (W þ S )

8.00

9.08

9.08

9.56

9.56

10.02

10.48

31

Price index Consumer price index Wholesale price index

1.00 1.00

1.04 1.00

1.08 1.10

1.09 1.07

1.10 1.02

1.07 1.06

1.05 1.00

1.08 1.10

a

At the date of the transfer, OSN’s average tariff of $18.90 decreased to $14.56 because of Aguas Argentinas’ winning bid. In January 2001, the MA increased $0.50 because of changes in the PSI through the addition of CIA fixed charge. c The regulator finances its budget from a levy of 2.67% on users’ tariffs. d The VAT rate was 18% until May 1995 and 21% thereafter. Source: Own elaboration based on ETOSS Resolutions, Aguas Argentinas’ Annual Reports and INDEC price data. b

only household expenditure study conducted in the country since 1986. Table 5 displays access, income and expenditure data sorted into income quintiles and untying the City of Buenos Aires from the Municipalities that form the Greater Buenos Aires area.18 The most notable difference between the two areas relates to access rates. While the network covers the city of Buenos Aires in full, penetration in the Municipalities was much lower, as by 1997 the water and sewerage networks had reached 63 and 40 percent of households, respectively. Access to sanitation services in the municipalities increases with income. On aggregate, only 55 percent of poor families had access to water services in contrast to about 76 percent of the rich; differences in sewerage are larger. Common to both districts is the increase in mean expenditure as a proportion of income as households become poorer. The average income of the poor was about one-tenth that of the rich, though sanitation bills for the former were about two-thirds those of the latter. The data also indicate that water and sanitation expenditure for the poor ranged from 2.1 to 3.3 percent of household income, the burden being heavier for those residing in the municipalities. The data illustrates that difficulties in connecting new users to the network had probably been related to the high access costs, which seemed to have acted as an insurmountable barrier to system expansion into poorest areas. By mid-1997, connection fees accounted for about 176 and 90 percent of a household’s monthly income in the first and second income quintiles, for example. Moreover, the addition of an infrastructure charge installment to the use-of-service bill implies that 18 The data includes seven municipalities that do not take part of the franchise area. It is not possible to split that data from the sample, as the INDEC data impedes identification at the municipality level. This fact should not however bias the socio-economic nature of the results related to the concession.

a poor newcomer would have ended up paying about $125 each two-month period, or 23 percent of income.19 Moreover, the restructuring of tariffs brought about by the contract renegotiation of 1997 (which replaced the IC by the lower CIS and introduced the SU and MA) could have alleviated the burden of access costs, but at the expense of bringing in additional difficulties in affording use-of-service tariffs. We also used household expenditure and tariff data to estimate changes in consumer surplus (dS ), as computed by the difference of household expenditure in sanitation services between May 1993 (soon after privatization) and January 2002, when the contract terms became suspended.20 Results are summarized in the last two columns of Table 5. The computations indicate that users residing in the city of Buenos Aires and in the municipalities have experienced, on average, an annual welfare loss of US$97 and US$83, respectively.21 Welfare losses have been more or less even across groups, a situation that is explained by the fact that prices are unrelated to consumption and that fixed charges explain most of tariff changes. Results indicate that tariff adjustments and the introduction of additional charges constituted a relatively heavier burden for

19

Anecdotal evidence also suggests that even new consumers who could afford access charges resented the requirement to connect, partly because they had alternative sanitation systems that were outlawed. Another source of resentment was the fact that customers who had been connected before the concession had not paid any infrastructure fee (Alcazar et al., 2000). 20 This comes from making dS ¼ (P1  P2)Q1 þ 1/2(P1  P2)(Q2Q1), where Pi and Qi, for i ¼ 1,2 are the prices and quantities consumed before and after reforms. Assuming a perfectly inelastic demandda reasonable assumption given that the vast majority of consumption is non-metereddwe obtain dS ¼ E2 E1 (where E2 ¼ P2Q1). 21 The computation of changes in consumer surplus ignores changes in service quality, which improved notably since the reform. We thank a reviewer for making this point.

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242

Table 5 Access and expenditure data at the household level: March 1996 to March 1997 (in US dollars) Income quintile

Total households (thousand)

Total population (thousand)

Average incomea

Water coverage rateb (%)

Sewerage coverage rateb (%)

Average expenditurec

Expenditure over income (%)

Expenditure change 1993e2002d

Expenditure change over income (%)

City of Buenos Aires Average 1022 Poorest 205 2nd 204 3rd 205 4th 204 Richest 204

2877 366 517 635 636 723

19650 5190 10237 15076 22325 45522

100 100 100 100 100 100

99.9 99.6 99.7 100 100 100

135.09 97.64 122.76 132.33 140.29 172.22

0.99 2.11 1.20 0.88 0.63 0.33

97.19 87.95 93.93 96.55 98.53 106.45

0.78 1.88 0.92 0.64 0.45 0.26

Municipalities Average Poorest 2nd 3rd 4th Richest

8948 1369 1669 1819 2007 2084

12211 3238 6330 9349 13780 28616

40.3 32.2 33.7 35.0 45.0 55.7

125.45 106.14 115.57 120.50 121.06 148.78

1.39 3.30 1.85 1.31 0.87 0.55

83.17 77.58 79.71 80.40 81.26 91.65

0.97 2.47 1.28 0.88 0.60 0.35

2402 481 480 481 480 480

63.4 55.4 57.1 59.5 68.7 76.3

a

Average annual income per household. Percentage of total households. c Average annual expenditure per household. d Expenditure changes are computed from May 1993 (soon after to privatization) and January 2002, right before the contract was cancelled. Source: Own elaboration based on EGH (INDEC, 1998). b

poor users, for whom these tariff changes represented 2.5 percent of their income. 5. The economic performance of the concessionaire Privatization caused a shift from OSN’s multiple optimization criteria, as revealed by the subsidization of consumption or the promotion of new jobs, for example, to others in which the maximization of profits played a predominant role. Table 6 summarizes the evolution of Aguas Argentinas financial statements. The data indicate that the firm’s revenues more than doubled between 1993 and 2001, from $245 to $534 million. Such an increase resulted from a combination of higher tariffs, a larger customer base, the addition of users that were excluded from OSN’s billing system and the re-categorization of others, the updating of property features in the billing system, and better collection rates.22 Operating costs also increased, though much more moderately, from $277 to $386 million. The faster growth of revenues over operating costs led the way to a rapid increase of earnings before interests and taxes (EBIT), which soared from 9 to about 28 percent of total income. Consequently, prior to the currency devaluation of 2002, cumulated total net incomedover an initial equity investment of $150 milliondtotaled $419 million, a sum that goes up to $534 million if operators’ fees are considered; throughout that period, total cash dividends and operator’s fees totaled $224 million. The financial ratios highlight major features of Aguas Argentinas’ financial structure. The ratio of debt to total assets shows that the concession’s owners began their operations adopting a highly leveraged capital 22 OSN’s collection rates averaged at about 86%, while Aguas Argentinas collection rates between 1993 and 1997 ranged from 94% to 99%.

structure. The figures indicate that return on equity (ROE) was well above the 20 percent rate for most of the period. We examine the economic performance of the concession using a simple model of disaggregated performance measurement that allows for the decomposition of the firm’s profitability into their productivity and price recovery components. Changes in the profitability of a firm can be explained by efficiency changes in the allocation of resources, variations in the relationship between the prices of outputs and inputs, or by a combination of both. Following Waters and Tretheway (1999) and Saal and Parker (2001), it is possible to examine the linkage between profits, tariffs, input prices and productivity by writing profits as P ¼ R/C ¼ (P1Q1 þ / þ PmQm)/ (W1X1 þ / þ WnXn) where R is total revenues and C total costs; Qi and Xj for i ¼ 1,.,m and j ¼ 1,.,n are the quantities of m outputs and n inputs, and Pi and Wj their respective prices. After some manipulation, changes in profitability can be expressed as: X m dP ¼ 0:5ðuis þ uit ÞðlogQis  logQit Þ P 1  n X    0:5 vjs þ vjt logXjs  logXjt  1

þ

X m

0:5ðuis þ uit ÞðlogPis  logPit Þ

1



n X

   0:5 vjs þ vjt logWjs  logWjt

 ð2Þ

1

where Qit and Xjt represent the ith output and jth input in period t; uit ¼ PitQit/PtQt is the revenue share for output i at t; vjt ¼ WjtXit/WtXt the cost share of input j at t, and Pit and Wjt the respective output and input prices. Expression (2) is the

A.A. Casarin et al. / Utilities Policy 15 (2007) 234e247

243

Table 6 Aguas Argentinas financial statements in 1993 constant values (million US dollars) Concept

1993a

1994

1995

1996

1997

1998

1999

2000

2001

Income statement Total revenues Operating costsb EBIT Net financial costs Taxes Net income

245.0 277.0 32.0 2.0 1.0 34.0

279.3 254.4 25.0 1.0 1.9 24.0

335.2 285.1 50.1 0.0 0.0 50.1

349.5 291.1 58.4 4.6 0.0 53.8

387.3 321.9 65.5 12.0 0.0 53.5

399.3 335.4 64.0 18.3 12.8 33.8

472.5 360.6 111.9 26.8 27.7 57.3

479.7 336.0 144.7 30.8 33.6 79.3

534.0 386.8 148.1 36.8 40.6 69.8

111.0 95.0

234.2 120.9

370.5 171.8

504.3 213.2

642.8 251.8

710.9 266.8

817.3 308.8

926.8 371.5

868.9 419.8

24.2 8.9 65.9

34.4 14.9 68.3 166.1

28.1 16.8 70.3 12.4

23.0 16.8 71.9 5.5

12.9 16.0 72.7 3.5

19.8 23.7 72.6 4.2

23.2 30.0 71.4 4.6

17.5 27.6 67.4 4.0

Balance sheet Debt Equity Financial ratios Return on equity (in %)c Gross profit margin (in %)d Debt to assets (in %) Interest coverage (times)e a b c d e

e

Data for 1993 has been annualized because the licensee took over in May of that year. It includes depreciation of fixed assets. Return on equity is computed as [NIt/0.5(Et þ Et  1)], where NI is net income and E the total equity value. Gross profit margins result from the ratio of EBIT to total revenues. Interest coverage is the ratio of EBIT to interest expenses. Source: Own elaboration based on Aguas Argentinas’ Annual Reports.

logarithmic form of a Tornqvist index, which shows that profitability changes can be disaggregated into both changes in efficiency and in the relative prices of outputs and inputs. The first term of Eq. (2) is the usual measure of total factor productivity (TFP) (Coelli et al., 2000), while the second can be referred to as total price performance (TPP). Naturally, increases in both TFP and TPP lead to profitability improvements. Aguas Argentinas’ TFP and TPP were estimated using Eq. (2) as follows. Output was proxied by the total number of customers, as more disaggregated data were unfortunately unavailable. An average output price was computed dividing total revenues by the number of users. Three inputs were used in the estimations. The capital stock was estimated using the perpetual inventory method. The residual value of fixed assets received from OSN was used as a benchmark, while gross annual investments as well as depreciations were obtained from Aguas Argentinas’ financial statements.23 The price of the capital input is the sum of depreciation rates and the opportunity cost of capital; depreciation rates were estimated for each year as the ratio of total depreciation to gross capital stocks, while the opportunity cost was computed using the weighted average cost of capital (WACC).24 Total capital costs then resulted from multiplying the capital stock by the price of capital.

23 The value of OSN’s fixed assets ($1699 million, as recorded in OSN’s financial statement) was depreciated using an average rate that assumes an assets’ life equal to the length of the concession. 24 The average of depreciation rates is 3.9%. It was not possible to obtain WACC estimates from the regulator. We therefore computed our estimates using the Capital Asset Pricing Model. The average WACC value is 10.6%. After adjusting for leverage and systematic risk, our results proved consistent with those available for other utilities sector in Argentina.

The quantity of labor was approximated by the total number of employees, while labor expenses result from the sum of wages and social security charges as reported in the firm’s annual accounts. The price of labor results from dividing labor expenses by the number of employees. The quantity of other inputs used in production, hereafter referred to as the materials input, was estimated residually by firstly computing materials expenses, which result from subtracting labor and depreciation costs from total operating costs. Materials expenses were then divided into three groups: energy, chemical products and other material expenses, which were each adjusted by a price index and finally added up to provide a proxy for the quantity of materials used in production. Total costs are the sum of capital, labor and materials expenses, while cost shares sj for each input at t result from dividing those input expenses by total costs. Table 7 summarizes the results. The data show that Aguas Argentinas’ productivity appears to be poor, as it decreased at an average annual rate of 0.10 percent: while output increased by 2.44 percent per year, on average, inputs did so more rapidly, at 2.55 percent. Input growth was mainly driven by the

Table 7 Profits, total factor productivity and total price performance: Aguas Argentinas 1993e2002 (average annual growth rates, in percentages) Indexes

Total

Output Capital QP KWK

Labor LWL

Materials MWM

Input index

Total factor productivity (TFP) Total price performance (TPP)

0.10

2.44

4.31

0.80

1.55

2.55

6.05

7.20

0.08

3.01

1.98

1.09

The average input shares are as follows: sK ¼ 50%. sL ¼ 18% and sM ¼ 32%. Source: Own elaboration based on Aguas Argentinas’ Annual Reports and INDEC price series data.

244

A.A. Casarin et al. / Utilities Policy 15 (2007) 234e247

capital input, which contributed with 2.12 percent, or 83 percent of total input growth, as capital accounts for about 50 percent of total input costs and the stock increased at an average annual growth rate of 4.31 percent (2.12 z 4.31  0.50). The contribution of labor of 0.12 percent was actually negative due to reductions in the labor force, while the 0.54 percent added by materials, though positive, was moderate. The more rapid increase of the capital input over outputdwhich drives the productivity estimatesdmay reflect the fact that post-privatization capital additions were aimed at network expansions towards more distant, less densely populated areas, and at replacing the heavily deteriorated assets transferred with the reform. To some extent, it may also reflect the presence of additional sludge treatment capacity not fully used.25 The evolution of total price performance shows a different story because of the dissimilarity between output and input prices growth rates. In this case, the results indicate that the noticeable annual increase of about 6.05 percent in the prices gap was the consequence of the fact that the annual growth in tariffs of 7.20 percent was well above the more moderate increase of input prices, which totaled 1.09 percent. Note that tariffs increased twice as much as labor cost did. As a result, the firm’s profits increased at an annual growth rate of 5.95 percent. These results go together with both the tariff and financial performance analysis developed above because they indicate that the increase of the firm’s profitability is a direct consequence of sustained tariffs adjustments that very much exceeded the increase of input prices, and also because improvements in productivity were nil. Fig. 1 displays the evolution of the TFP and TPP indexes.26 The findings related to total factor productivity performance, however, should not obscure significant improvements in other directions. Several usual partial productivity indicators, for instance, show that since the date of transfer water production jumped from 174 to 411 thousand cubic meters per employee and also that the population served went up from 1.4 to 3.5 thousand users per employee. The ratios that relate the number of customers to employees and to network length, clearly linked to output density, did increase as well: the former from 493 to 1262 and the latter from 207 to 229. Finally, the relationship between network length and number of employees, related to the intensity of capital usage, practically doubled. However, it may be recalled that these improvements are to a great extent explained by the large staff layoffs that followed privatization, when the workforce declined from 7365 to 3770. There was also important progress in service 25

Estache and Trujillo (2003) TFP estimates for Aguas Argentinas for the period 1993e2001 are based on an output definition that combines the volume of water production and of sewerage collected, and on an input index that includes the length of the network (in kilometres) as capital input. They report a positive productivity performance that results from an output increase of 1. 15% (well below our estimates) and an input decrease of 0.8%. We presume this is caused by a more restrictive definition of the capital input that excludes replacements, investments in sludge treatment plants, and other assets. 26 The profit growth rate as defined by P ¼ R/C is obtained by adding to the firm’s operating costs the cost of capital imputable to OSN’s fixed assets transferred to the licensee (which constitutes an implicit subsidy).

2,0 TFP

1,8

TPP

1,6 1,4 1,2 1,0 0,8 0,6 0,4 0,2 0,0

1993

1995

1997

1999

2001

Fig. 1. Total factor productivity and total price performance: Aguas Argentinas 1993e2002. Index 1993 ¼ 1.

quality. In fact, quality of service indicators as measured by improvements in the quality of drinking water, leakage repairs, water pressure and delays in repair requests suggest significant changes for the better. As pointed out by Dore et al. (2004), improvements in service quality are most probably one of the strongest benefits of privatization. 6. Regulatory failure and contract cancellation The Buenos Aires concession seems to be a very unusual case where a single watchdog regulates a single firm. Some observers have pointed out several arguments that challenge the office’s regulatory efficacy. For instance, the Water and Sanitation Program (2001:3) argues that the ETOSS ‘‘. was staffed mainly by former OSN employees who were poorly qualified for the responsibility of tariff settings and had no experience in regulating a commercial venture .’’, while others warned that its staff could be tempted to adopt pro-concession attitudes, as the firm was the most likely employer of the office’s members (Artana et al., 1999). Other factors added further concerns. For instance, ETOSS funding comes from a proportional charge levied on users’ bills, creating a direct link between tariff increases and the regulator’s resources. Unlike those of other regulators in Argentina, ETOSS’ revenues are not increased by fines, a situation that could diminish incentives to punish unobserved contract duties. Additionally, the office seems to retain a striking discretionary power, as its ruling is kept out from public hearings.27 These concerns seem to be confirmed by several ETOSS rulings, which appeared to be most frequently biased towards the regulated firm. For instance, Artana et al. (1999) indicate that the regulator (i) allowed the firm to set unusually high 27 ETOSS’ decisions, however, are subject to innocuous audits and legal overviews from Tribunal de Cuentas de la Nacio´n.

A.A. Casarin et al. / Utilities Policy 15 (2007) 234e247

meter installation tariffs, (ii) granted unexplained tariff adjustments with little economic analysis, (iii) transferred business risk to consumers through adjustments in access charges and (iv) gave consent to delays in the installation of meters. However, one of the most remarkable episodes of regulatory failure seems to have been the first contract renegotiation, which modified basic features of the concession. Bypassing the role of ETOSS, the Natural Resources and Sustainable Development Secretariat, which reported directly to the Nation’s Presidency, (i) relaxed some water and sewerage expansion targets, (ii) cancelled fines for investment delaysdprobably setting the precedent that the licensee may not be imputable for contractual failuresdand, most surprisingly, (iii) established that, in cases of changes in the peso-dollar parity, the firm’s tariff will remain dollar denominated. The regulator may have also disregarded its responsibility as it relates to the monitoring of the licensee’s capital structure. The economic proposal built-in in Aguas Argentinas’ bid stipulated upper limits to leverage ratios that then went unobserved. By 1998, a predetermined debt to equity ratio of 0.73 had been surpassed remarkably to one of 2.67, as debt became the main source to finance investment in fixed assets (given the irrelevance of initial equity investment and the firm’s high dividend pay out ratio; see Table 8). However, in 1999, and during a second contract renegotiation, the Natural Resources and Sustainable Development Secretariat gave way to the non-fulfillment of leverage targets ruling out (ex post) an increase of the debt to equity ratio from 0.73 to 2.65, well above the 0.66e1 range observed in utilities industries (Jenkinson, 2006). The evidence seems to indicate that neither the Secretariat nor the regulator were aware of the increasing risks to which customers were exposed through the licensee’s increasing leveraged financial structure. It could be expected that a significant leveraged capital structure may magnify a licensee’s financial risk, with an ultimate effect on consumers. The Buenos Aires water concession seems to offer a good example of this regulatory concern, as it exposes the effect of the peso devaluation on the financial position of Aguas Argentinas. In January 2002, a new administration passed an Economic Emergency Law that put an end to the fixed exchange rate regime that had existed since Table 8 Cash flow statement: Aguas Argentinas 1993e2001 (million US dollars) Source of funds

$

%

Debtsa Depreciationb Net incomed

875 582 428

40 27 19

Previsions and bad debts Equity Total

195

9

120 2200

5 100

a

Resource allocation

$

Fixed assets (investments) Current assetsc Dividends and management fees

1546 429 224

% 70 20 10

1991. The argentine peso devalued very rapidly, and in a few months it went up from 1 to 3.5 pesos per US dollar. One of the many other mandates of the law was the elimination of most utilities’ rightsdincluding Aguas Argentinas’dto calculate tariffs in US dollars and to express them in pesos at the exchange rate of the billing date. The law mandated the conversion of tariffs from dollars to pesos at the pre-devaluation fixed exchange rate of one US dollar to one peso. The legal measures also forbade licensees’ right to adjust tariffs according to the evolution of inflation rates, while requiring firms to observe all contractual and regulatory obligations. As part of this process, the government directed all regulatory offices to cease all ongoing tariff reviews and to refrain from any tariff or price adjusting. The devaluation caused the firm’s debt almost to triple (as did the exchange rate) because it was mostly issued in foreign currency. Consequently, in 2002 the firm recorded a net loss that originated almost exclusively in an exchange rate loss brought about by the devaluation.28 As a result, the firm’s net worth was wiped off and total debts practically doubled the value of the firm’s assets. The firm’s financial position, which in practice means that debt holders had become (probably against their wish) the new owners of the firm, has impeded the funding of further network expansion with the use of additional debt.29 Following several renegotiation attempts headed by the executive powerdwhich continued the practice of side-lining the regulatordand in which the granting of tariff increases were systematically refused, the government cancelled the concession and created a new state owned firm that took over Aguas Argentinas’ operations in March 2006.

7. Conclusion The Buenos Aires water concession went forward as part of the block of privatization transactions carried out in Argentina since 1989. Like that of other public utilities worldwide, the privatization of sanitation services was motivated by a general discontent with the public sector performance as revealed by under-investment, sluggish system expansion, poor service quality and long-standing operating deficits. As with most water privatization in countries with a lesser degree of development, private sector involvement in Buenos Aires’ sanitation services was aimed at overcoming government difficulties to improve service coverage. The operation was handed over to the Aguas Argentinas consortium under a thirty-year concession contract in May 1993. The concession contract specified 28

Total

2200

100

Commercial debt, loans and others. b Depreciation of fixed assets and amortization of intangibles. c Cash and banks holdings, accounts receivables and others. d It includes management fees. Source: Own elaboration based on Concession Contract and Aguas Argentinas’ Annual Reports.

245

The 2002 average exchange rate was 1 US dollar ¼ 3.27 pesos. That same year, the wholesale price index increased 75%, and the consumer price index increased 26%. 29 If tariff adjustments were disregarded, it seems that the licensee was not able to fulfill the concession’s targets without an increase of equity capital. A rough projection of its financial statements suggests that tariffs did not suffice to fund additional investments and that the financial fragility of the firm would have deteriorated its credit rating, ultimately increasing the financial cost of any additional debt.

246

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precise expansion targets aimed at achieving both full coverage and quality of service standards, and created a single agency to regulate a single firm. Privatization was run speedily and the franchise was granted to the bidder that offered the largest tariff reduction over prevailing tariffs. Our analysis of the Buenos Aires sanitation concession throughout the period of private management concentrated on the evolution of system performance as it related to the privatization objectives of expanding coverage, reducing consumers’ tariffs and increasing service standards. The comparison of the contract’s targets against the firm’s outcomes shows that, despite a noteworthy increase, coverage rates remained behind targets by a half in the case of water and by about three-quarters in the case of sewerage. The non-fulfillment of goals implied the failure to supply water to more than one million people and sewerage to about one and half million people. Failure to comply has been more severe in the poorest areas. In monetary terms, the figures indicate that investments, mostly funded by tariff increases and debt, were on aggregate a quarter behind goals. The data suggests that difficulties in the collection of initially high access costs seem to have contributed to restrain network expansion mainly to the poorest areas and to have led towards contract renegotiations that introduced fundamental changes in key features of the concession. Theory also indicates that, if concessions are renegotiated shortly after their award, the initial bidding or auction turns into a bilateral negotiation between the winning operator and the government, eroding the competitive discipline of the auction. Operators then have significant leverage, because the government is often unable to reject renegotiation and is usually unwilling to claim failuredand let operators abandon the concessiondfor fear of political backlash and additional transactions costs. In such cases the operator, through renegotiations, can undermine all the benefits of the bidding process. The evidence for Buenos Aires suggests that several renegotiations of Aguas Argentinas’ contract came along with significant tariff changes. On the one hand, the one-off access cost levied on newcomers was replaced by another of lower value, a reduction that in revenue terms was more than compensated for by the adoption of newer fixed charges applicable to all users. On the other hand, the first decade of private management has also witnessed five tariff adjustments and the introduction of additional fixed charges. On the whole, the addition of all tariff changes indicates that the actual bill for an average residential customer has increased more than 80 percent in real terms. Contrary to privatization objectives, several contract renegotiations turned an initial and still unsolved access problem into an affordability one. Renegotiation also ended up relaxing some licensee’s contractual duties related to expansion targets and canceling fines imposed on the firm. However, tariff adjustments seem to have transformed the concession into one of the most profitable water operations worldwide. Total net income earned prior to the devaluation more than tripled the initial equity investment. The breakdown of changes in economic profits into productivity and price components indicates that the remarkable increase in profits

were originated almost exclusively by tariff increases, as the contribution of total factor productivity improvements and of input prices have been negligible. Partial productivity indicators improved significantly, however, though partly as a result of large staff layoffs. High profits were also due to a combination of a modest equity investment with a financing policy that mostly rested on debt additions. This was not however at no cost, as the devaluation of 2002 wiped off the firm’s net worth in such a way that total debts almost doubled the total value of assets. The subsequent burden of financial costs drained the concession’s capacity to attend debt services, which therefore appeared to have closed any possibility to fund further investments with additional debt. Although the devaluation was exogenous to both the firm and the regulator, this experience seems to suggest that regulators should consider protecting the interests of consumers by setting capital requirements or leverage levels. Still, a good number of the concession’s failures seem in turn to have been explained by the presence of a weak and inexpert regulator, which had to confront several issues not clearly addressed by the government at the time of privatization. These all favored an opportunistic behavior of the licensee. Structural design problems related to the agency’s financing, the incompatibilities between the staff and their duties, the office’s discretionary power, and political pressures help to explain its ineffectiveness, a fact confirmed by several agency rules most frequently in conflict with customers’ interests. A non-credible regulatory framework has created the conditions for the government to become the owner and operator by default. It remains to be seen whether government ownership will overcome the difficulties that motivated privatization in the first place. Acknowledgments Marcelo Delfino and Luciana Nicollier provided valuable research assistance for the computations in Sections 5 and 6, respectively. We are grateful to Lorenzo Preve, Cecilia Ugaz and two anonymous referees for helpful comments and suggestions. All errors are ours. References Aghion, P., Dewatripont, M., Rey, P., 1994. Renegotiation design with unverifiable information. Econometrica 62 (2), 257e282. Alcazar, L., Abdala, M., Shirley, M., 2000. The Buenos Aires Water Concession. Policy Research Working Paper Series 2311. World Bank, Washington, DC. Artana, D., Navajas, F., Urbiztondo, S., 1999. Governance and regulation: a tale of two concessions in Argentina. In: Savedoff, W.D., Spiller, P.T. (Eds.), Spilled Water: Institutional Commitment in the Provision of Water Services. Inter-American Development Bank, Washington, DC. Basa~nes, F., Willig, R. (Eds.), 2002. Second-Generation Reforms in Infrastructure Services. Inter-American Development Bank, Washington, DC. Chisari, O., Estache, A., 1999. Universal Service Obligations in Utility Concession Contracts and the Needs of the Poor in Argentina’s Privatizations. Policy Research Working Paper Series 2250. World Bank, Washington, DC.

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