6. PRICING WATER SUPPLY SERVICES

72 6. PRICING WATER SUPPLY SERVICES A. Introduction 6.1 Chapter 6 reviews the pricing practice of the water utilities (PDAMs) in Indonesia and makes recommendations on improving the current pricing policies. It is organized as follows: Section B discusses the pricing principles of economic and financial efficiency, social equity, and simplicity, and the practical trade-offs among them. Section C reviews the pricing practices of PDAMs including water tariff regulations, an evaluation of water tariffs and household connection fees. Section D makes recommendation for changes in tariff policies and outlines implementation measures. Section E presents a case study on restructuring tariffs. 6.2 This Chapter made use of the PDAM data collected under an ADB financed study, Water Tariff Structure and Financial Policies of Water Enterprises, a technical assistance project for the Ministry of Home Affairs, Indonesia. The work has benefited from the ADB study, the PDAM tariff workshops and discussion with the ADB project team. B. Principles of Water Supply Pricing 6.3 There are four major principles in pricing water supply services. The first is the economic efficiency principle. This principle states that economic resources such as water should be allocated efficiently. The second is the financial viability principle. This principle requires that the water prices raise sufficient revenues to meet the financial requirement of the water utility. The third is the social equity principle. This is to ensure provision of a minimum level of water supply to people who may not be able to afford the full cost. The fourth is the simplicity principle. It means that the water tariff must be simple in structure and stable over time so that the users can understand and plan for the long term, and the water supply utilities can administer effectively. Water pricing should be designed in such as a way that these four important principles can be substantially met. Economic Efficiency 6.4 The principle of economic efficiency, as applied to water supply, requires that the price be set equal to the incremental (or marginal) costs of providing an incremental supply of water services. The costs consist of operation and maintenance costs, capacity expansion

73 expenditures which are necessary to increase water supply to consumers, and environmental or other externality costs. 6.5 The rationale for setting the price equal to marginal costs is well known. On the one hand, if price is higher than marginal cost, inefficiency occurs because there are people who value additional water more than what it would cost to provide it, but they would not purchase that water because the price is too high. In this case, there would be an under-consumption of water. On the other hand, if the price is less than marginal cost, inefficiency also occurs because additional water is provided at a cost which is higher than the value placed by those who purchase it. Therefore, there would be an over-consumption of water. Only when price is set equal to marginal cost would the total social benefits, i.e., the sum of consumer and producer benefits, be maximized. 6.6 Marginal cost pricing implies that pricing should be determined individually within each water utility, according to the individual costs, rather than imposed uniformly over all water utilities. What should be pointed out is that, ideally, the marginal costs used to set prices should be efficient marginal costs; they should not include certain avoidable operating costs which are passed on through higher prices to consumers. In other words, marginal cost pricing should be determined as if there is a competitive market at work, and the price is set according to the cost of the most efficient firm. An example of inefficient operating costs is the high rate of UfW, on average some 40%. A reduction of about half of this is considered feasible and economical. Another example is that the number of staff employed is much larger than necessary in many water utilities. This part of the inefficiency costs, which can be realistically eliminated, should not be added to the marginal costs and charged to water users through higher prices. Rather, its elimination should be tied with schemes such as government equity contributions or salary bonus schemes, so as to create an incentive for the utility management to seek out efficiency improvements. 6.7 The economic costs of water use also include costs of disposing and treating wastewater, or costs of cleaning-up external environmental damage created by inadequate treatment of wastewater. For industries with particularly harmful effluent discharges, separate fees equal to the additional costs (above what is already covered by the water price) should be set. Adding a sewerage surcharge on water use would provide water users an incentive to use water and waste disposal facilities in a manner that is efficient from the society s perspective. The revenues collected to cover wastewater disposal and treatment costs should not accrue to the water utility unless the utility also provides sewerage, drains and treatment services. Financial Viability 6.8 Financial viability requires that the water price be set at a level such that the revenues cover the O&M costs and depreciation expenses and also provide an acceptable return on assets. Depreciation charges provide for the recovery of the utility s capital investment over the useful life of the assets. The return on assets is to pay for the interest cost of debt capital as well as a fair rate of return for the equity capital.

74 6.9 A widely used criterion of financial viability is the utility s potential to earn an acceptable rate of return on assets (i.e., the net operating income after taxes given as a fraction of net fixed assets in operation). In the case of private utilities, the regulatory authorities traditionally impose a fair rate of return as an upper limit on earnings, and therefore, on average unit price. In the case of government-owned utilities, as in most developing countries, the target rate of return is usually considered a minimum requirement to help resist social and political pressures to keep the price too low. 6.10 Another criterion, which is useful when the utility expands rapidly, requires the utility to make a reasonable contribution to its investment program from its own revenues. This selffinancing ratio is often expressed by the amount of internally generated funds available after operating expenses and debt service as a fraction of capital expenditures. 6.11 A price that produces a desirable financial performance for the water utility may not be economically efficient: it is backward-looking; it uses costs that are not relevant for long-term capacity planning. On the other hand, an economically efficient pricing policy may not lead to a satisfactory financial situation; either excessive surpluses or losses may accrue to the utility. When this happens, it is necessary to adjust the price so that it allows for an acceptable financial performance while still maintains many efficiency advantages. It is also possible that in initial stages a public equity contribution may be required to bridge the gap between economic and financial flows. 6.12 For example, when a marginal cost-based price generates a large revenue surplus, the surplus may be used to subsidize the poor in water and sewerage charges. When marginal cost pricing results in loss-making, a simple solution is to use a two-part tariff consisting of a variable charge based on consumption and a lump sum charge. The variable charge is set according to the marginal cost while the lump sum charge is set to cover the costs that do not depend on amount of consumption (e.g., connection, metering, billing, and administrative costs) so that a satisfactory financial performance can be achieved. 6.13 Another example regards the revaluation of assets at replacement costs when a rate of return test is used to judge if the utility is financially viable. This is because using historical costs for working assets, typically original book costs less depreciation, would tend to understate their value when capacity costs rise rapidly, or when there is no indexing to inflation, or when depreciation is on an accelerated schedule, etc. Social Equity 6.14 The principle of social equity is advanced to ensure that the poor obtain an adequate amount of water and/or adequate waste disposal facilities. It is in favor of subsidizing water rates for the poor whose income levels restrict their consumption of clean water to levels below what is needed for health reasons, at standard tariffs. Given the presence of health externalities, there are also efficiency grounds for subsidizing a minimum quantity of water for low income consumers.

75 6.15 This principle can be achieved through a low subsidized lifeline rate for a small quantity of water, for example, the first 10 cubic meters per household per month. As water connections are shown to correlate strongly with urban household income (see Table ), another major way to help the poor is through reduced initial connection fees combined with installments (by converting connection fees into a fixed monthly charge). Methods of deferred connection payments have been particularly effective in encouraging the poor to connect to the piped water system. 6.16 A commonly used method in developing countries to help the poor is provision of subsidized community water standpipes. It has been estimated, however, that this method in fact costs more per user than shared household connections, in both economic and financial costs. This is due to the fact that the fixed cost of water from a standpipe is some 2.5 up to 17 times the cost of a metered house connection, depending on whether the standpipe is supervised or not; and moreover, the actual prices charged by the supervising attendants for standpipe water are much higher than the costs. Simplicity 6.17 The principle of simplicity is to ensure that water prices are both simple in structure and stable over time. Tariff structure should be simple enough for the average consumer to understand so that individuals are able to respond to price signals and adjust their consumption accordingly. Moreover, the number of customer categories and consumption blocks should be few so as to allow the utility to administer effectively (e.g., forecasting revenues and credit needs, metering and billing, etc.). 6.18 The principle of simplicity also means that water prices should avoid significant fluctuations over time. This is because large price fluctuations are a source of uncertainty for consumers and create problems in cash flows and long-term investment planning in facilities with significant water usage. In water supply projects in Indonesia, it is usually the case that productive capacity is installed just to make up for current supply deficits or to meet future demand for only a few years. Investment costs are often lumpy, in relation to operating and maintenance costs. Due to this capital lumpiness, pricing on the basis of strict short-run marginal costs would result in sudden large price increases over time, as short-run marginal costs rise sharply when the capacity is reached and drop immediately after the capacity is expanded. To avoid this problem, marginal cost-based prices should utilize formulations of long-run incremental costs averaged over the lifetime of the assets rather than short-run marginal costs. Water Tariffs Regulations C. Review of PDAM Water Tariffs 6.19 Prices charged by PDAMs for water services are set based on national guidelines, as currently defined in MoHA Decree No.690 069/1992, which replaced the previous 1984 guidelines. Under the MoHA guidelines, PDAMs should pursue both commercial and social

76 goals through tariff-setting and are required to recover O&M costs, depreciation and interest on loans. 6.20 The tariff structure in general separates user groups into a number of categories: social (including public taps, schools, hospitals, etc.), non-commercial (including households and governments), small and large commercial, small and large industry. Under each category there may be some additional sub-categories, according to factors such as household income level, etc. This gives a total of some 10 to 15 user groups. Unlike the 1984 tariff structure which imposed strict progressivity factors (progressivity refers to the degree of tariff increases relative to consumption increases, e.g., high progressivity means a relatively large tariff increase for a relatively small consumption increase), the current MoHA tariff guidelines indicate only that tariffs should be progressive with four consumption blocks. For kabupatens the four consumption blocks are 10 m 3 or less, 10-20 m 3, 20-30 m 3, and 30 m 3 or more. For kotamadyas they are 15 m 3 or less, 15-30 m 3, 30-50 m 3 and 50 m 3 or more. The guidelines also indicate that, for a given quantity of water, commercial and industrial users should in general pay more than social and non-commercial users. 6.21 Tariff changes must be approved by local governments, and the approval may also need ratification by the next higher level authority. At the discretion of the local governments, PDAMs may also be responsible for setting and collecting charges for private use of groundwater from deep wells. 6.22 On the use of groundwater, the current MoHA Ministerial Instruction 5/1995 specifies that any business, including real estate and industrial areas, should use PDAM water if it is available. In particular, it states that where PDAM water is available, groundwater licensing should be limited so as to avoid land subsidence and ground water salivation. 6.23 The current groundwater charges typically aim at non-domestic abstraction from deep wells. Abstraction is supposed to be registered with local governments, but there is no charge for the right to abstract deep groundwater. Similar to the piped water tariff structure, the groundwater tariff structure is divided into about 12 categories of user groups and five progressive water consumption blocks. Households that use shallow groundwater from their own wells are not charged. Households that depend on deep groundwater are exempted if their consumption is not excessive (e.g., less than 100 m 3 per month). Evaluation of Water Tariffs 6.24 Current PDAM tariffs in general do not meet the principles of economic efficiency, financial viability, social equity and administrative simplicity. 6.25 Economic Efficiency: The PDAM tariffs do not reflect the principle of economic efficiency. The relationship between PDAM costs and tariffs has been examined, and a detailed description of the data and estimation procedures is provided in the Annex (to be included). The costs examined include average and marginal full costs (including O&M, depreciation and

77 5% return on assets), MoHA defined cost (including O&M, depreciation and 11.5% interest on debt), cash cost (including O&M and debt service on loans with 11.5% interest and 15 years maturity), and O&M cost. Chart 6.1 presents the averages of these costs and tariffs. Chart 6.2 illustrates how these costs and tariffs vary with the volume of water sold. 6.26 The vast majority of PDAMs (over 95%) are fairly small, selling less than 20 million m 3 of water per year. Analyses show that these PDAMs exhibit significant economies of scale: average cost decreases as the volume of water sold increases. For the few large PDAMs, they experience dis-economies of scale; average cost increases as the volume of water sold increases. Lines A (average full cost) and C (marginal full cost) in Chart 6.2 illustrate how the average and marginal costs vary with the volume of water sold. The MoHA cost, represented by Line B, exhibits the same trend and lies between Lines A and C. Line D shows that the O&M costs enjoy economies of scale as well; larger volumes of water sold are associated with lower unit O&M costs. Line E indicates that the unit cash flow costs are almost constant, or increasing slightly, as the volume of water sold increases. Line F indicates that large PDAMs tend to charge relatively higher rates than small PDAMs. 6.27 Economic efficiency requires that the tariffs follow marginal costs. Yet as Chart 6.1 shows, average PDAM tariff is about Rp 484/m 3, 1 which is about 30% below the marginal cost, estimated at Rp 709/m 3. Chart 6.2 shows that the tariff, i.e., Line F, covers only O&M costs for most of the PDAMs and cash flow costs for only large PDAMs. They do not at all cover the full cost or MoHA-defined costs. 6.28 Low tariffs encourage over-consumption of water: people use water to the point where its value to them is less than the cost of supplying the water. At the same time, those households who are not connected but who are willing to pay do not have access as most PDAMs are selling at capacity. The resulting welfare loss is estimated at a minimum of Rp 32 per m 3 of water sold. This loss totals about Rp 34 billion per year for the total PDAM water sold (estimated at 1.1 billion m 3 in 1994). In addition, the low tariff implies that those who are served by PDAMs are getting extra value at the expense of the PDAMs, the general public, and particularly those who are without access to the PDAM water systems. The total expense is estimated at a minimum of Rp 323 per m 3 of water sold, giving a total loss of revenues of about Rp 345 billion per year for the all PDAM water sold. This loss is about 40% of PDAMs total revenues. 1 The average tariff per m3 here is obtained through regression analysis, rather than simple or weighted averaging. Regression analysis reflects the majority of tariffs per m3 and discounts the effects of few extreme high or low tariffs per m3 (i.e., outliners). Neither simple nor weighted averaging can achieve this because they can not distinguish whether a tariff per m3 is too high or too low relative to the majority of the values. All the other average values in this Chapter are obtained through regression analyses.

78 Chart 6.1 PDAM Costs and Tariffs (1995) (Rp/m3) 1,000 900 800 700 600 500 400 300 200 100 0 820 Average Full Cost 709 Marginal Full Cost 763 MOHA Cost 509 Cash Cost 419 O&M Cost 484 Tariff Note: Full Cost = O&M, depreciation and 5% return on assets MOHA Cost = O&M, depreciation and 11.5% interest on debt Cash Cost = O&M and debt service (11.5% interest, 15 years) Source: PDAMs data set (with 185 PDAMs) and World Bank estimates Chart 6.2 Costs and Tariffs of Water Supply (Rp/m3) 1,600 1,400 1,200 1,000 800 600 400 200 0 A B C D E F 0 1 10 100 1,000 Volume of Water Sold (million m3, log scale) C B A F E D A: average full cost, B: average MOHA cost, C: marginal full cost D: average O&M cost, E: average cash cost, F: average tariff Source: PDAMs data set and World Bank estimates 6.29 The large variation of tariffs among user groups and the high progressivity with consumption volume is another aspect of efficiency distortion. While the unit economic costs of water supply are similar among all user groups and consumption volumes, PDAMs charge widely different tariffs to different user groups and different consumption volumes. 6.30 Tariffs are based on the so-called A factor, which is the tariff rate for the first consumption block by household users. The typical ranges of PDAM tariffs for the various user

79 groups are: Social: 80% of A; Non-commercial (including households and government): 100% to 300% of A; Small commercial: 200% to 500% of A; Large commercial: 400% to 800% of A; Small industry: 300% to 600% of A; Large industry: 500% to 1000%. (See Table 6.5 as an illustration) Chart 6.3 illustrates how the average tariffs vary with volume of water used for three user groups: households, large commercial and large industry. 6.31 Water tariffs paid by large water users such as large-scale industries and commercial business are usually much higher than the marginal costs. These high tariffs not only enable connected households to pay tariffs which are considerably below the marginal costs, but they also cause the industries and commercial operations to turn to alternative sources of supply such as deep groundwater. This reduces the PDAM revenue base from industry and business users. In areas where groundwater charges do not reflect the true economic costs of groundwater abstraction, this may lead to over-exploitation of deep groundwater, causing environmental damage such as land subsidence, salination and lowering of shallow groundwater tables. In addition, the high tariffs on industry and business users also increase their production costs, which are eventually passed on to consumers. Chart 6.3 Examples of Average Water Tariffs Rp/m3 8,000 A 7,000 6,000 B 5,000 4,000 3,000 2,000 1,000 C 0 0 10 20 30 40 50 60 70 Consumption of Water (m3/month) A: Large industry, B: Large commercial, C: Households Source: Tariff schedule of PDAM Pontianak, West Kalimantan. 6.32 Financial Viability: PDAM tariffs do not cover full financial costs (O&M costs, depreciation and a return on assets), neither do they cover cash flow costs (O&M costs and debt services). They also fail to meet the MoHA required costs (O&M costs, depreciation and interest on debt). This is illustrated in Charts 6.1 and 6.2. 6.33 The average tariff of Rp 484/m 3 is about 40% below the full financial cost, estimated at Rp 820/m 3. It barely meets the cash flow cost of Rp 509/m 3 and falls about 36% short of the MoHA required costs of Rp 763/m 3. This is due to the low tariffs on households and the small

80 revenue base from large scale industries and commercial operations. It is also attributed to significant operating deficiencies such as the high rate of UfW, typically around 40%, of which nearly 70% is considered to be due to physical loss. 6.34 The poor financial performance makes PDAMs financially dependent on government subsidies and reduces their capacity to fund necessary capacity expansion investments. Moreover, if PDAMs are reasonably assured that their financial obligations will be met on a basis not related to performance (or even worse, negatively related to performance), through government provided equity, etc., they will have no strong incentive to improve their operating efficiency and extend their service. 6.35 Social Equity: The water tariffs also have a negative effect on the intended goal of social equity. It is primarily higher income households who have PDAM connections and benefit from subsidized water. The lower income households, who do not have PDAM connections, have to pay high prices for alternative sources of water supplies, such as bottled water from vendors, for their drinking needs. Table 6.1 shows that the average per capita expenditure by a PDAM customer is Rp 79,000 per month, while it is Rp 50,000 per month for a non-pdam customer, only 64% of the former. Table 6.1 also shows that the expenditure on PDAM water by those with PDAM connections is mostly below 3% of per capita total expenditure, indicating that the water is very affordable to them. 6.36 In addition, the use of the minimum consumption of 10 m 3 (or 15 m 3 ) and the large progressivity of water tariffs may also have adverse effects on the poor. As shown in Chart 6.3, those households whose consumption is within the first consumption block are paying high average rates because of the required minimum consumption in the tariff structure. Many of these households are poor. It is also often the case that many poor households living in densely populated urban areas either share water connections or purchase water from commercial vendors. Consequently, the progressive tariffs actually hurt them the most because they have to pay a high price for the large amount of shared consumption of water. 6.37 Simplicity: The tariff structure is also complex, with differentiated rates among numerous consumer categories and progressivity consumption blocks. The tariff schedule of PDAM Pontianak, West Kalimantan, as shown in Table 6.5, has over 60 different tariffs. This structure complicates the tasks of billing and increases administrative costs. It creates opportunities for corruption. Simplification of the tariff structure is necessary considering the weak managerial and technical capability of many PDAMs. Table 6.1 Average Per Capita Monthly Expenditure, 1995 Province PDAM Non-PDAM Non-PDAM/ PDAM Customers Customers Customers PDAM Water Water Total Total Share Expenditure Expenditure

81 Expenditure Expenditure Share (Rp 000) (Rp 000) (%) (Rp 000) (%) Aceh 91 46 51% 2.7 2.9% Sumatera Utara 74 47 64% 1.9 2.5% Sumatera Barat 85 55 65% 1.6 1.9% Riau 117 63 54% 3.7 3.1% Jambi 74 50 68% 1.5 2.1% Sumatera Selatan 73 44 60% 1.7 2.4% Bengkulu 69 48 70% 1.3 1.9% Lampung 69 42 61% 1.6 2.3% DKI Jakarta 120 110 92% 7.6 6.4% Jawa Barat 94 59 63% 2.0 2.2% Jawa Tengah 71 40 56% 1.7 2.3% Yogyakarta 96 73 76% 1.2 1.3% Jawa Timur 94 42 45% 2.6 2.8% Bali 74 63 85% 2.5 3.4% Nusa Tenggara Barat 49 39 80% 1.0 2.1% Nusa Tenggara Timur 60 33 55% 1.9 3.1% Timor Timur 49 38 78% Kalimantan Barat 86 53 62% 1.7 2.0% Kalimantan Tengah 80 58 73% 1.5 1.9% Kalimanan Selatan 83 46 55% 5.3 6.4% Kalimantan Timur 98 62 63% 5.3 5.5% Sulawesi Utara 70 43 61% 1.3 1.8% Sulawesi Tengah 55 45 82% 0.8 1.4% Sulawesi Selatan 66 41 62% 1.6 2.4% Sulawesi Tenggara 63 37 59% Maluku 70 43 61% 1.6 2.4% Irian Jaya 103 42 41% 1.8 1.7% Simple Average 79 50 64% 2.3 2.9% Source: SUSENAS 1995 and estimates from PDAM data

82 Household Connection Fees 6.38 PDAMs charge a connection fee to those who wish to connect to the piped water system. The charge is supposedly cost-based, but this is difficult to confirm. The fees paid can include unofficial items which increase the cost to customers significantly. Demand surveys in Indonesia have shown that the connection fees represent a significant deterrent to connection demand. In one survey of 45 towns in East Java, 28% of those surveyed (who were not connected to PDAM systems) said they would want a connection. Among them, all would be willing to pay Rp 100,000 for it. Only 36% would be willing to pay Rp 240,000. The proportion fell to 7% when confronted with Rp 300,000 (see Chart 6.4). In a similar survey of 43 towns in Bali, 48% of those non-connected said they would like a connection. Among them, only 28% would pay a fee of Rp 200,000. 6.39 The way the PDAMs handle their connection fees is also not according to proper financial standards. The connection fees are entered on the revenue side in the income statement while the costs of connections are entered in the balance sheet as investments. The effect of this practice is to increase the PDAMs revenues and profits during the expansion period. This increases the corporation tax liability but also increases employee and local government profit shares. But this practice delays necessary tariff increases. When the expansion period ends and connection fees are no longer available, the PDAMs experience a large revenue shortfall and usually face great difficulties serving the debt. They would have to either raise tariffs significantly or rely on governments for financial assistance. For example, over 20% of the revenues for the eight PDAMs in Bali came from connection fees in each of the past three years. The expansion is now ending and significant revenue drops are expected. The PDAMs in East Java face a similar situation. Chart 6.4 Connection Fees and Demand % of Those Wanting a Connection 100% 90% 80% 70% 60% 50% 40% 30% 20% 10% 0% 100% 36% 7% 100 240 300 Connection Fees (Rp.000) Source: Demand survey of East Java

83 D. Recommendations for Water Supply Pricing 6.40 The above review shows that the current PDAM water tariffs are not economically efficient in allocating demand and resources; do not raise enough revenues for the PDAMs to be financially independent; tend to benefit high-income rather than low-income households; and are complex and difficult to administer effectively. A simple tariff system is proposed below. It attempts to address these problems and follow the principles of economic efficiency, financial viability, social equity and administrative simplicity. Water Tariffs 6.41 The major elements of the proposed tariff system are as follows: a) a two-part tariff structure, consisting of a small fixed fee for covering administration and meter maintenance costs and a tariff rate per m 3 of water consumed; b) only two consumption blocks, the first consumption block is 10 m 3 per month; c) the tariff rate consists of a lifeline rate for the first consumption block and a base rate thereafter; d) no minimum consumption amount; e) the lifeline rate is set such that the water consumption within the first block would not cost more than 4% to 5% of the total expenditure of an average low-income household; f) the base rate is set such that the overall average tariff represents a balance between the economically efficient marginal cost and financially viable average cost; and g) relatively lower tariffs can be charged for public taps and special groups such as schools and hospitals, and relatively higher tariffs can be charged for business and industry users. 6.42 The reduction in the number of user groups and extent of tariff progressivity represents an improvement in economic efficiency as well as in simplicity. The lifeline rate for the first consumption block and for public taps and social groups ensures that low-income users can afford a sufficient amount of water for their basic needs. The relatively higher rates for larger consumption and for business and industry groups balance the needs for both achieving economic efficiency and financial viability. The following discusses each of these elements in more detail. 6.43 Persons per Connection: To determine an appropriate lifeline rate and the volume of the first consumption block, the number of persons using a connection must be known. Note that this is slightly different from the number of persons in a household as some households share a connection. The Ministry of Public Works uses seven persons per connection. A recent survey of 43 towns in Bali shows the average household size ranges from 3.9 to 6.4 and the average number of persons per connection ranges from 5.3 to 9.9. For seven people per one connection, 10 m 3 per month (30 days) would provide 48 liters of water per person per day. The amount of water considered essential for human needs is typically estimated at 25 to 50

84 liters per capita per day. Available data also shows that between 20% to 30% of the households who are connected to the PDAM systems use less than 10 m 3 of water per month. 6.44 Lifeline Rate: The lifeline rate can be set so that consumption within the first block would not cost more than 4% to 5% of the total expenditure of an average low-income household. Table 1 shows that the average expenditures of those non-connected households is about Rp 50,000 per capita per month (in 1995 prices). The 1990 regional poverty lines estimated by the World Bank range from Rp 15,000 to Rp 20,000 per month, or about Rp 22,000 to Rp 29,000 per month in 1995 prices. In addition, the 1995 SUSENAS data show that except NTT, Timor Timur, Sulawesi Tenggara and Irian Jaya, the other provinces all have less than 3% of the population with expenditures below Rp 15,000 per month. 6.45 Then, for seven persons per connection and a monthly expenditure of Rp 15,000 per person (i.e., total monthly expenditure of Rp 105,000), a lifeline rate of Rp 400/m 3 would supply the first 10 m 3 of water at a cost of Rp 4,000, which is 3.8% of the total monthly expenditures; a rate of Rp 500/m 3 would mean a 4.8% of the total expenditures. 6.46 Average Full Cost: The higher rate for consumption above 10 m 3 can be set so that the overall average tariff is a compromise between marginal full (economic) cost to achieve economic efficiency, and average full (financial) cost to ensure financial viability. The average financial full cost is obtained by dividing the total of O&M costs, depreciation, and an acceptable return on assets by the total volume of water sold. Depreciation charge provides for the recovery of the utility s capital investment over the useful life of the assets. The PDAMs now follow the Tax Law of the Ministry of Finance which requires the double declining balance method. This law replaced the previous straight line method recommended by the Ministry of Public Works. The return on assets is used to cover the interest cost of debt capital as well as to provide a fair rate of return for equity capital. The rate of return on equity should technically be commensurate with the return from other enterprises having similar risks. However, considering the weak financial position of the PDAMs and large investment needs, returns on equity, if they ever exist, should be retained by PDAMs rather than distributed to local governments. They should be used to provide capacity expansion, lower debt financing requirements, repair environmental damages, and subsidize the poor. The assets, on which the return is based, is normally called a rate base. It primarily consists of PDAM plant and property useful in serving the public. Some allowance for materials and supplies, working capital, and construction works in progress can also be included in the rate base. On the other hand, contributions towards construction and customer advances for construction are generally deducted from the rate base. 6.47 Marginal Full Cost: Several formulations exist to determine marginal full economic costs but the recommended one is the long-run average incremental cost (AIC) formulation. Technically, AIC can be defined as:

85 AIC = T t-1 ( Ct + I t) / (1+ r) t=1 T t-1 Qt / (1+ r) t=1 Ct is the incremental O&M costs in year t as compared to the base year 0; I t is the capital investment in year t; Qt is the incremental water sold in year t as compared to the base year 0; r is the discount rate; and T is the number of years for which investments are planned and water demand and supply is forecast, usually 10 to 15 years. Residual values of investments at the end of the estimation period should be taken into account. The AIC formulation appears complicated but, as illustrated in Table 6.7 of Section E, the process of using it is actually quite straightforward. 6.48 Wastewater and Other External Costs: Following the economic efficiency principle discussed in Section B, AIC, as an economic cost, should also include costs of disposing and treating wastewater, or costs of cleaning up external environmental damage created by a lack of adequate wastewater treatment. In practice this is often difficult due to a lack of a reasonable measure of wastewater costs. Moreover, considering the fact that uses of alternative water sources, such as groundwater, all incur wastewater costs, most of which are not charged at all, it may not be socially efficient to add wastewater costs to marginal cost pricing without first charging for the uses of alternative water sources. This is because it may simply drive more people to alternative water sources and cause higher total costs. 6.49 Base Tariff: As discussed in Section C, economies of scale exist for the majority of PDAMs; as these small PDAMs increase their water sold, their unit costs decrease. For these PDAMs, the marginal cost, or AIC, is lower than the average cost. As shown in Chart 6.2, the marginal cost Line C lies below the average cost Line A for PDAMs with less than 2 million m3 of water sold. On average, the marginal cost is about 13% below the average cost. For the few large PDAMs, dis-economies of scale prevail; larger PDAMs have higher average costs than smaller ones. In this case, the marginal cost is higher than the average cost. However, regardless of economies or diseconomies of scale, the MoHA defined cost, i.e., O&M costs plus depreciation and interest on debt, appears to fall between the average and marginal costs; that is, Line B in Chart 6.2 lies between Lines A and C. Consequently, in practical rate design, the MoHA cost can be used as a very useful reference when a tariff has to be set between the average full (financial) cost and marginal full (economic) cost. A case study is presented in Section E where the procedure of determining lifeline and the higher rates is illustrated. Connection Fees 6.50 To make connection fees less of a deterrent to demand, a simple approach is to make the connection fees payable in multiple installments over an extended period of time. This has been adopted by PDAMs with varying degrees.

86 6.51 As an example, Table 6.2 calculates the monthly fees for a connection fee of Rp 250,000. Depending on the interest charges and the repayment period, the monthly charges range from Rp 5,600 to Rp 8,700. For an average-income household with seven people, this monthly charge represent less than 2.5% of their total expenditure (see Table 6.1). But for the very low-income families, this may still be a significant amount and may raise their water expenditure above 8% of the total expenditure. Table 6.2 Connection Fees in Multiple Installments Connection Annual Repayment Monthly Fees Interest Period Fees (Rp) (%) (year) (Rp) 250,000 15% 3 8,666 250,000 15% 5 5,947 250,000 12% 3 8,304 250,000 12% 5 5,561 6.52 To further reduce the impact of the connection fees, another approach is to make the connection fees part of the tariffs. In other words, connections are provided free of charges to new customers and connection costs are recovered from tariff revenues. The consequent increases on tariffs are very small because the tariff revenues are collected from both existing and new customers, i.e., the existing customers share part of the connection costs of the new customers. 6.53 For example, consider a PDAM with 10,000 connections, with an average tariff at Rp 400 per m 3 of water sold, and average water sold at 12 m 3 per month per connection. If the PDAM increases its connections by 10% to 11,000, the total monthly tariff revenues at Rp 400/m 3 would be Rp 52.8 million. If these 1,000 new connections are made at a cost of Rp 250,000 per connection, the total connection costs would be Rp 250 million. At an annual interest of 12%, the equivalent monthly costs would be Rp 2.5 million. Collecting this Rp 2.5 million through tariff revenues means that the tariff should be increased from the current Rp 400/m 3 to Rp 419/m 3, a 4.7% increase. 6.54 While under this approach the existing customers share part of the connection costs of the new customers, the required tariff increases are very small and the existing customers are generally wealthier than the new ones. To avoid inactive connections, however, the new customers should be asked to make some advance payment on their water bills, say between six months to a year. Implementation

87 6.55 Before fully adopting the proposed tariff structure, the water tariff-setting may go through a transitional period (e.g., one to three years). During this period, the number of user groups and the degree of progressivity can be reduced to some intermediate levels. 6.56 During the transition, PDAMs should improve their monitoring and reporting systems so that more timely and reliable operational, financial and general management information is available for evaluating performance, reducing costs, setting tariffs, and planning investments. 6.57 Efforts should also be made to improve operational efficiency, such as reducing UfW and improving labor productivity. Savings can be passed on to consumers and the extent of tariff increases would be reduced, and part of it can also contribute to efficiency bonuses and to capital expansions. 6.58 Consideration may also be given to establishing a water supply regulatory agency at the provincial level to manage the tariff setting process. It should be a small, high level organization drawing on expertise from within existing agencies. Its main responsibilities should include overseeing pricing principles and price adjustments, reviewing compliance by government agencies and enterprises (e.g., PDAMs) with their contractual obligations under commercial contracts, coordinating with line agencies of the government on related water sector issues such as catchment area management, groundwater regulation, tariffs and collection of accounts, water quality rights allocation, etc. 6.59 Currently PDAM tariffs are increased about every three years. Consideration should be given to a mechanism where tariff reviews between PDAMs and the Board of Supervisors (or the regulatory agency) take place only every four to five years. Between the reviews, tariffs should be annually, and automatically revised on the basis of an agreed cost index formula. This process would provide sufficient incentives to PDAMs to improve their productivity, and would avoid erosion of PDAM revenues and subsequent lumpy tariff increases. Guidelines should be issued by MoHA on the basis of tariff reviews, information to be prepared by PDAMs, and the cost index formulation. E. Case Study PDAM Pontianak 6.60 PDAM Pontianak, West Kalimantan, is used here as an example to illustrate the process of establishing a new tariff structure and to examine its impact on water users and the PDAM. 6.61 As of September 1996, the PDAM had a total of 29,400 connections, covering nearly 40% of the city s population (population of 460,000 in 1995). It obtains raw water from the Kapuas river which can be of unacceptable salinity for up to two months per year. It also intakes from the same river 28 km upstream where the water is usually of good quality. In 1995, water production was about 14.6 million m 3, and the amount of water sold was 6.5 million m 3.

88 6.62 The PDAM is currently implementing an investment program under the Kalimantan Urban Development Project (KUDP, Ln. 3854-IND). The program consists of: (a) reducing UfW from the current level of 53% to 28% by the year 2000; (b) extending the production capacity of 300 l/s by constructing a water treatment plant (WTP) IV in Imam Bonjol; (c) extending the distribution network and facilities; and (d) increasing connections by 25,515. The total capital expenditure of this program is Rp 35.6 billion. In addition, the PDAM is also carrying out a routine capital investment program for the period 1996-2000. This includes rehabilitation of distribution not covered by KUDP and upgrading WTP I, II, and III. The total cost is Rp 475 million. 6.63 Following the process described in Section D, Table 6.3 estimates the average (economic) incremental cost (AIC); average O&M cost; average O&M plus depreciation and interest (MoHA defined cost); average O&M plus interest and debt repayment (cash flow cost); and average O&M plus depreciation and a 10% return on fixed assets (average financial full cost). 6.64 Table 6.3 shows that the average incremental cost is estimated at Rp 875 per m 3 of water sold, average O&M at Rp 555/m 3, average MoHA cost at Rp 956/m 3, cash flow cost at Rp 796/m 3, and average financial full cost at Rp 1,050/m 3. 6.65 To examine how the PDAM tariffs match the costs, Table 6.4 shows the tariff revenues, volume of water sold, number of connections, average tariffs and average consumption for 1995. Households account for about 86% of the connections but only contribute about 50% of the revenues. On the other hand, business and industry users account for only 11% of the connections but provide about 44% of the revenues. Comparing the tariffs (in effect since May 1993) with the various average costs in Table 6.3, it is clear that the average tariff paid by the households, at Rp 540/m 3, does not even cover the average O&M cost. But the average tariff of the business and industry are about twice the average full financial cost. The overall average tariff is Rp 798/m 3, about 9% below the average incremental (economic) cost and 24% below the average full (financial) cost. 6.66 In December 1995, the PDAM increased the tariffs by about 25%. Table 6.5 shows the new tariff schedule. The PDAM provided the Bank with a full set of the customer database for the month of October 1996. Table 6.6 presents the consumption and total and average tariffs for that month.

89 Table 6.3 PDAM Pontianak: Calculation of Average Incremental Costs and Other Costs 1995-2010 1,995 1,996 1,997 1,998 1,999 2,000 2,001 2,002 2,003 2,004-10 Year 0 1 2 3 4 5 6 7 8 9-15 Vol of Water Sold (000 m3) 6,535 6,861 8,754 10,596 13,417 14,975 16,495 16,770 17,045 17,320 Incre l Water Sold (000 m3) 326 2,219 4,061 6,882 8,440 9,960 10,235 10,510 10,785 11,060 PV (@10%) 58,307 Calculation of Avg Incremental Cost (in Constant 1995 Price) Total Operating Costs (Rp m) 3,626 4,691 5,517 6,561 7,526 7,978 8,210 8,253 8,298 8,344 Incremental Op. Costs (Rp m) 1,065 1,891 2,935 3,900 4,352 4,584 4,627 4,672 4,718 4,740 Investment Costs (Rp m) 1,016 7,778 13,868 6,697 2,913 600 0 0 0 0 Total Investment and Incremental Operating Costs (Rp m) 2,082 9,669 16,803 10,596 7,265 5,184 4,627 4,672 4,718 4,765 PV (@10%) 51,023 Avg Incre l Cost (Rp/m3) 875 Calculation of Avg Financial Costs (in Current Price) Total Operating Costs (Rp m) 3,626 4,973 6,199 7,814 9,501 10,676 Depreciation (Rp m) 1,622 2,168 3,458 4,534 5,061 5,083 Interest (Rp m) 1,001 1,471 2,321 3,104 3,284 3,195 Debt Repayment (Rp m) 572 565 162 992 1,287 1,262 Avg Fixed Asset (Rp m) 16,145 19,583 26,778 34,237 37,550 37,465 Return on Assets (@10%) 1,614 1,958 2,678 3,424 3,755 3,747 Average Costs (Rp/m3): O&M 555 725 708 737 708 713 O&M, Dep. and Interest 956 1,255 1,368 1,458 1,330 1,266 O&M, Interest and 796 1,022 992 1,124 1,049 1,011 Principal O&M, Dep. and Return 1,050 1,285 1,331 1,370 1,218 1,122

90 Table 6.4 PDAM Pontianak - Water Tariff Revenues and Consumption 1995 Public Taps Hospitals, Households Embassy, Business, Total Schools Government Industry Connections (#) 273 204 22,028 227 2,764 25,496 Tariff Revenues (Rp m) 32.38 69 2,584 245 2,287 5,217 Consumption (000m 3 ) 169 193 4,789 307 1,077 6,535 Percentages by Users: Connections 1.1% 0.8% 86.4% 0.9% 10.8% 100.0% Tariff Revenues 0.6% 1.3% 49.5% 4.7% 43.8% 100.0% Consumption 2.6% 3.0% 73.3% 4.7% 16.5% 100.0% Average Tariff (Rp/m 3 ) 191 358 540 799 2,123 798 Consum/Mon/Connect 52 79 18 113 32 21 (m 3 ) Source: Financial accounts of PDAM Pontianak, West Kalimantan Table 6.5 PDAM Pontianak: Tariff Schedule (effective December 1995) Minimum - 15 m3 16-30 m3 31-50 m3 +50 m3 (m3) (Rp/m3) (Rp/m3) (Rp/m3) (Rp/m3) I. Social a. Public Taps 15 100 150 200 250 b. Schools, 15 250 300 350 500 Hospitals II. Non-Commercial a1. Household 15 400 600 800 1200 a2. Household 15 500 700 900 1300 a3. Household 15 500 700 900 1300 b1. Household 15 400 600 800 1200 b2. Household 15 500 700 900 1300 b3. Household 15 700 800 1000 1400 c. Household 15 600 700 1000 1400 d. Household 15 800 1000 1200 1800 e. Embassy 15 700 800 1000 1400 f. Government 15 600 700 800 1200 III. Commercial a. Small 30 1200 1600 2000 b. Large 30 1600 2400 3300 IV. Industry a. Small 30 1200 1600 2000 b. Large 30 1600 2400 3300 V. Special a. Harbor 50 3500 4000 b. Tank Truck no limit 1600 1600 1600 1600 Note: Household categories II/a to II/d refer to households in different areas (non-commercial and commercial) and different types of houses (permanent, semi-permanent, and simple).

91 6.67 While the new tariff schedule is much more complicated than the previous one, Table 6.6 does show that the tariff change raised the overall tariffs closer to the cost recovery level. But it also reveals the distortion of the very low average tariffs for the households (e.g., groups IIa and IIb) and the very high average tariffs for business and industry users (groups III and IV). In addition, average tariffs for those connections with monthly consumption below 10 m 3 are extremely high, ranging from Rp 1,500/m3 to Rp 12,000/m 3. This is caused by the minimum consumption requirement (15 m 3 or 30 m 3 ) in the tariff schedule. 6.68 Following the recommendation in Section D, and considering the following elements: (a) the incremental and average costs in Table 6.3; (b) the water consumption patterns of the user groups; and (c) the expenditure levels of Pontianak population in Table 6.7, a new tariff schedule is constructed and presented in Table 6.12. Table 6.6 PDAM Pontianak Water Tariff Revenues and Consumption for October 1996, I/a I/b II/a1 II/a2 II/a3 II/b II/cd II/ef III/ab IV/ab Total Connections 348 230 12472 7483 701 1243 3807 220 2874 52 29,430 Tariff Rev (Rp 000) 4,628 11,020 152,930 126,596 17,117 30,054 75,030 27,824 236,586 3,193 684,976 Consumption (m3) 20,733 23,418 233,993 155,537 21,093 36,128 78,783 25,599 102,608 1,849 699,741 Avg Tariff (Rp/m3) 10 m3 or less 1,536 2,227 1,782 2,601 1,920 1,856 2,467 4,966 12,191 8,833 2,839 above 10 m3 215 459 585 729 786 805 876 1,074 2,110 1,645 901 Overall 223 471 654 814 812 832 952 1,087 2,306 1,727 979 Table 6.7 PDAM Pontianak: Monthly Per Capita Expenditure Class (1995) (Rp 000) 10 less 10-15 15-20 20-30 30-40 40-60 60-80 80-100 100-150 150-200 200 more Total % of Pop - - - 1.5 7.2 27.1 23.8 17.9 13.7 5.4 3.5 100.0 Table 6.8 PDAM Pontianak: Proposed Tariff Schedule Monthly Water Consumption Minimum below 10 m 3 above 10 m 3 (m 3 ) (Rp/m 3 ) (Rp/m 3 ) I. Social a. Public Taps no limit 300 300 b. Schools, Hospitals no limit 500 500 II. Non-Commercial a. Households no limit 500 1000 b. Embassy and Government no limit 1000 1000 III. Commercial and Industry no limit 1000 1000 6.69 Table 6.9 presents the tariff revenues and consumption under the proposed tariff schedule. In estimating the consumption under the proposed tariffs, price elasticity estimates are

92 used; -0.3 for social groups, households and embassies and governments, and -0.6 for business and industry users. In addition, no consumption change is assumed for those connections whose consumption amounts are 10 m 3 or less, even though their average tariffs are reduced significantly under the proposed tariff schedule. This is because the consumption amounts of these connections are not constrained by the current tariffs (at least in the short run) due to the minimum consumption requirement. 6.70 The current fixed charges include a central government stamp charge at Rp 1,000, administration charges ranging from Rp 200 to Rp 2,000 per connection, and meter maintenance fees ranging from Rp 1,000 to Rp 30,000 per meter. These charges don t follow the actual fixed costs incurred. For the current case study, the fixed charge can be set as follows: From the estimated AIC (Rp 875/m3) and average full financial cost (Rp 1,050/m3) in Table 6.3, an estimated fixed cost can be obtained as Rp 175 (=1,050-875) per m3 of water sold. Then using the figures of average monthly consumption per connection in Table 6.4, estimates of fixed monthly charges can be obtained, e.g., Rp 3,150 for households, Rp 5,600 for business and industries, Rp 19,800 for embassy and government offices, etc. For simplicity, this case study assumes fixed charges of Rp 1,500 for public taps, hospitals and schools; Rp 3,500 for households; and Rp 6,000 for embassy and government offices, business and industries. 6.71 A comparison of Table 6.9 with Table 6.3 shows that the average tariffs paid by all groups, in particular, the households and business and industry users, are much closer to the average and marginal costs than before, therefore reducing price distortions and increasing economic efficiency. The tariffs on business and industry users are reduced, particularly for the large group of business users, making the charges more in line with the costs and encouraging more efficient choices of sources of water, types of technologies, etc. While the average tariffs are increased for households, many elements of the proposed tariff schedule, including the lifeline rate, the elimination of minimum consumption requirement, and the low rates for public taps and other social groups, significantly lower the average tariffs for consumption below 10 m 3 and ensure that the water is affordable by the poor and low-income social groups.