Cost recovery and the water contracts

Over the holidays, I have been exchanging notes with a former official in government who had intimate knowledge of how the water contracts took form. Being retired, he prefers to live in simple anonymity. But I want to share some important points he made.

First of all, there are two basic ingredients to pricing PPP projects: “Cost recovery” and “reasonable returns”. While it is possible these ingredients (the cost and the returns) may be prone to abuse by unscrupulous businesses, government is expected to put in the necessary safeguards and preventive measures to minimize abuse. 

Operating on the assumption that we have those “guardrails” in place, these basic ingredients must be clearly defined in a “Terms of Reference” (TOR), which will be the basis for the businesses to price the service. 

As an aside, to give some clarification to a controversial issue in the water concessionaire contracts, the TOR stipulated that the taxes will be shouldered by government so the bidders did not include them in their pricing. Not to favor anybody but probably because in the end, cost recovery requires that that cost be included in the price which will result in higher and “unpopular” water rates which government probably wanted to avoid.  

Another important element of the TOR is “risk allocation” which also has a significant bearing on the cost. There is a tendency of government contract administrators with strong protective legal background to assign all the risks of the contract to the contractor or service provider. This has resulted in many serious bidders to avoid bidding for such government contracts.

Risk assessment and proper assignment of risks seems to be challenging to government contract administrators. For example, the recent inclination to eliminate the usual clauses related to the disposition of MAGA conditions.

This bureaucratic tendency is contrary to the proven WB formula for risk assignment – “The various risks in a contract should be assigned to the party who can best manage a particular risk and for those  risks which are not clear-cut, there should be a mechanism for the two parties to arrive at a mutually advantageous win-win solution to address the problem.”

Probably because of a reasonably well-designed TOR, recall that the eventual bids for the two concessions were initial water rates that were signifantly lower than the MWSS basic rate of P8/cum at the time. 

To address changes in the business environment and to respond to future investment requirements and water rates setting, a five year “rate rebasing” scheme was put in place. This is the responsibility of an internal regulatory body within MWSS, but subject to the final decision of the MWSS Board. 

Admittedly, there may have been some issues, not with the underlying principle of the process, but possible manipulation of the data and results which escaped proper supervision, sometimes referred to as “regulatory capture”

Note that, as designed in the TOR, the concessionaires were just “operators” of MWSS who was still the “public utility” company subject to the review of the NWRB which assumed the powers of the defunct Public Service Commission. 

Most basic of the requirement was the limitation on the “returns” of the public utility against its assets, or MWSS’s total assets, not the assets of the concessionaires. And because of the large assets of MWSS, the limitation on the “percent return” was never exceeded. 

It was not all roses for the concessionaires (and maybe proof that the awards were not “lutong macao” or a “give-away”). While Manila Water was very successful, over seven years Maynilad was in financial distress as the Asian financial crisis set in. 

Yes, there were some mismanagement on the part of Maynilad, but my source believes that part of their error was their failure to realize that the TOR was also defective on the matter concerning CERA. 

Raffy Alunan mentioned that Maynilad was made responsible for paying about $700 million of MWSS’ s $800 million loans, Manila Water assumed only about $100 million. Soon after the bidding and award in 1997 from a bid reference value of about P27:$1 exchange rate, in about four years the exchange rate quickly moved up and ballooned eventually to about P52:$1. You can imagine the impact on their cost. 

Unfortunately, the Currency Exchange Rate Adjustment (CERA) formula in place in the contract, as recommended by IFC the financial consultant of MWSS, did not properly address those cost increase implications. Maynilad was losing P3 to P4 per cum of water sold, while Manila Water was actually still GAINING about P0.10 per cum from the CERA formula. 

Under those conditions, former Manila Water executives looked like geniuses compared to the “bumbling” of the Maynilad executives. It is to the credit of Manila Water that those cost advantages were translated to significant improvements in their water distribution management  resulting in NRW (non-revenue water) much less than 10 percent, beating even world class levels and translating into lower eventual water cost to the customers. 

Eventually everybody realized that disparity and by the end of 2004, MWSS granted an increase in the Maynilad water rates so that by the end of 2005, Maynilad had a partial recovery of the total of about P7 billion lost from 1997-2004. Maynilad made a profit of P 2 billion. 

That helped facilitate that “recovery and turn-around” of Maynilad from a company in the Rehabilitation Court. It made Maynilad an attractive viable business again. 

The Lopez Group stepped out as agreed. The new Group led by DMCI and Metro Pacific won the bid to take over with a commitment to inject $500 million into the business. 

Today it looks like the principles of “cost recovery and reasonable returns” are under attack again and the financial sector and business are reacti-ng with some panic! Hopefully they will not ban “cost recovery and reasonable returns” like they wanted to do with “typhoons” in the early days.

Boo Chanco’s email address is [email protected]. Follow him on Twitter @boochanco.