Module 13: Financing (cost recovery)

13.2. What are the key processes?

The key processes for cost recovery include:

1. Establishing a cost recovery strategy;
2. Tariffs and charges structuring;
3. Subsidising; and
4. Billing and collection.

1. Establishing a cost recovery strategy

PPPs can play an important role in reaching cost recovery goals. They open up avenues of communication that help solve the problems that often arise during infrastructure projects. They also make a wider range of solutions available and can help ensure wider support for the projects and cost recovery objectives.

Projects that are successful at achieving their cost recovery goals have adopted several different types of strategies. These strategies relate to many aspects of the project, such as:

◊ tariff and fee structure, for example, targeted subsidies or a low rate for the first block of water used;

◊ forming an appropriate and feasible payment scheme;

◊ designing appropriate payment options;

◊ billing, charging and payment, for example, change the frequency of payments, improve the billing system and delivery, increase or change payment points or work with a community group to collect money;

◊ customer relations/education;

◊ rewards and punishments, for example, random prize draws for houses that pay or service cut-off for non-payment; and
◊ community mobilisation and participation or communal billing.

The delineation between these strategies is not always clear and in many cases they overlap—for example, working with or establishing community institutions can help with both education and better bill payment.

2. Tariff structuring

A "tariff" means a service charge that the municipality charges for the use of services. Tariff structuring depends on many factors, thus it is not possible to make “one size fits all” recommendations.
The process of tariff structuring is important in the promotion of the sector reform process. The main objectives of tariff setting are:

◊ to recover the cost of service supplying;

◊ to ensure efficient use of services by consumers; and

◊ to ensure access of all groups to basic minimum service needs.

Basic types of water tariff structures

a) Single-part tariff (single-tariff pricing)
a method of pricing that consolidates rates across multiple service territories owned and operated by a multi-system utility that may or may not be contiguous or physically interconnected. Also known as “consolidated rates”.
A single-part tariff consists of either:

1. A fixed charge – the monthly water bill is independent of the volume consumed (not based on measured water use); or

2. A volumetric charge – this charge is made for the volume of water, which is measured through a supply point. It may be:
– a uniform price volumetric tariff (unblocked) – all units of water are billed at the same price;
– an increasing linear tariff – unit charge increases linearly as water use increases;
– block-type structures – two or more prices, each applies to use within a defined segment (block) of monthly use. Unit charge is constant over a specified range of water use and then shifts as use increases; or
– decreasing block pricing (or declining-block pricing) – a pricing structure in which both the average and marginal price per unit decreases as consumption increases.

b) Two-part tariffs
a pricing technique in which users pay a fixed sum for access to a service and pay another charge for each unit of the service they consume. The charge per unit may vary, making the system a multi-part tariff.

Tariffs can be differentiated by type of user (residential or commercial, industry or tourism, for instance.)
In developing the tariff structure, municipalities and their advisors will need to consider the factors that will affect implementation. These may include:

◊ the failure to link tariff regimes to productivity and thus ensure private sector incentives;
◊ the low metering levels in poor areas – thus undermining the “user pays” principle;
◊ the distortions that pro-poor tariff structures produce in the market incentives for the private operator; and
◊ the lack of a clear mechanism for tariff setting and revision.

However, government finance may be necessary in many developing countries, where users cannot afford the full costs of the necessary infrastructure programmes.

3. Subsidising

Many projects around the world never recover all costs. In fact, it is only in some western countries that customers (rather than ”beneficiaries”) of an infrastructure service pay completely for the service they get, be it directly or indirectly through taxes.

In most developing countries there will be a conflict if sound financial arrangements are to mean both full cost recovery and equity. In such a case targeted subsidies are necessary from the rich to the poor who cannot afford service costs.
Accurate information on the costs of supplying a service and information on the patterns of service demand, are both critical for decision-making process. With this information decision makers then need to decide:

– what they prioritise for subsidy;
– what element/stage/aspect of the service to subsidise;
– how the subsidy should be delivered; and
– who the recipients of the subsidy should be.

Subsidies generally come in two forms:

1. Direct subsidisation
The financing mechanism used to cover the shortfall in supply costs by the injection of finance from outside the sector or industry. Examples of direct subsidies include the widespread financing of solid waste services or donor support to governments that are undergoing sectoral reform.

The main advantages of direct subsidies are that they are transparent, explicit, and minimise distortions in the behaviour of water utilities and their customers. The main drawbacks of direct subsidies are the difficulty of defining suitable eligibility criteria as well as the administrative cost entailed in identifying eligible households.

2. Cross-subsidisation
A mechanism to cover costs by shifting the burden from one consumer group to another within that sector or industry. For example, the costs of delivery are significantly higher in the more remote, less concentrated areas; alternatively, high-consumption users pay a higher unit rate than low-consumption users.

Cross-subsidy of the poor (by charging richer users more) is commonly regarded as a desirable objective of water systems. This may involve cross-subsidies between different social, economic or regional groups of users. The most common method of doing this is through some form of stepped “block” tariff, which is usually intended to reduce the cost of water for poorer households. This can include a “lifeline” element of free water, the cost of which is covered by higher charges elsewhere. Another simple form of cross-subsidy within a given service is a “solidarity charge”, whereby affluent users, or those with their own connection, pay a supplement designed to cover the cost of supplying water to poorer users.

4. Billing and collection

The collection of payments due from users is important to balance income and expenditure and achieve the financial plan. Failure to collect all charges due from users is a common reason for financial deficits – increasing collection rates is a simple method of restoring profitability.

This is usually the most significant change introduced by private companies. It is a technically and managerially simple process to create a comprehensive and up-to-date database of users, and to then issue invoices for the amounts owed.

Identification of the constraints to the effective collection of tariffs

As a part of the tariff policy structuring, municipalities should explore the factors affecting payment and, where possible, design mechanisms to address constraints. Analysis should identify the reasons for low-cost recovery and the constraints affecting service provision and access.

A. Demand
In order to establish the level of service demand, it is necessary to know what are the needs of the urban poor and how those needs can be better served. Experience shows that the poor must become participant in (rather than beneficiaries of) the process, and that development processes must be designed with flexibility to ensure that participation can be achieved. The participation of poor communities is essential to ensure efficacy and sustainability in project ends, and to maximise the benefits of project means.

Partnership and service delivery incentives should respond to the demands of the poor, adapt to different levels of demand within a community and should provide different levels of service or means of payment.

B. Affordability and willingness to pay
Affordability and willingness to pay studies are a crucial stage of the partnership development and should be carried out in the context of a broader livelihood analysis.

A qualitative and quantitative poverty assessment should expose how much the poor currently pay for service provision. Such an assessment should also reveal the following:

– the source of the service and the service alternatives currently available to poor households;
– the frequency of payment, the flexibility of payment conditions and the options available in a time of crisis;
– the percentage of households’ incomes spent on each service and the opportunity cost of that expenditure;
– how many of the poor can be categorised as being “able to pay”, how this could defined, the trends among different poor groups, the differences between willingness to pay and having no choice but to pay and the links between affordability and other characteristics; and
– The factors affecting service affordability (seasonal unemployment, flooding, sickness, marriage and so on).

C. Income levels
Raising tariffs to cost-reflective levels might have a disproportionate impact on the real income of the poor, for whom water comprises a larger share of their consumption “basket” than it does for the non-poor. This, in turn, may serve as a pretext for mobilising political opposition to tariff reform.

It is necessary to recognise that there is a great diversity in the capability, vulnerability and capacity of low-income groups. Urban areas, communities, neighbourhoods, households and individuals experience different levels of poverty and are affected in very different ways. Various poverty assessments show that a significant difference between the poorest urban dwellers and their slightly-less poor and better-off poor neighbours lies in the way households prioritise service needs and fund service expenditure. Poor people develop complex strategies to ensure their survival in a crisis, or simply to cope with seasonal variations in their poverty. In particular, poor households make economies by cutting down on education, health care, food and cutting back on the utilisation of services. Thus cost recovery will increase and decrease in relation to these factors and livelihood assets.

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