REGULATED RATE OF RETURN DETERMINATION 1 This Version: …

REGULATED RATE OF RETURN DETERMINATION 1

This Version: 19 November 2019

Regulated Rate of Return Determination in the Privatized Water Sector in the Philippines

Joel C. Yu, Ph.D.

Associate Professor Cesar E.A. Virata School of Business University of the Philippines Diliman

Correspondence Cesar E.A. Virata School of Business University of the Philippines Diliman UP Campus, Diliman, Quezon City 1101 Philippines Tel. No. (63) 02 928 4571-75. Email: [email protected]

Acknowledgement The author acknowledges the support of the Bangko Sentral ng Pilipinas and the Business Research Foundation of the University of the Philippines. The views expressed in this paper are those of the author and do not reflect the position of the Bangko Sentral ng Pilipinas and the University of the Philippines Cesar E.A. Virata School of Business.


Abstract

The Regulatory Office of the Metropolitan Waterworks and Sewerage System initiated the development of a methodology to institutionalize the determination of the rate of return earned by the operators in the privatized water and wastewater services in Metro Manila and a few adjacent localities. This initiative addresses the inherent regulatory uncertainty in jurisdictions governed by regulation by contracts. Contract incompleteness allows a wide range of possible rate of return determinations that are consistent with the general provisions of the concession contracts. To ensure transparency in its methods and determinations, it is vital for the Regulatory Office to engage the stakeholders in the development of rate of return methodology.


Regulated Rate of Return Determination

in the Privatized Water Sector in the Philippines

Joel C. Yu, Ph.D. Associate Professor

Cesar E.A. Virata School of Business University of the Philippines Diliman

1. Introduction

The Regulatory Office of the Metropolitan Waterworks and Sewerage System (MWSS) determines the rate of return earned by the private operators of water and wastewater services in Metro Manila and a few adjacent localities. In its determination, the Regulatory Office is guided by the relevant provision of the Concession Agreements (CAs) entered into by the MWSS with its two concessionaires: Manila Water Company, Inc. (Manila Water), the operator for the East Concession area1, and Maynilad Water Services, Inc. (Maynilad), the operator for the West Concession area2. The CAs provide for a water tariff that permits the operators to earn a rate of return “being allowed from time to time to operators of long-term infrastructure concession arrangements in other countries having a credit standing similar to that of the Philippines” (Concession Agreements, 1997, p. 44). In the determination of this rate of return, referred to in the contract as the Appropriate Discount Rate, or simply ADR, the CAs give general guidance to the Regulatory Office. A review of the rate of return determinations for the privatized water operators of the MWSS shows consistency between the general guidance of the CAs and the ADR determinations. But this guidance can be consistent with a wide range of estimates, creating regulatory uncertainty for the stakeholders.

1 The East concession area covers the East Zone of Metro Manila and Rizal Province, consisting of 23 cities and municipalities. These include parts of Makati, Mandaluyong, Pasig, Pateros, San Juan, Taguig, Marikina, most parts of Quezon City, San Andres and Sta. Ana in Manila, as well as the following cities and towns in Rizal: Angono, Antipolo, Baras, Binangonan, Cainta, Cardona, Jalajala, Morong, Pililia, Rodriguez, San Mateo, Tanay, Taytay, and Teresa.

2 The West concession area consists of 17 cities and municipalities: Manila (all but portions of San Andres and Sta. Ana), Quezon City (west of San Juan River, West Avenue, EDSA, Congressional, Mindanao Avenue, the northern part starting from the Districts of Holy Spirit and Batasan Hills), Makati (west of South Super Highway), Caloocan, Pasay, Parañaque, Las Piñas, Muntinlupa, Valenzuela, Navotas and Malabon, all in Metro Manila; the cities of Cavite, Bacoor and Imus, and the towns of Kawit, Noveleta and Rosario, all in the Province of Cavite.


To address this regulatory uncertainty, the Regulatory Office initiated the development of a methodology to institutionalize its rate of return determination. To ensure transparency in its methods and determinations, it is vital for the Regulatory Office to engage the stakeholders in the development of rate of return methodology. Section 2 develops a theoretical framework to establish the relevance of regulatory rate of return determination in achieving a competitive outcome in natural monopolies. Section 3 is a brief narration of the privatization of the MWSS and characterizes the regulatory regime that governs the privatized water and wastewater services in its jurisdiction. Section 4 provides a chronology and analysis of the rate of return determination since the privatization of the MWSS. Section 5 concludes.

2. Theory

Markets are generally a good way to organize economic activities. The interactions of self-interested economic agents result in an optimal economic outcome. Goods are produced at a quality and price that allocates scarce resources and achieves maximum economic welfare. However, market failures may require government intervention. One case of such market failure pertains to the nature of the industry where sellers have market power in determining the availability, quality, and price of a good. In the case of a natural monopoly, high start-up costs and significant economies of scale make one firm as the most cost efficient market structure. Natural monopolies are regulated to protect consumers, while ensuring that the firm remains viable and has incentives to operate efficiently. Tirole (1988) demonstrated the Bertrand paradox which shows that oligopolists behave like competitive firms. The Bertrand model is a basic model of price competition and serves as a foundation in pursuing alternative models. Here, the model presented and modified to establish the relevance of regulatory rate of return in achieving a competitive outcome in natural monopolies.


2.1 Bertrand model3

Assume two firms that sell identical products and has the same cost structure. In addition, these firms meet only once: they simultaneously and non-cooperatively compete in price. Consumers buy from the seller that charges the lower price. If the two firms charge the same price, each firm gets half the market. Define the market demand function as:

(1) ! = $(&) Predicated on having the same cost structure, the two firms have the same average production cost, c. The profit of firm i is:

(2) () &), &+ = (&) − -)$)(&), &+) The demand for firm i’s output, Di(pi, pj), is given by:

(3) $) &), &+ =$) &) ./&) < &+

12 $) &), &+ ./&) = &+

0 ./&) > &+

Let the aggregate profit and monopoly profits be given by

(4) Aggregate profit: (1 + (2 (5) Monopoly profit: (6 = max

:;&6 − - $(&6)

By charging a price higher than the marginal cost, c, each firm can enjoy a non-negative profit. A reasonable prediction must yield the following:

(6) 0 ≤ (1 + (2 ≤ (6 The two firms engage in a simultaneous and non-cooperative competition in price. Each firm does not have information on the price that will be charged by its competitor. Each firm anticipates a competitor price that will maximize profits. We simplify that each firm anticipates the competitor price correctly.

3 This is based on the demonstration of Tirole (1988) in his book, Theory of Industrial Organization.


We define a Nash equilibrium in prices—the Bertrand equilibrium— as a pair of prices, (&)∗, &+∗), that maximizes each firm’s profits given the other firm’s price:��

� �� ()(&)∗, &+∗) ≥ ()(&) , &+∗)� The unique equilibrium solution of the model is a pair of prices (&1∗, &2∗) such that the two firms charge a competitive price.

(8) &1∗ = &2∗ = - This is referred to as a paradox since the number of firms in an industry is irrelevant in the study of price. Provided that the oligopolists engage in non-cooperative competition in price, the competitive market outcome is achieved: firms price at marginal cost and do not earn economic profits. 2.2 Modified Bertrand Model

We modify the Bertrand model to represent the regulatory regime that governs the water and wastewater sector in the jurisdiction of MWSS. We maintain the assumption that there are two firms with the same cost structure. Each firm incurs a unit production cost, c. We proceed with a new assumption that the first firm is an incumbent monopolist and the second firm is a potential entrant. The first firm maintains its monopoly of the market as long as it can match the price of the potential entrant. Otherwise, the potential entrant serves the entire market. Accordingly, the firm demand for the incumbent is given in equation (9); the firm demand for the potential entrant is given in equation (10).

(9) $1 &1, &2 =$1 &1 ./&1 ≤ &2

0 ./&1 > &2

(10) $2 &1, &2 =$2 &2 ./&1 > &2

0 ./&1 ≤ &2

The incumbent, firm 1, loses its monopoly of the market if &1∗ > &2∗. If the incumbent charges a price &1∗ ≤ &2∗, it will maintain its monopoly. It is to be best interest of the incumbent to set a price that matches the price of the potential entrant.

(11) &1 = &2∗ − ? In this case, the incumbent continues to serve the entire market ! = $ &1 = $(&2∗ − ?) and enjoys a margin of &2∗ − ? − -.


Since both firms will not charge a price below its cost, c, there is an incentive for both firms to charge a price that is exactly equal to c and monopolize the market. Consequently, a perfectly competitive outcome is achieved. 2.3 Rate of Return Determination in Regulation

A regulator conceives of a notional potential entrant during rate setting for a natural monopolist. The regulator estimates the efficient cost of operation of the potential entrant and sets a price that equates the rate of return to the cost of capital. This limits the economic profit to zero: In the absence of monopoly rent, the investors of the firm are compensated with nothing more than the time value of money plus an appropriate premium for risk. The determination of the cost of capital is a key element in ensuring a competitive outcome in regulated industries. If the cost of capital is underestimated, investors do not have sufficient incentives to fund the capital expenditures of the firm. Investors will move their investments to other business interests. On the other hand, if the cost of capital is overestimated, investors enjoy ample incentives and may tend to overinvest in capital expenditures. Most determinations employ the weighted average cost of capital (WACC) based on the premise that firms employ debt and common equity. The proportions of debt and equity capital correspond to the optimal capital structure. The cost of debt is generally estimated based on the yields of related debt instruments. The cost of equity is commonly estimated using the Capital Asset Pricing Model (CAPM).

3. The MWSS Privatization Story

3.1 Creation and Privatization of the MWSS

In 1971, Republic Act (R.A.) 6234 created the MWSS to own and have jurisdiction over the Metro Manila, Rizal, and the cities of Cavite, Bacoor and Imus, and the towns of Kawit, Noveleta and Rosario, all in the Province of Cavite. Among its functions are the provision of water and wastewater services over its jurisdiction and to fix water rate and sanitary sewerage fees. In the 1990s, it was evident that the MWSS was not efficiently operated and failed to fulfill its mandate to provide water and sanitation services within its jurisdiction. (Refer to Table 1.) Preparations were made to pave the way for the privatization of the MWSS. (Refer to Table 2.) In 1997, the MWSS was privatized. The jurisdiction of the MWSS was divided into the East and West Concession zones. After a competitive bidding, the East zone was awarded to Manila Water, a joint venture between Ayala corporation and United Utilities Bechtel; the West zone was awarded to Maynilad, a joint venture between Benpres Holdings Corporation and Suez Lyonnaise de Eaux.


The MWSS was privatized through concession agreements with the winning bidders. (Refer to Table 3 for the contents of the CAs.) These contracts define the obligations of the parties and the retained functions of the MWSS after the privatization (Articles 5 to 8) as well as the provisions on rates and connection charges (Article 9). A key feature of these CAs is the creation of a Regulatory Office (Article 11) with functions and powers described in Exhibit A.

Table 1. MWSS Service Compared to Other Major Asian Cities

City Population (millions)

Water Availability (hours/day)

Water Coverage (% of population)

NRW* (% of production)

Staff per 1,000 connections

Manila 10.6 16 58.7 63 9.8 Singapore 3.0 24 100.0 7 2.0 Hong Kong 6.3 24 100.0 36 2.8 Seoul 10.6 24 100.0 35 2.3 Kuala Lumpur 1.4 24 100.0 36 1.4 Bangkok 7.3 24 82.0 38 4.6 * NRW: Non-revenue water

Source: Second Water Utilities Data Book, Asian and Pacific Region, Asian Development Bank, October 1997, as cited by Wu Xun & Malaluan (2011)

Table 2. Privatization of MWSS: Chronology of Events

Date Event 1994

July President Ramos creates MWSS Privatization Committee. Initial research done 1995

June Congress passes the “Water Crisis Act”� �� July French government approves grant for technical aspect of privatization study

September Local bank agrees to finance remaining cost of privatization advisory contract November 10 MWSS engages IFC as the lead adviser for privatization

1996 March Registration of interested investors

May “Data room” opened to interested companies that pay the fee July MWSS Board approves privatization strategy

August Start of formal prequalification of bidders Oct/Nov Prenegotiation of contract with bidders

December Final approval of prequalified bidders Final tender documents issued� President Ramos approves privatization strategy

1997 January 6 President Ramos approves Concession Agreement Submission of bids Jan. 7–22 Evaluation of technical bids

January 23 Opening of bids January 31 MWSS Board endorses recommendation of award to Committee on Privatization

(COP)� February 21 COP endorses recommendation of award to President Ramos

Concession agreements signed August 1 Concessionaires take over operations

Source: Dumol (2000)


Table 3. 1997 MWSS Concession Agreement Article Title

Article 1 Definitions Article 2 Appointment Article 3 Transitional Arrangements Article 4 Representations and Warranties Article 5 Service Obligations of the Concessionaire Article 6 Other Obligations of the Concessionaire Article 7 Obligations of MWSS Article 8 Retained Functions of MWSS Article 9 Rates and Connection Charges

Article 10 Events of Early Termination; Penalties Article 11 Regulatory Office Article 12 Dispute Resolution Article 13 Information and Reporting Requirements Article 14 Indemnities Article 15 Conditions Precedent Article 16 Miscellaneous

Source: Concession Agreements (1997) 3.2 Rate Setting and Rate of Return Determination in the Privatized MWSS

The CAs provide for the following general rate setting policy / rate rebasing determination. Section 9.4 General Rate Setting Policy / Rate Rebasing Determination

xxx the rates for water and sewerage services provided by the Concessionaire shall be set at a level that will permit the Concessionaire to recover over the 25-year term of the Concession… operating, capital maintenance, and investment expenditures efficiently and prudently incurred, Philippine business taxes and payments corresponding to debt service on the MWSS Loans and Concessionaire Loans incurred to finance such expenditures, and to earn a rate of return (referred to herein as the “Appropriate Discount Rate”) on these expenditures for the remaining term of the Concession in line with the rates of return being allowed from time to time to operators of long-term infrastructure concession arrangements in other countries having a credit standing similar to that of the Philippines.

The CAs also provide a definition of the appropriate discount rate (“ADR”) and general guidelines in its computations.

“Appropriate Discount Rate” means, at any time, the real (i.e., not inflation adjusted) weighted average cost of capital (after taxes payable by the concession business). In determining the Appropriate Discount Rate, the Regulatory Office shall apply conventional and internationally accepted methods, and in particular shall make estimates of the cost of debt in domestic and international markets, the cost of equity for utility businesses in the Philippines and abroad and shall make adjustments to such estimates to reflect country risk, exchange rate risk and any other project risks.


The Regulatory Office, at its sole discretion, may consider the Concessionaire’s rate of return, either stated or implied in its bid, in determining the Appropriate Discount Rate.

The definition of ADR provides two elements in its determination. The first element is mandatory and requires an objective determination of the costs of debt in domestic and international markets and equity for utility businesses in the Philippines and abroad adjusted to reflect country risk, exchange rate risk and any other project risk. The second element is discretionary, allowing the Regulatory Office, “at its own discretion,” to consider the Concessionaire’s rate of return, either stated or implied in its bid, in determining the ADR.

4. Rate of Return Determination: A Chronology and Analysis

This section provides a chronology and analysis of the ADR determinations. It shows the nuances in the estimates of the ADR parameters and analyzes underlying assumptions in those estimates. 4.1 Arbitration 2000

On 30 March 1998, Manila Water filed a petition for Extraordinary Price Adjustment (EPA). The CA provides for such price adjustment to account for the financial consequences of unforeseen events during the term of the concession (Section 9.3 Extraordinary Price Adjustments). In its petition for EPA, Manila Water identified the following grounds for the EPA4:

1. The 52% devaluation of the Philippine peso compared with the benchmark exchange rate of December 6, 1996 assumed in the bid.

2. The reduction in water supply by nearly 35% brought about by El Niño and changes in government rules or orders affecting raw water allocation.

3. The material deterioration of the water distribution network and a significant increase in employee salaries during the transition period resulting in higher operating costs and capital expenditures.

4. The further expected increase in the Concession Fee due to anticipated Cost Overrun of Existing Projects.

4 Final Award: Arbitration No UNC24/HGN/OL between Manila Water Company Inc. and Metropolitan Waterworks and Sewerage System and the Regulatory Office. (8 August 2000).


Manila Water petitioned an increase of Php3.23 per cubic meter in the average basic water rate for the period 1999 to 2002 and Php 0.97 per cubic meter for the balance of the term of the concession. Eventually, Manila Water proposed a positive EPA that will continue until the end of the term of the concession. The petition was initially premised on an ADR of 18% but was later reduced to 15%. The Regulatory Office granted an EPA; However, it limited the adjustment in the basic water rate to Php0.0425 per cubic meter. The determination of the Regulatory Office is based on an ADR of 5.2% which was used by Manila Water in its bid. Manila Water appealed the determination of the Regulatory Office before an Arbitration Panel following the relevant provisions of the CA (i.e., Section 9.3.3: Concessionaire’s Right of Appeal and Section 12: Dispute Resolution). Manila Water presented an expert opinion that the ADR is in the range of 13.3% to 15.9% in the long term and 15% to 21.8% for the short term. On balance, the short- and long-term composite range is 14.0% to 16.0%. On the other hand, the Regulatory Office argued that the ADR should be the 5.2%, i.e., the rate of return implied in the bid of Manila Water. On 8 August 2000, the Arbitration Panel issued the Final Award on the case which provides details of the ADR that it used in the determination of the EPA for Manila Water. (Refer to Table 4.) The Arbitration Panel viewed that the Regulatory Office cannot disregard the first element: The Regulatory Office must either consider the first element alone or consider both together. However, it cannot consider the second element alone. In case the Regulatory Office exercises its discretion to employ the second element of the ADR definition, the Arbitration Panel considered it appropriate to adjust the figure obtained in the first element, either up or down, to reflect the higher or lower rate of return in the bid. 4.2 Rate Rebasing

Every five years, the Regulatory Office implements the rate rebasing to determine an adjustment in water tariff. First Rate Rebasing. In the initial rate rebasing, the Regulatory Office had to determine the two ADRs. One ADR is applied on the historical cash flows to determine the opening cash position, i.e., the unrecovered investments of the concessionaires. Another ADR is applied in the future cash flows. (UPEcon, 2002) For the historical cash flows, two ADRs were determined: one for each concessionaire. For Maynilad, the ADR was 10.4%, the rate of return implied in the bid. In contrast, for Manila Water, the ADR was 8.8%, the weighted average of the 5.2% implied in the bid and the 9.3% determined by the Appeals Panel. The weights were based on the bid price of the Manila Water and the adjusted water tariff in the future cash flow.


In discounting the future cash flows, the Regulator Office determined one ADR of 10.4% for both concessionaires. At this stage, the rate of return for a notional water operator was implied in the decision of the Regulatory Office. This was sustained for the succeeding rate rebasing. In the determination of the ADR to discount future cash flows, a suitable range was determined based on the estimates of the components of the WACC. (UPecon, 2000, Appendix F) A summary of the estimates for these component is presented in Table 5. Below are the highlights of the estimates: First, the risk-free rate was estimated using the one-year average yield of a ten-year USD-denominated bond issued by the Philippine government. To estimate the risk-free rate in real terms, the average yield was adjusted for inflation using the 10-year average inflation rate in the US.

• The risk-free rate used in estimating the cost of debt is the same as that used in estimating the cost of equity. This suggests that the creditors and the shareholders have the same time horizon of ten years. They are differentiated only by their degree of risk aversion.

• Using the yields of a Philippine sovereign bond suggests that a country risk premium is

embedded in the estimates of both the cost of debt and equity.

• Lastly, the one-year averaging period implies that the risk-free rate estimate is a measure of the compensation for the time value of money that prevails during the rate rebasing year.

Second, the debt premium was estimated from the prevailing yields of commercial bonds. The equity premium was estimated based on the CAPM: the equity beta was estimated at 1.00 and the market risk premium was estimated at 6.00. The former was based on comparators while the latter is based on the market risk premium in the US as reported in academic literature. Third, WACC estimates were made based on the fact that the concessionaires had a five-year income tax holiday. During these years, the concessionaires do not enjoy the tax shield from interest expense. This was properly reflected in estimating the cost of debt. Second Rate Rebasing. In the second rate rebasing, the determination of the ADR seem to draw from the method used in the previous rate rebasing. However, there were several modifications made in the estimates of the WACC components. First, the risk-free rate was estimated using the five-year average yields of 15-year Philippine bonds.

• Two facets of the approach in the previous rate rebasing were maintained: First, the risk free-rate was the same for the cost of debt and the cost of equity. Second, the country risk premium is implied in the risk-free rate since it was estimated using the average yields of bonds issued by the Philippine government.


• There are also a couple to changes made in the estimates of the risk-free rate. First, the

tenor of the Philippine sovereign bond was raised from 10 years to 15 years. Second, the averaging period was altered from one year to five years. There was no explicit reason provided in the change in the tenor of the Philippine bond used in estimating the risk-free rate. As regards the averaging period, it was argued that it is fairer to use an average than either the highest or lowest rates.

The risk premia for debt and equity were based on the following:

• The risk premium for debt was based on prevailing yields of commercial bonds.

• The risk premium for equity was raised to 7.0%. This implies the retention of the equity beta of 1.00 but a higher market risk premium. This risk premium seems to be based on the higher end of the range of long-run average market risk premium in the US.

Third Rate Rebasing and Rate Rebasing Review. In the third rate rebasing, the Regulatory Office initiated efforts to institutionalize its determinations. Methods were developed and procedures were drafted in the conduct of the rate rebasing. The initiative also includes a proposed method in the determination of the ADR. The proposed method for the determination of the ADR adopted use of yields of a Philippine sovereign bond with a tenor of ten years. It also specified the cut-off date for a five-year averaging period. However, for the third rate rebasing, the Regulatory Office considered to use a three-year averaging period to exclude observations during the global financial crisis in 2008 to 2009. As regards the risk premium for debt, the proposed method adopted the use of yields of a US corporate bond with a rating that corresponds to the sovereign rating of the Philippines. Consistent with the estimate of the risk-free rate, the Regulatory Office also adopted a five-year averaging period in the estimate. With regard to the risk premium for equity, the proposed method is the forward-looking market risk premium in the US equity market. Employing the dividend discount model, a five-year averaging period was used in the estimate. The estimate for the equity beta was based on the asset beta of the industry and the assumed optimal capital structure of a notional water operator in an emerging economy like the Philippines. The debt beta is implicitly assumed to be zero. The concessionaires disputed he determinations of the Regulatory Office in the third rate rebasing. They availed of the remedy available to them in the CAs (Article 12 Dispute). Two separate arbitration were initiated to resolve disputed issues in the tariff adjustments. Among the disputed items is the determination of the ADR. In the arbitration case between Manila Water and the MWSS and the Regulatory Office, all the disputed items were resolved by the parties except for the issue on the recoverability of the corporate income tax in the tariff determination. A rate rebasing review was done by the


Regulatory Office to resolve the issues on the ADR determination. It resolved to employ a five-year averaging period in the estimates for the risk-free rate, the debt margin, and the market risk premium. It also resolved to develop a framework in the determination of the ADR, addressing issues on the tenor of the risk-free rate and the method in estimating the market risk premium. Fourth Rate Rebasing. In the fourth rate rebasing, the approach in the rate rebasing review was carried forward except in the estimates for the risk-free rate and the market risk premium. Until the fourth rate rebasing, the Regulatory Office has been consistent in its assumption that the investment horizon of creditors and equity investors are the same; The only difference between them is their degree of risk aversion. Thus, the tenors of the risk-free rate instrument for both debt and equity are the same. In the fourth rate rebasing, the Regulatory Office used yields of a ten-year tenor Philippine sovereign debt in estimating the cost of debt and yields of a similar debt instrument with a 20-year tenor in estimating the cost of equity. The choice of the 20-year tenor is based on the premise that equity investors lock-in their investments until the end of the concession period. The ten-year tenor was maintained which is consistent with the tenor of the debt instruments of the concessionaires. As regards the market risk premium, the Regulatory Office adjusted the forward-looking US market risk premium using the relative volatility of the Philippines and the US equity markets. Such adjustment virtually imputes a country risk premium in addition to what has been imputed in the risk-free rate. In sum, this review of the rate of return determinations shows consistency between the general guidance of the CAs and the ADR determinations. In all these instances, the Regulatory Office determined the ADR largely based on the proposed ADR of the concessionaires and the advice of its consultants. The methodology that was used in these determinations were not formally adopted to guide the succeeding determinations.


Table 4. Appropriate Discount Rate: Appeals Panel 2000

Variables Determination Remarks No Tax W/ Tax 1. Gearing g 60% 60% 2. Cost of Debt

Real Risk-free Rate, PH Rf = (iPH – πe) 7.00% 7.00% Inclusive of a country risk premium of 3.5%; long-term implied rate Nominal PH Risk-free rate iPH Less: Expected Inflation rate Πe

Debt Margin RPDebt=Credit Spread+Refi 1.50% 1.50% Credit Spread Credit Spread 1.50% 1.50% Assumes CAPM: Debt beta is 0.25 and market premium is 6.0% Refinancing Cost Refi

Cost of Debt (pre-tax) RD, pre-tax = rf + RPDebt 8.50% 8.50% Tax Rate T 0.0% 32.0% Manila Water had five-year income tax holiday Cost of Debt (post-tax) rD = (1 – T) RD, pre-tax 8.50% 5.78% 7.14%

3. Cost of Equity Risk-free rate Rf 7.00% 7.00% Same as the risk-free rate of the cost of debt

Nominal PH Risk-free rate iPH Less: Expected Inflation rate Πe

US Equity Risk Premium RPEquity = bEquity*MRP 6.75% 6.75%

Asset Beta bAsset 0.60 0.60 bAsset = 0.60 based on comparators Equity Beta bEquity =[1/(1-g)][ bAsset-(g)bDebt] 1.125 1.125 Derived from bAsset = 0.6; bDebt = 0.25; and g = 60% Market Risk Premium MRP 6.00% 6.00% Range: 6% - 8%

Cost of Equity rE 13.75% 13.75% 13.75% 4. Appropriate Discount Rate Pre-tax ADR = g*rD, pre-tax + (1-g)rE 10.60% 10.60% Post-tax ADR = g*rD, post-tax + (1-g)rE 10.60% 9.00% 9.81%

Adjustment -0.50% Adjustment: Discretionary determination Post-tax, adjusted 9.30% Rounded to single digit: 9.30%


Table 5. Appropriate Discount Rate: Rate Rebasing 2002

Note: In the first rebasing, an ADR was determined to be applied for the historical cash flows to compute for the Opening Cash Position. For Manila Water, the ADR was 8.8%. This is the weighted average of 5.2% and 9.3%. The lower bound of 5.2% is the implied rate of return in the bid of Manila Water; The upper bound of 9.3% is based on the ADR determination of the Appeals Panel in 2000. The weight for 5.2% is the ratio between the baser tariff of Php2.32/m3 and total tariff throughout the life of the concession. For Maynilad, the ADR was 10.4%, the rate return implied in its bid and proposed by the concessionaire. In discounting the future cash flows, the ADR was 10.4% for both concessionaires. Source of basic data: MWSS Regulatory Office

Variables Determination Remarks Low High Ave 1. Gearing g 60% 60% 2. Cost of Debt

Real Risk-free Rate, PH Rf = (iPH – πe) 7.40% 7.40% Nominal PH Risk-free rate iPH 10.06% 10.06% One-year average, 10-year USD-denominated PH bond Less: Expected Inflation rate Πe 2.66% 2.66% 1992-2001 average US inflation rate

Debt Margin RPDebt=Credit Spread+Refi 1.00% 2.50% Credit Spread Credit Spread 1.00% 2.50% Range: 1.00% - 2.50% Refinancing Cost Refi

Cost of Debt (pre-tax) RD, pre-tax = rf + RPDebt 8.40% 9.90% Tax Rate T 24.00% 24.00% T=24.0%=(5/20)*0% + 15/20*32%; five-year income tax holiday Cost of Debt (post-tax) rD = (1 – T) RD, pre-tax 6.38% 7.52% 6.95%

3. Cost of Equity Risk-free rate Rf 7.40% 7.40% Same as the risk-free rate of the cost of debt

Nominal PH Risk-free rate iPH 6.03% 6.03% Less: Expected Inflation rate Πe

US 2.24% 2.24% Equity Risk Premium RPEquity = bEquity*MRP 6.00% 6.00%

Asset Beta bAsset Equity Beta bEqu 1.000 1.000 Comparators & regulatory precedent (Appeals Panel 2000 decision) Market Risk Premium MRP 6.00% 6.00% US market risk premium, based on literature

Cost of Equity rE 13.40% 13.40% 13.40% 4. Appropriate Discount Rate* Pre-tax ADR = g*rD, pre-tax + (1-g)rE 10.40% 11.30% 10.85% Post-tax ADR = g*rD, post-tax + (1-g)rE 9.19% 9.87% 9.53% The ADR in discounting future cash flows is 10.4%

Adjustment Post-tax, adjusted



Source of basic data: MWSS Regulatory Office

Variables Determination Remarks 1. Gearing g 50% 2. Cost of Debt

Real Risk-free Rate, PH Rf = (iPH – πe) 6.30% Nominal PH Risk-free rate iPH 8.80% Five-year average yield, USD-denominated 15-year PH Bonds Less: Expected Inflation rate Πe 2.50% US inflation forecast

Debt Margin RPDebt=Credit Spread+Refi 1.50% Credit Spread Credit Spread 1.50% Comparators Refinancing Cost Refi

Cost of Debt (pre-tax) RD, pre-tax = rf + RPDebt 7.80% Tax Rate T 31.00% Cost of Debt (post-tax) rD = (1 – T) RD, pre-tax 5.38%

3. Cost of Equity Risk-free rate Rf 6.30% Same as the risk-free rate of the cost of debt

Nominal PH Risk-free rate iPH 8.80% Less: Expected Inflation rate Πe

US 2.50% Equity Risk Premium RPEquity = bEquity*MRP 7.00%

Asset Beta bAsset 0.50 Implied Equity Beta bEquity 1.00 Implied Market Risk Premium MRP 7.00%

Cost of Equity rE 13.30% 4. Appropriate Discount Rate Pre-tax ADR = g*rD, pre-tax + (1-g)rE 10.55% Post-tax ADR = g*rD, post-tax + (1-g)rE 9.30%





Variables Determination Remarks 1. Gearing g 40% Comparators 2. Cost of Debt

Real Risk-free Rate, PH Rf = (iPH – πe) 2.41% Nominal PH Risk-free rate iPH 4.43% Three-year average yield, USD denominated 10-year PH Bonds Less: Expected Inflation rate Πe 2.02% Inflation forecasts: WB, Bloomberg, Economist Intelligence Unit

Debt Margin RPDebt=Credit Spread+Refi 2.00% Credit Spread Credit Spread 1.75% Comparators Refinancing Cost Refi 0.25% Refinancing cost

Cost of Debt (pre-tax) RD, pre-tax = rf + RPDebt 4.41% Tax Rate T 0.00% Corporate Income Tax is not recoverable, T=0 Cost of Debt (post-tax) rD = (1 – T) RD, pre-tax 4.41%


Nominal PH Risk-free rate iPH 4.43% Less: Expected Inflation rate Πe

US 2.02% Equity Risk Premium RPEquity = bEquity*MRP 6.89%

Asset Beta bAsset 0.50 Comparators Equity Beta bEquity = bAsset/(1-g) 0.83 Derived from bAsset Market Risk Premium MRP 8.27% 3-year average implied market risk premium in the US

Cost of Equity rE 9.30% 4. Appropriate Discount Rate Pre-tax ADR = g*rD, pre-tax + (1-g)rE 7.35% Post-tax ADR = g*rD, post-tax + (1-g)rE 7.35%



Table 8. Appropriate Discount Rate Determination: Rate Rebasing Review 2014



Real Risk-free Rate, PH Rf = (iPH – πe) 3.14% Nominal PH Risk-free rate iPH 5.38% Five-year average yield, USD denominated 10-year PH Bonds Less: Expected Inflation rate Πe 2.24% Inflation forecast

Debt Margin RPDebt=Credit Spread+Refi 2.57% Credit Spread Credit Spread 2.27% Five-year average yield, US Corporate bond, BBB composite Refinancing Cost Refi 0.30% Refinancing cost

Cost of Debt (pre-tax) RD, pre-tax = rf + RPDebt 5.71% Tax Rate T 30.00% Statutory Corporate Income Tax Rate Cost of Debt (post-tax) rD = (1 – T) RD, pre-tax 3.99%


Nominal PH Risk-free rate iPH 5.38% Less: Expected Inflation rate Πe 2.24%

Equity Risk Premium RPEquity = bEquity*MRP 6.88% Asset Beta bAsset 0.50 Comparators Equity Beta bEquity = bAsset/(1-g) 0.83 Derived from bAsset Market Risk Premium MRP 8.25% 5-year average implied market risk premium in the US

Cost of Equity rE 10.02% 4. Appropriate Discount Rate Pre-tax ADR = g*rD, pre-tax + (1-g)rE 8.29% Post-tax ADR = g*rD, post-tax + (1-g)rE 7.61% 5. Adjustment

Post-tax, adjusted ADR


Table 9. Appropriate Discount Rate Determination: Arbitration 2017



Real Risk-free Rate, PH Rf = (iPH – πe) 1.70% Nominal PH Risk-free rate iPH 3.54% 5-year average yield, USD denominated 10-year PH Bonds Less: Expected Inflation rate Πe 1.84% Inflation forecast

Debt Margin RPDebt=Credit Spread+Refi 2.38% Credit Spread Credit Spread 2.08% 5-year average yield, US Corporate bond, BBB composite Refinancing Cost Refi 0.30% Refinancing cost

Cost of Debt (pre-tax) RD, pre-tax = rf + RPDebt 4.08% Tax Rate T 30.0% Statutory Corporate Income Tax Rate Cost of Debt (post-tax) rD = (1 – T) RD, pre-tax 2.86%

3. Cost of Equity Risk-free rate Rf 2.31% 5-year average yield, USD denominated 20-year PH Bonds

Nominal PH Risk-free rate iPH 4.15% Inflation forecast Less: Expected Inflation rate Πe 1.84%

Equity Risk Premium RPEquity = bEquity*MRP 8.10% Asset Beta bAsset 0.50 Comparators Equity Beta bEquity = bAsset/(1-g) 0.833 Derived from bAsset Market Risk Premium MRP 9.72% 5-year average implied market risk premium in the US + adjustment

Cost of Equity rE 10.41% 4. Appropriate Discount Rate Pre-tax ADR = g*rD, pre-tax + (1-g)rE 7.88% Post-tax ADR = g*rD, post-tax + (1-g)rE 7.39% 5. Adjustment No adjustments

Post-tax, adjusted ADR


5. Concluding Remarks

Wu Xun et. al (2011) note that “although concession agreements constrain the discretionary power of regulatory agencies, contract incompleteness, widespread and unavoidable in water sector, call for more extensive use of discretionary power.” (p. 361). They note that, in the initial years of the MWSS privatization, the CAs were effective in curbing opportunistic behavior. Eventually, the relevance and usefulness of the CAs as the primary regulatory mechanism declined; the regulatory system moved toward discretionary regulation. Over the years, the determination of the ADR in the privatized water distribution in Metro Manila has been changing. A part of these changes reflects the condition in the capital markets; Another part of these changes reflects the modifications in the underlying assumptions in the determination of what is deemed as an “appropriate” rate of return. It can be argued that the determinations of the Regulatory Office and those of the Appeals Panel are all within “conventional and internationally” accepted methods. As such, they are in line with the general provisions of the CAs between the MWSS and the concessionaires. To institutionalize its regulatory determinations, the Regulatory Office has initiated the development of a methodology for ADR computations. Better regulation calls for a rules-based determination of the ADR. Such rules will benefit the stakeholders of the sector. On the part of the concessionaires, a rules-based ADR determination reduces the regulatory uncertainty. Contract incompleteness allows the Regulatory Office ample discretion in identifying a method within a wide range of conventional and internationally accepted approaches in setting a rate of return for a regulatory period. These methods cover the determination on: (1) the specification of the components of the ADR, (2) the estimation of these components, particularly the country risk premium, and the risk premia for debt and equity of utility business operating in the Philippines.


References

Appeals Panel. (August 2000). Arbitration No UNC24/HGN/OL between Manila Water Company Inc. (Claimant) and Metropolitan Waterworks and Sewerage System-Regulatory Office (Respondents): Final Award.

Concession Agreements between MWSS and Manila Water. (1997).

Concession Agreements between MWSS and Manila Water. (1997).

Dumol, M. (2000). The Manila Water Concession: A Key Government Official’s Diary of the World’s Largest Water Privatization. The World Bank.

Energy Regulatory Commission. (May 2011). WACC for Final Determination, Third Regulatory Period: Group 1 Distribution Utilities (Meralco, Cepalco & Decorp). Retrieved from:

ING, (May 2002). Manila Water Company: Rate Rebasing Calculation of Appropriate Discount Rate. Unpublished Manuscript.

Jensen O. & Xun Wu (2017). The Hybrid Model for Economic Regulation of Water Utilities: Mission Impossible? Utilities Policy 48: 122-131.

London Economics. (March 2008). The Appropriate Discount Rate. Unpublished Manuscript.

Medalla, F., et al. (12 December 2007). 2007 Rate Rebasing.

MWSS Regulatory Office (2015). The Bigger Picture: MWSS Regulatory Office Accomplishment Report 2014. MWSS Regulatory Office.

MWSS Regulatory Office (2016). MWSS Tariff Rate Setting: Facts About the Third Rate Rebasing. Unpublished manuscript.

Saldana, Cesar G. (30 May 2002) Re-estimating the ADR for MWSI Based on the RO Consultants’ Assumptions and Using the CAPM in an Emerging Capital Market Environment. Unpublished Manuscript.

Tirole, J. (1988) The Theory of Industrial Organization. MIT Press.

UPecon (December 2002) MWSS Regulatory Office Rate Rebasing Exercise.

Xun Wu & N. Malaluan (2008). A Tale of Two Concessionaires: A Natural Experiment of Water Privatization in Metro Manila. Urban Studies 45(1): 207-229.

Xun Wu, L. Batac, & N. Malaluan (2011). Regulatory Independence and Contract Incompleteness: Assessing Regulatory Effectiveness in Water Privatization in Manila. In Jarvis D., M. Ramesh, Xun Wu, & E. Aralar (Eds.) Infrastructure Regulation: What Works, Why and How Do We Know? Lessons from Asia and Beyond, 261-390. World Scientific.


Xun Wu & L. Ching (2013). The French Model and Water Challenges in Developing Countries: Evidence from Jakarta and Manila, Policy and Society 32(2): 103-112.

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