East Asia Blog Series

Improving Financial Sustainability in the Water Sector through Tariff Reforms

Yi Xu 7 Nov 2023

Water utilities in many cities in the People’s Republic of China may have achieved high level of cost recovery because of increased tariffs.

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Introduction

Good tariff design is one of the key factors in enabling urban water and wastewater treatment systems to achieve full cost recovery and become financially independent. This requires in-depth tariff studies and financial and social analyses to inform policymaking, design tariff increases realistically, and gain public support for necessary reforms.

The experience of the People’s Republic of China (PRC) offers good practices in urban water and wastewater tariff reform for other countries in the region to consider. Since the late 1990s, the economic and enterprise reform programs of the PRC government required all water supply and wastewater management projects to be financially sustainable and capable of cost recovery. The Asian Development Bank (ADB) supported the government’s reform programs through water and wastewater tariff studies and helped finance water and sanitation projects to facilitate policy dialogue with the government and to assist water supply and wastewater treatment companies to achieve full cost recovery.

The Wuhan Wastewater and Stormwater Management Project, completed in 2015, demonstrates how cities can carry out water tariff reforms based on full cost recovery principles and considering local conditions. This article discusses in detail how a system approach to financial forecasting was used to determine a reasonable rate of return for the implementing agency, Wuhan Drainage Company (WDC), and to determine optimal tariff levels.

Three Water Tariff Studies

The preparation of the National Guidelines on Water Tariffs (NGWT) was a major output of the first of three water tariff studies funded by ADB. Promulgated by the National Development and Reform Commission (NDRC) and the Ministry of Construction (MOC) in September 1998, the NGWT reflects the following recommendations of the study: (i) selecting a tariff structure based on local conditions and priorities; (ii) adopting full cost recovery as the main objective in setting and approving tariff levels; (iii) using the public hearings mechanism to disseminate tariff increase plans to the public and obtain their feedback; and (iv) adopting a simplified process for tariff regulation, requiring evaluation and approval at the local municipal government level and supported by review and monitoring at the provincial and national level. The guidelines improved the long-term financial sustainability of the water supply companies and provided sufficient funds for operations and maintenance and service expansion, which would also help increase private sector participation in the water and wastewater sector.

Another water tariff study focused on assisting the government in developing institutional and technical capacities to implement the NGWT.

The PRC policy guidance on setting wastewater tariffs was amended in September 1999 by the government. It called for wastewater tariffs that are based on full cost recovery principles but allowed local governments the flexibility to decide when to adjust tariffs. Implemented between 2002 and 2003, ADB’s wastewater tariff study, the third study, contributed to this initiative to reform wastewater tariffs. The major output of the technical assistance was a detailed draft National Guidelines for Urban Wastewater Tariffs (NGWWT), including (i) Tariff Calculation Methodology, (iii) Model Agreement for Tariff Billing and Collection, (iv) Penalty and Administrative Remedies for Non-payment, and (v) Model Contract for Industrial Discharge to Sewer Network. MOC considered the recommendations in preparing the draft NGWWT to be approved by PRC State Council in 2005.

The Wuhan Project

Processed in 2005 and 2006, the wastewater and stormwater management project in Wuhan City entailed a total investment of $266.4 million, which included a $100 million loan from ADB. It was not a stand-alone investment but an integral part of the basin-wide Yangtze water resources management initiative, the Wuhan city urban development plan, the Wuhan municipal wastewater master plan, and the Wuhan stormwater drainage master plan. The Wuhan Municipal Government was implementing its wastewater master plan by installing additional wastewater treatment plants to achieve its target of 80% wastewater treatment rate by 2010.

In highlighting the project benefits, the Report and Recommendations of the President to the Board of Directors emphasized “improving cost recovery through a better tariff structure, with gradual increases to achieve cost recovery”, and “a demonstration impact on wastewater tariff reform in both the PRC and elsewhere in Asia.”

Historical tariffs. The tariff rates for water and wastewater (see Table 1) applied only to the seven central urban districts of Wuhan, and wastewater charges were based on actual water consumed. Wastewater tariff had not been introduced in suburban Caidian District, while 0.05 yuan/m³ wastewater tariff was levied on top of tap water sold in suburban Dongxihu District.

Table 1: Water and Wastewater Tariffs in Wuhan

	1997	1998	1999	2000	2001	2002	2003	2004	2005
Wastewater tariff
Resident	0.160	0.176	0.192	0.208	0.400	0.400	0.800	0.800	0.800
Public institutions	0.160	0.176	0.192	0.208	0.400	0.400	0.800	0.800	0.800
Industries	0.160	0.176	0.192	0.208	0.400	0.400	0.800	0.800	0.800
Operation and services businesses	0.160	0.176	0.192	0.208	0.400	0.400	0.800	0.800	0.800
Special industry	0.160	0.176	0.192	0.208	0.400	0.400	0.800	0.800	0.800
Water resources fee
Resident	–	–	–	–	0.010	0.010	0.010	0.010	0.010
Public institutions	–	–	–	–	0.010	0.010	0.010	0.010	0.010
Industries	–	–	–	–	0.020	0.020	0.020	0.020	0.020
Operation and services businesses	–	–	–	–	0.020	0.020	0.020	0.020	0.020
Special industry	–	–	–	–	0.020	0.020	0.020	0.020	0.020
Tap water tariff
Resident	0.450	0.450	0.620	0.620	0.700	0.700	0.700	0.700	0.700
Public institutions			0.690	0.690	0.800	0.800	0.800	0.800	0.800
Industries	0.600	0.600	0.880	0.880	1.000	1.000	1.000	1.000	1.000
Operation and services businesses	1.000	1.000	1.460	1.460	1.700	1.700	1.700	1.700	1.700
Special industry			1.660	1.660	1.900	1.900	1.900	1.900	1.900
End user combined tariff
Resident	0.610	0.626	0.812	0.828	1.110	1.110	1.510	1.510	1.510
Public institutions			0.882	0.898	1.210	1.210	1.610	1.610	1.610
Industries	0.760	0.776	1.072	1.088	1.420	1.420	1.820	1.820	1.820
Operation and services businesses	1.160	1.176	1.652	1.668	2.120	2.120	2.520	2.520	2.520
Special industry	0.160	0.176	1.852	1.868	2.320	2.320	2.720	2.720	2.720

Wuhan introduced a low wastewater tariff in 1997 and increased the tariff thereafter. When wastewater tariff was increased in 2003, the municipal government requested special subsidies for urban poor households recorded by the Wuhan Social Affairs Bureau.

The wastewater tariff of 0.80 yuan/m³ in Wuhan was relatively higher than many cities in the PRC as shown in Figure 1. Return on equity (ROE) for the WDC stood at 21.4%, 26.2%, and 19.7% from 2003 to 2005 respectively, showing full cost recovery achieved with the increased tariff at 0.80 yuan/m^3.Many cities charged different wastewater tariffs for different water user categories. It appears a certain level of cost recovery, including full cost recovery for some cities and high-level cost recovery for other cities, would have been achieved among many cities in 2005 based on their tariff levels.

Figure 1: Resident Wastewater Tariff in Some Cities in 2005

Methodologies. For each of the five wastewater treatment plants for the project, a financial cost–benefit analysis was conducted in real terms to determine weighted average cost of capital (WACC), financial internal rate of return (FIRR), and other indicators to assess financial viability of each plant (or subproject) and the incremental tariff required. For the three wastewater treatment plants in the central urban area, the incremental wastewater tariff assumed in the financial cost–benefit analysis was added to the existing wastewater tariff of 0.80 yuan/m³ in Wuhan, which will be levied on top of the water sold in the central urban areas, to arrive at the projected total wastewater tariff revenues for the implementing agency. For the two suburban wastewater treatment plants in Dongxihu and Caidian, which have different and much lower tariffs, the same financial cost–benefit analyses were conducted.

The wastewater tariffs in real terms used in the financial cost–benefit analysis for each of the five wastewater treatment plants were converted into nominal terms, and pro forma financial statements for each plant were separately prepared, projected, and analyzed.

Historical financial statements of WDC, the implementing agency for five wastewater subprojects, were analyzed, and projections were made. Financial statement projections, including income statement, balance sheet, and cash flow statement, were prepared in nominal price terms for a scenario without the project, taking into account major capital expenditures, associated operation and maintenance (O&M) costs, and other related costs and arrangements. Pro forma financial statement projections for the five wastewater treatment plants were consolidated into the financial statement projections for WDC for a scenario with the project.

The financial statement projections for WDC were prepared in nominal price terms and included inflation-adjusted costs and revenues for each year from 2006 to 2018. The consolidated financial statement projections were made to forecast the financial performance of the implementing agency, to assess profitability and debt service ability, and to test the tariff required for WDC to raise funds for project construction and achieve full cost recovery during operation.

Each wastewater treatment plant, or subproject, would normally require relatively higher incremental tariff, and different wastewater treatment plants would demand different tariff increases. All these needed to be tested in the whole system through the financial statement projections for WDC with due consideration to the tariff practice in Wuhan. Return on equity for WDC, based on the proposed tariff increase, would range from 6.0% to 21.4% during the project implementation until 2010 and from 4.3% to 7.5% when the project was operational from 2011 to 2018.

Further assessments and policy dialogue. The tariff arrived from the above analyses still cannot fully justify a proposed tariff increasing plan. Further assessments were needed, such as on customers’ willingness to pay the higher tariff and an affordability analysis. Pro-poor arrangements for urban poor households needed to be in place as well as measures to draw feedback on the planned increase and build public support for it.

Nonrevenue water (NRW), both technical loss and nontechnical loss, are important factors impacting the implementing agency’s financial performance. Reduced NRW due to improved engineering and tariff revenue collection had been assessed and incorporated into the financial cost–benefit analysis and the WDC’s financial statement projections.

For the Wuhan project, policy dialogue with government was proposed to support a realistic tariff reform program. Based on the analyses and assessments, it was recommended that wastewater tariff be increased in 6 years to 1.00 yuan/m³ from the current 0.80 yuan/m³.

Improved public awareness of the benefits accruing from effective drainage and treatment of wastewater significantly enhanced users’ willingness to pay wastewater charges. Socio-economic surveys undertaken during the loan processing indicated a significantly higher level of public willingness to pay, a positive indicator of public support for the project.

The tariff levels based on the principles of full cost recovery would enable WDC to become a financially autonomous and sustainable entity, and the availability of adequate funds for loan repayment, operations and maintenance, and eventual replacement of project facilities would be assured.

Findings in Project Completion Report by August 2015. The Wuhan Municipal Government held a public hearing on the tariff increase. Delayed by 2 years, the wastewater tariff was increased to 1.1 yuan/m³ in 2014 for urban residents, higher than suggested by ADB. The WDC complied with all financial covenants, which includes that “wastewater tariffs charged by WDC be set at a level that ensures cost recovery of operation and maintenance, depreciation and financial costs including the debt service obligations, and a reasonable profit margin for WDC.” The project is rated likely sustainable. Although there was delayed implementation for 1 WWTP, “the urban wastewater treatment rate in Wuhan reached 92.4% in 2010 and 93% in 2013.”

Current Water Tariff in Wuhan and Wastewater Tariff among Cities. The current water tariff in Wuhan is presented in Table 2.

Table 2: Water and Wastewater Tariff in Wuhan
(yuan/m³)

	Water	Wastewater	Combined
Resident	1.37	1.10	2.47
Nonresident	2.12	1.37	3.49
Special industries	8.10	1.37	9.47

Figure 2: Current Resident Wastewater Tariff in Some Cities

Implications

ADB’s first two water tariff studies were conducted when the gross domestic product (GDP) per capita in the PRC was at a low $609.66 in 1995 and $959.37 in 2000. This did not deter initiatives to reform the water and wastewater tariffs in the country with the objective of requiring full cost recovery from service providers. Figure 1 shows a high level of cost recovery would have been achieved in many cities because of increased wastewater tariffs when per capita GDP was about $1,753.42 in 2005. Figure 2 shows a high level of cost recovery, including full cost recovery for some cities, would have been achieved now among the cities.

In comparison, when per capita GDP in the Philippines was $1,741.60 in 2007 (Table 3 below), the combined water and wastewater tariff in Bonifacio Global City and Metro Manila was so high that full cost recovery should have already been achieved then. The Manila Water Company, Inc. provides water treatment, water distribution, sewerage, and sanitation services to more than six million people in the eastern side of Metro Manila (East Zone), which comprises a broad range of residential, semi-business, commercial. and industrial customers. The East Zone encompasses 23 cities and municipalities, spanning a 1,400-square kilometer area. The company is entitled to recover its operating, capital maintenance, and investment expenditures; business taxes; and concession fee payments over the concession period; and to earn a rate of return on these expenditures. Its return on equity from 2006 to 2020 ranged from 8.09% to 22.4%.

Table 3: GDP per Capita in Current Prices
(US$)

	1995	2000	2005	2007	2010	2015	2020	2021
People’s Republic of China	609.66	959.37	1,753.42	2,693.97	4,550.45	8,016.43	10,408.67	12,556.33
Philippines	1,222.29	1,073.26	1,245.29	1,741.60	2,201.78	2,974.30	3,224.42	3,460.53

Source: The World Bank.

Most water supply companies in the PRC are owned by the government. The Manila Water Company, a publicly listed company, is the concessionaire of the state-run Metropolitan Waterworks and Sewerage System. WDC and Manila Water Company achieved full cost recovery when per capita GDP was about $1,750 in the two countries.

Today, per capita GDP in most of developing Asia is around $1,750 or higher. Some countries even have a per capita GDP that is higher than $10,000. Yet, many water systems in the region are not financially sustainable and rely heavily on fiscal transfers and government subsidies despite improved economic well-being. Most water and sanitation projects are still justified based on their capacity to generate revenue to adequately cover O&M costs, and the government’s commitment to transfer adequate funds as necessary to cover such expenses.

With relatively higher inflation rates over the years, no increase in tariff in nominal terms means decreased tariff in real terms, further deteriorating the financial position of a water utility. This means the water utility will continue making demands on government’s scarce fiscal resources. It has no financial capacity for assets expansion or replacement to provide better services to the public.

Increased per capita GDP in a country normally improves the affordability profile, especially in its capital and major cities with relatively higher per capita GDP. When higher tariffs are affordable in a city, public support, willingness-to-pay, and pro-poor arrangement for poor households are sensitive and critical concerns before a water system can be moved up to a higher level of cost recovery. Continued policy dialogue with governments supported by a realistic tariff study and in-depth financial and social analyses, together with good practices in the water sector, would help build understanding and a better future for people and for countries.

References

Asian Development Bank (ADB). Wuhan Wastewater and Stormwater Management in the People’s Republic of China.

Author

Yi Xu

Former Senior Financial Management Specialist, Procurement, Portfolio and Financial Management Department, ADB

This blog is reproduced from Development Asia.

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