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IBRD

Concession Contracts and Regulation: Lessons from over 1000 Concessions in Latin America

J. Luis GuaschWorld Bank and University of California, San Diego

jguasch@worldbank.org

November 28, 2005Palermo, Italy

ANEA Seminar: La Regolazione del Servicio Idrico Integrato

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OUTLINE

MOTIVATION FOR INFRASTRUCTURE REFORM

REFORM PROGRAM IN INFRASTRUCTUREREGULATORY FRAMEWORK: CONTRACT VS OTHER

OUTCOMES OF REFORM PROGRAM– RETURNS TO INVESTORS (Sirtaine, Pinglo, Guasch and

Foster 2005)– PRODUCTIVITY, COVERAGE, QUALITY PRICES

(Andres, Foster and Guasch 2004)– RENEGOTIATION (Guasch 2004)

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Motivation for Reform on Infrastructure Sectors

Infrastructure matters: growth and poverty Deficient sector performance: Search for improvements in efficiency, technology and know-howDesired increases in coverage: poverty angleNeed for investment: scarcity of state resources

Redefining the role of the state

Led to Private Sector Participation

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Types of Private Participation in Infrastructure

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Salient Choice: Concessions

Concessions instrument mostly utilized for private participation in infrastructure services: ( 65% total, 98% transport, 90% water and santitation)

Privatization mostly used in the Telecom, and in Electricity - Generation sectors

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Government retainsproprietory rights

Provision for Termination/Cancellation of the concession

More Extensive

Limited/ 15-30 years

Transfer of right ofexploitation and use of thecompany's physical assets

CONCESSION

Non-existant

Generally non-existant

Less Extensive

Unlimited

Transfer of propertyto the company

PRIVATIZATION

DIFFERENCES

Rights/Property

Duration

Obligations

Clauses

Responsibility

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CONCESSIONS VS PRIVATIZATIONS

MAIN DIFFERENCE: Limited operation period vs unlimited operation period

THE ONLY ASSET UNDER A CONCESSIONS IS THE (CANCELABLE) RIGHTS TO THE CASH FLOWS OF THE PROVISION OF THE SERVICE

THE CONCESSIONAIRE DOES NOT OWN ANY PHYSICAL ASSET

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Concession Versus Privatization

Legal and/or constitutional impediments to privatization

Public Services

high visibility social & political impact belief that they should remain under state ownership and control: thus the preference of concessions over privatization

Concerns about outcomes of privatizations

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Key Determinants of Sector Performance(from theory and experience)

i) The design of the concession, the clarity and transparency of the rules of the game, and

ii) The regulatory framework, along with resolution of conflict mechanisms

iii) Those two are the best predictors to reduce regulatory risk and improve sector performance.

iv) Regulation by contract focus on concessions and contract design

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Concession Design and Regulation are Intrinsically Linked

An excellent concession design but poor regulatory oversight will lead to deficient sector performance.

An excellent regulatory oversight but with poor concession design will lead to deficient sector performance. Regulation CANNOT solve the problem of a poor concession design.

Key message: you need both for effective sector performance and to secure the gains from private sector participation.

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Types of Regulatory FrameworksLaw, Decree, Contract, and role of Regulatory Agency– Where the rules, rights and obligations are stated– Regulatory agency implements and interprets them: issue

degree of detail and discretion

Contract, Regulatory Agency: Key differences. Degree of discretion on regulatory issues and autonomy/independence

Contract (issues: dealing with disputes and incomplete contracts)– Ministry– Ministry-Experts Panels: examples (first three in water)

• Bucharest concessions: for tariff adjustments• Chile: for appeals from regulators’s decisions• Sofia concessions: dispute review board for all disputes• London Underground PPP arbiter: deciding periodic

reviews if parties cannot agree

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The French Water Sector: Regulation without a Regulator

The French water sector has operated for many years under regulatory contracts without a regulator. Under this system, implemented through hundreds of municipally granted concessions or leases, private companies provide about 80 percent of the water supply and about 45 percent of the sewage services.

Model contractsWell-developed case law and legal doctrinesA respected appellate tribunalPrivate operators are French companiesCommon educational backgroundsCultural traditions

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Alternative Regulatory ModelsFrance(Water Sector)

Latin America GreatBritain

United StatesIndia

Separate Regulator? No (Regulation by contract)

Yes Yes (national) Yes (national and state) Yes (national and state)

Specifity of Regulatory Contract

Medium High (Bolivia, Chile, Peru)Low (Brazil, Colombia)

High Low (general principles interpreted in case law)

Low (general principles without case law)

Regulatory Decisions Reviewed by Special Appellate Tribunal?

Yes No except for Bolivia and Chile

Yes (Competition Commission)

No No, but proposed by government

Ownership of Regulated Entities

Private Mostly public (only Chile private)

Mostly private Mostly private Mostly public

Form of Private Sector Participation

Concessions and leases

Concessions Full privatization Full privatization Mostly Concessions

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Limits of Regulation by Contract

Different than commercial contract: gov roleIncomplete contracts: how to respond to issues not in contract? Who bears the risk?Dealing with disputesCapture vs no discretionRegulatory credibility (large impact regulatory risk: 2-6 percentage points of cost of capital)Investor confidence In practice some convergence

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But Recall that Regulation Means…

The main objectives of a regulatory framework are:

to induce the regulated firm to operate at lowest (efficient) possible costs;to closely align prices (tariffs) with costs allowing the firm to earn only normal profits.

Usually there are other subordinate objectives as well that complement the main ones such as to induce increase coverage and access, improve quality of service and to address issues of universal service obligations

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CRITICAL FACTORS

Determining future tariffs– Cost of capital– Valuation of assets– Efficient benchmark criterias– Triggers for adjustments

Financial equilibriumIncomplete contractsConflict resolutionRegulation by contract in the strict sense, does not do well handling these factors

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Regulatory agencies

Yet regulatory agencies have had also problems:– Limited autonomy/independence– Limited capacity– Limited experience– Potential capture

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Conflicts of interest: non- compatibles

Users

Government

Maximize fiscal revenues

Expand coverage for those with no service

Seek lower tariffs

- -

Labor forceProtect jobs

Investors

Maximize earnings

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Data SetBased on the analysis of more than 1,300 concessions in the infrastructure sector awarded since the 1980s to date, in Latin America and Caribbean (Guasch 2004). The data set has seven blocks describing: (i) country characteristics; (ii) type of project or transaction; (iii) award and bidding details; (iv) regulatory framework; (v) concession details; (vi) renegotiation details; and (vii) risk bearing details

TelecomsRailRoads

Water & Sanitation

Ports Airports

Electricity

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Sample Characteristics

Water and Sanitation Concessions about 300Most of them were regulated by contractIn addition many of electricity distribution concessions were also regulated by contractMost of transport concessions were regulated by contract

OUTCOMES: On average regulation by contract did worse than when there was an “autonomous regulatory agency”

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OUTCOMES

Returns to Investors

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Long-term Concession Returns by Sectors

-55%

-35%

-15%

5%

25%

Water Transport Telecom Energy

Project IRR vc WACC

IRR, no TV IRR, with FV IRR, with TVIRR with fees adj IRR with fees & Inv Mkup adj WACC

Source: own calculations, based on concessions’ historical financial statements and the authors’ growth assumptions.

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DID THE QUALITY OF REGULATION MATTER ON THE LEVEL OF RETURNS TO INVESTORS?

Objective: To align cost of capital with rate of return

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Construction of Regulatory Quality IndicesWeight Scoring

Legal solidity 0.33 1 if regulatory framework established by law, 0 otherwise.

Financial capacity 0.33 Sum of scores on factors detailed below.

•Financial independence 0.17 •1 if funded from regulatory levy, 0 if funded from public budget

•Financial strength 0.17 •Regulatory budget as % sectoral GDP normalized on [0,1] scale

Decision-making autonomy 0.33 Sum of scores on factors detailed below.

•Independence of appointment 0.11 •0 if appointed directly by executive, 1 if screening by legislature

•Duration of appointment 0.11 •1 for a single fixed term, 0 for indefinite appointment

•Collegiality of decisions 0.11 •1 if headed by regulatory commission, 0 if by individual regulator

Note: Scores between 0 and 1 are given for intermediate cases.

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Summary of Regression Results

Dependent variable

ln(IRR-WACC absolute

differential without terminal

value)

ln(IRR-WACC absolute

differential with terminal value)

ln(IRR-WACC absolute differential

with terminal value and adjustment for

management fee)

ln(IRR-WACC absolute differential with terminal value and management fee and adjustment for

transfer pricing)

Financial independence 1.071 -0.653 -0.001 0.071

Financial strength 2.619** -2.478 -2.488** -2.140**

Legal solidity -0.697 0.928 0.412 0.844**

Independence of appointment 1.147 0.974 0.577 -0.050

Duration of appointment -0.478 1.412 1.053 0.767

Collegiality of decisions -1.771 -0.810 -0.456 -0.243

Constant -1.104 -2.618** -2.365** -2.487**

P-value 0.094* 0.273 0.125 0.049**

R-squared 0.171 0.069 0.156 0.242

No. of observations 32 30 30 30

Notes: Regressions based on 30 observations; *, **, *** indicate significance at 10 percent, 5 percent, and 1 percent level respectively

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OUTCOMES

Sector Performance Outcomes:

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DEPENDENT VARIABLES-PERFORMANCE RELATED TESTED

RENEGOTIATION

PRODUCTIVITYCOVERAGEQUALITY OF SERVICEPRICES

SOURCE: GUASCH (2004) and ANDRES, FOSTER AND GUASCH (2005)

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OUTCOMEOBJECTIVE RESULT

FINANCING/ OPERATIONAL PARTICIPATION OF THE PRIVATE

SECTORVERY POSITIVE

OPERATIONAL EFFICIENCY FAIRLY POSITIVECOVERAGE ADEQUATE

ALIGNMENT OF COSTS AND TARIFFS PROBLEMATIC

SUSTAINABILITY DEFFICIENT

OVERALL CONCLUSIONMIXED, PARTIALLY

POSITIVE

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Empirical Resuls: Changes in Trends…

Transición Post-transición Transición Post-transición Transition Post-transitionNúmber os users (*)

Output (*)

Númer of Workers

Labor Producty (*)

Losses in distribution

Quality

Coveraqge (*)

Prices ? ?

Distribución de la electricidad Telecomunicaciones fijas Water and Sewage

Númer of workers –Sector

Fuente: Andres, Foster y Guasch (2004).Nota: (*) Estas variables fueron reportadas tras considerar los efectos fijos de la firma y otros fenómenos contemporáneos en la economía.

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5010

015

020

025

0

-5 0 5t

ALL Trend before Trend after

Connections of drinkable water per employeeWater - Distribution

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100

102

104

106

108

110

-5 0 5t

ALL Trend before Trend after

CoverageWater - Distribution

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Outcomes: RENEGOTIATION

High Incidence reflects:– GOVERNANCE OR/AND – REGULATORY FAILURE?

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WHY ARE WE CONCERNED ABOUT RENEGOTIATION?

IT BREAKS THE CONTRACT

IT ELIMINATES THE COMPETITIVE EFFECT OF THE AUCTION ALLOCATING THE CONCESSION: QUESTIONS CREDIBILITY OF MODEL

RENEGOTIATION TAKES PLACE AWAY FROM COMPETITIVE PRESSURES IN A BILATERAL-GOVERNMENT/OPERATOR-ENVIRONMENT

COMPETITIVE BIDDING DISTORTED

MOST LIKELY WINNER IS NOT MOST EFFICIENT OPERATOR BUT THAT MOST SKILLED IN RENEGOTIATION

WHILE SOME RENEGOTIATIONS ARE EFFICIENT, MANY ARE OPPORTUNISTIC AND SHOULD BE DETERRED

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RENEGOTIATION THE NORM RATHER THAN THE EXCEPTION

Higher in regulation by contract contexts

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Incidence of Renegotiation of Infrastructure Concessions in Latin America and Average Time to Renegotiation

1988-2001

Renegotiated Concession

Average Time to Renegotiation

All Sectors 42% 2.1 years

Electricity 10 % 2.3 years

Transport 57% 3.1 years

Water 75% 1.7 years

Source: Guasch (2004)

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Very Low Incidence of Cancelled Concession

1990-2001

Total World Infrastructure PPI Projects

Cancelled Percentage

2,485 48Composition

19 toll roads9 energy7 water & sanitation8 telecom

2.1%By Sector

5.8%

3.5%

Source: Harris (2002)

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CORRELATION BETWEEN RENEGOTIATION AND PROFITABILITY

CORRELATION BETWEEN AGGRESIVE BIDDING AND RENEGOTIATION

AGGRESSIVE BIDDING-LOW PROFITABILITY-RENEGOTIATION AGGRESSIVE BIDDING: PQ-OC-T-D<rK FINANCIAL EQUILIBRIUM ISSUE

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CORRELATION BETWEEN RENEGOTIATION INCIDENCE AND PROFITABILITY: Average Profitability by Sector of

Privatized and Concessioned Firms and the Cost of Equity in Latin American and Caribbean Countries, 1990-2002(percent)

Sector

IRR (adjusted) a

Initial Cost of Equityb

Telecommunications 21.0 14

Water and Sanitation 11.0 15.5

Energy 14.5 14

Transport 11.5 13.5 a. The IRR has been adjusted to incorporate management fees. b. Cost of equity is evaluated at the time of the transaction.

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Contract Award Processes for Concessions in Latin America and the Caribbean by Sector, mid-1980s–

2000 Award process

Telecom

Energy

Transport

Water and

sanitation

Total

Share of total (percent)

Competitive bidding

245 95 231 125 696 78 (46%

renegotiated) Direct adjudication (bilateral negotiation)

15 143 37 4 199 22 (8%

renegotiated)

Total 260 238 268 129 895 100 Source: Guasch (2004)

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Distribution of Concessions by Type of Regulation

Price Caps 56%

Rate of Return 20%

Hybrid* 24% *Hybrid regimes are defined when, under a price or revenue cap regulatory regime, a large number of costs components are allowed automatic pass through into tariff adjustments Source: Author’ s calculations

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Distribution of Concessions by Existence of Investment Obligations in Contract

Investment Obligations in Contract 73%

No Investment Obligations in Contract but Performance Indicators

21%

Hybrid 6%

Source: Author’s calculations

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Typology of RenegotiationInitiated by Government

Opportunistic (politically)

Change in priorities

Initiated by Operator

Opportunistic (rent seeking)

Shock related

Ambiguous

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Who initiated the Renegotiation?(% of total requests)

Both

Government

and Operator

Government

Operator

All sectors 13% 26% 61%

Water and

Sanitation

10% 24% 66%

Transport 16% 27% 57%

Source: Author’s calculations

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Who Initiated the Renegotiation Conditioned on Regulatory Regime?

(% of Total Requests)

Both Government

and Operator

Government

Operator

All sectors

Price Caps 11% 6% 83%

Rate of Return 39% 34% 26%

Hybrid Regime 30% 26% 44%

Source: Author’s calculations

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Water Sector Incidence of Renegotiated Concession Contracts According to Characteristics

FeatureIncidence of Renegotiation

(percent)

Award Criteria

Lowest tariff 81

High price 66

Regulation Criteria

Regulation by means (investments) 85

Regulation by objectives (performance indicators) 25

Regulatory Framework

Price cap 88

Rate of return 14

Existence of Regulatory Body

Regulatory body in existence 40

Regulatory body not in existence 87

Impact of the Legal Framework

When regulatory framework imbedded in law 55

When regulatory framework imbedded in decree 83

When regulatory framework imbedded in contract 70

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Common Outcomes of the Renegotiation Process

Percentage of renegotiated concession contracts with

that outcome Delays on Investment Obligations Targets 69% Acceleration of Investment Obligations 18% Tariff Increases 62% Tariff Decreases 19% Increase in the number of cost components with automatic pass-through to tariff increases

59%

Extension of Concession Period 38% Reduction of Investment Obligations 62% Adjustment of canon-annual fee paid by operator to government Favorable to operator Unfavorable to operator

31% 17%

Changes in the Asset-Capital Base Favorable to Operator Unfavorable to Operator

46% 22%

Source: Guasch (2004)

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Contract Features and the Incidence of Renegotiated: Determinants Feature Incidence of renegotiation

(percent) Award criteria

Lowest tariff 60

Highest transfer fee 29

Regulation criteria

Investment requirements (regulation by means) 70

Performance indicators (regulation by objectives) 18

Regulatory framework

Price cap 59

Rate of return 16

Existence of regulatory body

Regulatory body not in existence 62

Regulatory body in existence 23

Impact of legal framework

Regulatory framework embedded in contract 61

Regulatory framework embedded in decree 41

Regulatory framework embedded in law 18 Source: Guasch (2004).

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I. PROBIT ANALYSIS

II. Award Criteria

Selecting the highest transfer fee decreases the probability of renegotiation by 30-40%Selecting minimum tariff increases the probability of renegotiation by 30-40%

II. Proper Regulatory Body in Place

Having in place a proper regulatory body decreases the probability of renegotiation by 40-50%.If regulatory body is part of Ministry (thus not autonomous) increases the probability of renegotiation by 20-30%

III. Proper Regulatory Type Framework

Having a Price Cap Regime increases probability of renegotiation by 15-30%Having a Rate of Return Regime increases probability of renegotiation by 15-30%

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Significant Variables and Largest Marginal Effects

Award Criteria 25 to 40%

Existence of Proper Regulatory Body 40 to 50%

Type of Regulation

(Price Caps vs. Rate of Return) 20 to 30%

Regulating by Means (Investment) vs.

Regulating by Objectives (Parameter) 15 to 30%

Nationality of Operator 15 to 20%

Autonomy of Regulator 10 to 35%

Political Cycle 10 to 20%

Macro Shocks 15 to 25%

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Other significant variables

Existence of investment obligation increases the probability of renegotiationThe longer the duration of the concession the lower the probability of renegotiationThe stronger the legal groundings (law, decree, contract) of regulatory framework the lower the probability of renegotiationReputation effect

As the country has renegotiations incidence the probability of renegotiation increases (there might be also a learning effect)

Competition: number of bidders The greater the number of bidders the higher the probability of renegotiation

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ISSUES ON RENEGOTIATION

FINANCIAL EQUILIBRIUMSANCTITY OF THE BID: R= PQ-0C-T-D<rKiREGULATORY ACCOUNTINGINCOMPLETE CONTRACTSINFORMATIONAL ASSYMETRIESCONTINGENT EVENTS

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Regulatory Accounting: Deficiencies

Adjusted Results for Water Services Companies (Year Ending March 1992)

As stated As Remodeled

AverageCCA Capital

Employed

CCAOperating

Profit

CCARate ofReturn

AverageCCA Capital

Employed

CCAOperating

Profit

CCARate ofReturn

(£ million) (£ million) (percent) (£ million) (£ million) (percent)

Anglian 10,531.3 164.9 1.6% 907.5 192.1 21.2%

Northembria 3,252.9 27.5 0.8% 89.0 39.0 43.5%

North West 18,860.0 206.6 1.1% 1,094.9 224.0 20.5%

Severn Trent 19,847.7 168.9 0.9% 1,053.3 232.2 22.0%

Southern 9,528.8 43.6 0.5% 469.1 68.6 14.6%

South West 3,629.4 59.2 1.6% 479.9 65.9 13.7%

Thames 34,267.7 194.7 0.6% 1,513.0 216.0 14.3%

Welsh 7,396.2 102.3 1.4% 429.4 126.7 29.5%

Wessex 5,242.0 44.1 0.8% 334.0 56.6 17.0%

Yorkshire 11,875.8 97.1 0.8% 958.8 117.2 12.2%

TOTALS 124,431.8 1,108.9 0.9% 7,329.4 1,338.3 18.3%

Source: Carey, Cave, Duncan, Houston, Langford 1994.

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Common Questionable Actions That Need To Be Addressed Through Regulatory Accounting

Management fees—often equivalent to half of the firm

net’s profits Contracting subsidiaries or related companies to provide

services or equipment at significantly higher prices than standard market prices Accuracy of reported investments Transfer of accumulated profits into the regulated capital

base Transfer of capital in non-regulated areas of the firm into

the regulated capital base of the firm Valuation of pre-privatized assets at replacement costs Using, when convenient, past performance as

justification for demands for future higher tariffs Financial equilibrium, yes but based on best practices

and the sanctity of the bid

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Lessons: Efforts Should be Placed in Properly Addressing:

I. Pre-Concession Issues

II. Concession Design Issues

III. Concession Award Issues

IV. Regulatory Issues

a) Institutionalb) Economic/Technicalc) Administrative Procedures

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Instruments for Regulation

Information!!!

Cost Model

Financial Model

Regulation Accounting & Standards

Benchmarking

Efficiency Measures

Tariff Structure

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LESSONS AND DESIGN FOCUS: Key determinants of Sector Performance: o Design of Concession o Regulatory Framework: inducing firms to produce at

efficient costs and aligning tariffs with costs

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Key Lessons: Concession Design

Assign Concession through Competitive BiddingHigh transparency of processCommunications campaign if neededPerformance Bond: should be binding: 2% of total value of contract or 20% of estimated annual revenueAward Criteria: transfer price (annual or lump sum) vs minimum tariffRespect for and enforcement of the sanctity of the bid at the time of the auctionDissuasion through financial incentives of opportunistic renegotiations and development of a credible commitment to the non-renegotiation of opportunistic petitionsCostly unilateral changes of the agreed-upon contractual terms of the concession

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Key Lessons: Regulatory FrameworkRegulatory credibilityAn incentive-based regulatory frameworkPrice caps vs rate of return vs revenue capsPerformance Indicators rather than investment commitmentsAppropriate regulatory and antitrust legislationAutonomous regulatory institutions, well-trained and well-

compensated professionals, and effective enforcementIssues with regulation by contract.Informational requirements to operators and regulatory accounting system should be stated in the contractAn appropriate set of regulatory instruments should be used such as cost and financial models, and benchmarking referential dataValuation of Concession AssetsDetermining future tariffsCost of Capital and how should it be determinedConflict resolution rules