Sirota & Mosgo : Public–Private Partnership in Housing and Utilities Sector

In the Russian Federation, utilities sector is a major complex industry aimed at supplying high-quality services to population and national economy, protecting natural resources like gas and water from depletion and insufficient use, as well as ensuring their quantitative and qualitative reproduction.

The utilities sector has been developing in straitened conditions of underinvestment. According to data of the Ministry of Economic Development of Russia, the housing and utilities industry lacks approximately 2 billion roubles (~$70 million) of direct investments. The majority of housing and utility companies meet the bankruptcy criteria. Practice has shown that municipal budgets are insufficient for large-scale investments in infrastructure development and maintenance. As a result, the degree of deterioration of the utility and housing infrastructure in Russia has reached the critical level of 65-70%.

The share of private operators in the least developed segment of the housing and utilities sector - the water supply and sewage facilities - accounts for as low as 16% (foreign company’s market share is less than 1%).

Apparently, there is an urgent need to improve the effectiveness of investment activities management in this sector, and to attract financing to renovate and develop the utilities infrastructure.

Investment attractiveness of public utilities industry

At the same time, studies indicate that utilities supplying business in Russia can be attractive for private investors, since supplying companies usually enjoy monopoly status in the regions, the sector features guaranteed and basically stable markets which seems to be a good competitive edge versus other sectors of the economy. Public utilities business, sure enough, must not be a super-profitable investment target. A merit and point of attractiveness of this industry can be rooted in different aspects – in low investment risks and in the guarantee that the invested funds will most certainly be repaid as per the agreed terms and timeframes.

The investment attractiveness of this industry is confirmed with rising activity of Russian and foreign private professional operators (Rosvodokanal/Alfa-bank, Don Water Company, REMONDIS, Veolia) which enter long-term investment agreements with local governments, lease and efficiently operate utilities engineering systems.

Public-private partnership as the effective mechanism of balancing between the supplier’s and consumer’s needs

As mentioned, the housing and utilities industry urgently needs private investments and renovations. It implies a broad spectrum of commercial agreements on managing state-owned (municipal) property by private operators. On the other hand, water, heat, gas and electricity are social goods, and the state is responsible for ensuring equal access to them for everyone. In other words, housing and utilities sector is always kind of trade-off between public needs, utilities’ need and solvency of a consumer. Thus, considering the social role of this industry and necessity to reach the balance of contradictory interests between suppliers’ desires and consumer’s capabilities, the most efficient direction of modernizing utility sector is through the partnership between the state (municipal governments) and private companies.

Tariff regulation

The operation of utilities companies in Russia is subject to state regulation. The legal framework of tariff regulation and general principles of tariff policy for public utilities are established by the Federal law No210-FZ dated December 30, 2004 «On Principles of Public Utility Tariffs Regulation» (the Law On Tariffs), the Decree of the Federal Government No 520 dated July 14, 2008 «On Pricing Principles and Regulation of Tariffs Surcharges and Price Caps to be used by Public Utilities».

Under the current law, the tariffs for public utilities are regulated by the Federal Tariff Service and its regional departments. The federal executive body is authorized to exercise legal control of the national regulation of the prices (tariffs) for services and to monitor the use thereof; it also sets the average price change limits (price cap) for the subjects of the Russian Federation, while regional services set tariffs for particular utility companies and average price change limits for certain municipalities. Abovementioned change limits are approved annually; tariffs are set for no less than one year.

Profitability and politicization of tariffs

Apparently, utilities prices must cover all justified costs of the operating company and ensure the level of revenues which would allow to maintain the network’s operability. Formally, profitability of operators is the claimed priority of tariffs making procedure. All applicable tariffs regulation acts proclaim that tariff must ensure operating companies’ revenues sufficient for the maintenance and development of the engineering infrastructure.

At the same time, tariffs must be socially justified, i.e. ensure accessibility of the said services for all consumers, even those with low income. Thus, tariff value decision making bears a clear indication of political colouring in Russia, i.e. subject to short-term political influence particularly during pre-election period. For example, in 2010 the Federal Government promised it would not let more than 15% utilities rates rise in the next year. As a result, many operators were forced to reconsider their already approved 2-year tariffs plans, since the regulating body immediately approved 15% price change limit in most of the regions of Russia. So, the process of considering and approving tariffs sometimes occurs spontaneously. Apparently, it leaves little room for operator’s confidence in tariffs in this situation.

It is interesting that Russian utilities suppliers sometimes respond with filing lawsuits against regulating bodies demanding compensation of difference between the approved tariff and economically justified rates enough for covering the operator’s costs (so called fallen out revenues). Up till now such lawsuits have been commonly filed against local self-governments, since before 2010 utilities tariff regulating competence was assigned to municipalities. Due to the change introduced into the Law on Tariffs in August 2010, municipalities were deprived their tariffs-setting powers which were granted to regional tariff services.

In March 2011 the Constitutional Court of Russia supported the right of operators for compensation of fallen out revenues from local budgets, but indicated that compensation shall be the liability of the body in charge, i.e. of those bodies that set “wrong” tariff or price cap, not only of the local governments.

What is even more important, deprivation of municipalities of their tariff regulating powers implies inability to meet their commitments under investments agreements made with private operators. With no direct rates regulating authorities, local governments obviously cannot secure certain level of profitability promised to private investors. In our opinion, the tariff regulating powers should be returned to municipalities, so they could be reckoned as reliable partners by private operators.

Structuring of utilities tariffs: Cost + system vs. RAB regulation

Another serious problem hampering modernization of the sector is that current tariff regulation does not provide economic incentives for the company motivating it to raise the efficacy of its operation and to cut non-operational costs and losses. Furthermore, it objectively motivates them to increase costs. In Russian regulated environment the tariffs are formed as a totality of certain necessary costs plus a certain earning on the capital (so called «costs +» method). In other words, tariffs for public utilities services are set contingent on the company’s costs: the higher costs the higher is the tariff and consequently – the higher is the profit. This system is predominantly practiced in Russia as well as many post-Soviet courtiers. Losses mean the increase in costs and price. Resources’ saving means the reduction of the tariff, i.e. losses. As a result, the company remains operating to the set tariffs without any incentive to cut costs but dreaming to have them raised by the next regulatory period.

It is obvious that Cost + system, though profitable for utilities, is inefficient in the terms of modernization of the sector and should be turned down. Russia has already announced its plans to implement RAB (Regulatory Asset Base) regulation - an alternative method which is based on long-term tariff regulating. RAB system has been already employed in electricity and heat supplying sectors (the Federal Government Decree No от 26.02.2004 N 109 «On Pricing In Respect of Electricity and Heating in the Russian Federation») and is planned to be implemented in water supplying and sewage industry under the Bill «On Water Supplying and Sewage» which passed the first reading in the State Duma.

The fundamental advantage of RAB regulation in comparison to the former Cost + policy is the guaranteed return on capital, which is an explicit component in the allowed revenues. The return on capital implies compensation for assets depreciation as well as the cost of invested capital. RAB regulation assumes long-term tariffs (5-year period in Russia), which improves the visibility and transparency of regulated utilities’ future cash flows, allows network companies to predict their income and costs for several years and, therefore, attract long-term debt.

In addition, this technique enables regulators to introduce a number of requirements regarding the quality of utilities distribution services as well as to promote operational efficiency. Below we highlight several important advantages of the RAB regulation in comparison to the Cost + rate policy:

  • Long-term tariff setting
  • Explicit return on capital guarantee;
  • More predictable and transparent cash flows;
  • Operational efficiency incentives;
  • Services quality targets
  • Ability to attract long-term debt.

Summing up, the housing and utilities business may be attractive for private investors, provided that tariffs are set at the level guaranteeing reasonable revenue for utility adequate for maintaining a normal operative regime of engineering systems at this point of time and in conceivable future. In other words, tariffs formation system must stimulate private business’ interest in this sector.

On the other hand, utilities services should remain accessible for everyone, even for law-income consumers. Balancing between suppliers’ and consumer’s needs as well as demands for modernization of the sector may be effected by practicing public-private partnership mechanisms, i.e. by establishing operating companies, owned by local self-government and private investors, making long-term lease or concession agreements on advantageous terms with respect to the municipal networking systems.

However, municipalities should be returned their tariff setting powers to enable them to meet their obligations under investment agreements, made with private operators, and secure already launched projects. The utility company can reach its investment targets only if guaranteed by local authorities with the certain level of tariff, necessary to safeguard implementation of the approved production and investment programs.

Current system of tariff regulation discourages operators from saving resources and cutting their costs, since higher costs mean higher tariffs and, thus, higher profit. Good tariff regulation system must turn down Cost+ principle and transfer to a RAB principle, which assumes long-term (5-year period) tariffs and allows network companies to predict their income and cost for several years.

Oleg Mosgo - partner at Sirota & Mosgo law firm. D-r Mosgo is an expert in the area of Public Private Partnerships (PPP), involving foreign investments. In 2010-2011 CEO of LLC REMONDIS Arzamas Service - Russian subsidiary of REMONDIS group, that launched one of the first PPP projects in the sphere of water supply and sewage in Russia.

Maria Belova – associate at Sirota&Mosgo law firm, advises on Public Private Partnerships in housing and utilities sector

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