AFTER A NOISY CLASH over the possible disallowance of claims for income tax payments, the Metropolitan Water and Sewerage System (MWSS) and its two private concessionaires are in the midst of another row.
This time, it is over the level of guaranteed returns that the water companies are entitled to get — a major factor in setting water tariffs.
How this debate ends will determine not only what price customers will have to pay for water but also how much profit the water firms could make in the next five years.
Manila Water Co., which provides water service in the eastern half of Metro Manila and surrounding areas, wants to increase rates by P5.83 per cubic meter or 21 percent to P34.12 per cubic meter.
Maynilad Water Services, Inc., which runs the water system in the west zone, is proposing to increase average basic rates by P8.58 per cubic meter or 25 percent to P42.55 per cubic meter.
Since MWSS was privatized in 1997, water rates have soared nine-fold in Manila Water’s east zone and more than six-fold in Maynilad’s west zone.
Apart from being allowed to recover past expenses and future costs from tariffs paid by customers, the two water companies are also allowed to earn a return on those cash outflows.
For the next five years until 2017, they want a return, also called the appropriate discount rate or ADR, of 8.99 percent, according to people privy to the discussions. The ADR is real or net of inflation so the actual return would be higher depending on the pace of consumer price increases.
That is almost unchanged from the discount rate of 9.3 percent for 2008-2012, and slightly lower than the ADR of 10.4 percent for 2003-2007, despite sharply falling yields on long-term government bonds.
Impact on customers
The water firms’ proposed ADR means they will earn almost nine pesos out of every P100 they spend, including that for income taxes. That is apart from rightly getting back the P100 itself.
The ADR also works like a compounded interest on the water companies’ unrecovered expenses. At nine percent, an unrecovered expense of, say, P100 five years ago is now worth P154.
As any struggling borrower knows, compounding interest rates can be a heavy burden, making the ADR a central issue in the rate rebasing process.
Indeed, more than 90 percent of Maynilad’s unrecovered expenses of about P67 billion as of end-2012 actually represent “cost of money” or compounded interest, according to its own presentation in a public consultation last June.
Manila Water did not say how much of its P41-billion unrecovered expenses represent compounded interest, but it will likely be similar to Maynilad.
MWSS water regulators find the proposed discount rate of 8.99 percent too high, given that yields on long-term Philippine government bonds have plummeted, especially in the last five or six years as the country’s economic fundamentals have gotten better alongside falling U.S. interest rates.
The regulators are said to have initially set the ADR at 6.16 percent, according to people familiar with the discussions between the MWSS and water firms.
Neither the MWSS Regulatory Office nor the water companies would officially comment on their respective ADR estimates.
Emmanuel Caparas, the MWSS regulator chief, refused to comment on regulators’ ADR estimate, saying they are still in discussion with the water companies. He said though that the regulators think the ADR should drop sharply in line with lower yields on Philippine government bonds.
Maynilad Water’s chief financial officer Randolph Estrellado, meanwhile said the two water companies are constrained from disclosing any information on their ADR estimates by restrictions in their agreement with a common international consultant.
Changed reality
Interestingly, the slow decline in the proposed ADR today contrasts with its quick rise in the late 1990s and early 2000s when it almost doubled in the wake of the Asian financial crisis of 1997-1998. (See chart)
In plain terms, water rates increased faster in the early years of privatization as a result of big jumps in the ADR, because of higher interest rates and the peso’s decline.
Today, amid lower interest rates and a stronger peso, the returns of water firms are expected to also fall proportionately, thus tempering any increase in the price of water.
However, by many accounts, the water firms’ proposed ADR of 8.99 percent does not seem to reflect this changed reality.
It remains to be seen if the two parties will eventually bridge the wide gap in their ADR estimates. Should they not, the regulators’ sharply lower discount rate could trim a big part of the water companies’ proposed rate increases.
Manila Water could be facing a cut of more than two-thirds in its expected rate increase from P5.83 per cubic meter to only P1.63 per cubic meter. Maynilad may see its proposed rate increase almost halved from P8.58 per cubic meter to just P4.38.
The figures are PCIJ’s calculations based on water regulators’ estimate that a percentage change in the ADR adjusts water rates by P1.40 per cubic meter. The figures do not yet take into account the rate impact of expenses disallowed by regulators for failing to meet the prudence and efficiency standards.
The water companies are warning that the regulators’ ADR estimate of 6.16 percent, which effectively shaves off about a third from their existing guaranteed return of 9.3 percent, could dampen their incentive to invest, and result in withdrawal of shareholder capital and decline in water service standards, according to people close to the water firms. “The most expensive water is no water,” one of them said.
Formula vs. practice
Though there is a formula for the ADR, calculating its value can be difficult in practice because of the subjective decisions that need to be made, according to Felipe Medalla, the former economics planning chief who was MWSS’s consultant on determining the ADR in 2002 and 2007. “One of the debates is how much of the past do you include,” he said.
In 2007, the water companies’ consultant pushed for the use of the yields on 25-year Philippine government bond as basis for estimating the risk-free rate while Medalla argued for the 10-year or 15-year Philippine bond. Medalla is an independent member of the Monetary Board.
The risk-free rate refers to the return on an investment with zero or very minimal chance of defaulting. The yield on a long-term government bond is often used to approximate the risk-free rate, which is a big factor in the ADR’s final value.
Today the water companies are again pushing for the 25-year Philippine bond as benchmark for the risk-free rate while the regulators are insisting on the 10-year bond, according to people familiar with the discussions. The dispute is not a trivial one. At stake is about a one-percentage point addition to the value of ADR if the 25-year bond is used, according to PCIJ calculations.
Another source of variance between the regulators and water firms’ ADR estimate is whether the bond yields are averaged over a year or five years. The water companies want to use a five-year mean while the regulators want a period of just a year.
The precedents are mixed. In 2002, the regulators and water firms agreed on a one-year average to set the ADR for the 2003-2007 period. But in 2007, they revised this to five years for the ADR for the 2008-2012 period. Again, the issue is critical, as difference between the two averages could be 1.9 percentage points in the final ADR.
Medalla said he had expected the water concessionaires to propose an ADR of seven percent or even eight percent, and was surprised to hear they were actually pushing for almost nine percent. “Could you believe that the cost of money dropped by just 0.3 percentage points (in the last five years)?” he asked, comparing the proposed ADR to the previous discount rate of 9.3 percent set in 2007.
Medalla’s figure
Doing his own rough calculations by hand, Medalla believes the ADR for the water companies should fall to below six percent mainly because the yield on Philippine government debt has plummeted.
From 7.4 percent in mid-2007, when the previous ADR was set, the nominal yield on 10-year U.S. dollar denominated Philippine government bond dropped to just 3.97 per cent mid-July, according to Bloomberg data. (See chart)
Medalla estimates that the real risk-free rate, based on yields on 10-year U.S. dollar Philippine government bonds adjusted for inflation, averaged only three percent in the last five years or so compared to about 6.3 percent in the five-year period to 2007 when the last rate rebasing was done.
His estimates exclude the recent peaks in yields following the collapse of U.S. investment bank Lehman Brothers in 2008. Noted Medalla: “Do you think another Lehman-like collapse will happen again soon? They said it was the worst financial crisis since the Great Depression in the 1930s. So, I would not include that.”
Securities analysts who cover Manila Water also came up with an ADR estimate that is quite close to, though a bit lower than, the water companies’ proposal. In a research note released early July, Laura Dy-Liacco of ATR Kim Eng Securities assumed a discount rate of 8.3 percent for the water firm in estimating Manila Water’s future revenue and profits.
No textbook rules
A water regulator agreed with Medalla that there are no textbook rules on the maturity of benchmarks or the averaging period to be used. According to the regulator, the point of the entire exercise is to predict as closely as possible the future direction of the cost of funds.
While both the regulators and the water firms agree that Philippine government bond yields are on the way up from recent lows, they disagree on the pace of the increase. The water firms believe the upward slope will be steep while the regulators think it will be modest.
Still, the regulator interviewed by PCIJ wants to use a one-year average as it is a better predictor of future rates in the current period. The water official points out that past estimates of the risk-free rate, based on a five-year average, overshot the actual average between 2008 and 2012 by around 2.5 percentage points. That added billions of pesos to the present value of the water firms’ unrecovered past claims, which are compounded using the ADR.
“It’s understandable they will argue for a longer averaging period. As investors, they want stability,” said the regulator. “However, we also have to consider the welfare of the consumers and not just the water companies.”
Déjà vu debate
In some ways, the debates today echo the discussions between Manila Water’s consultant and Medalla, as a MWSS consultant, in June 2007 when they were debating the ADR for the 2008-2012 period.
The water company’s consultant, Mabuhay Capital Corp., wanted to use yields on the 25-year Philippine government bond as a proxy for the risk-free rate instead of the 10-year bond used in 2002. It argued that the real yields on 10-year bonds, which were then averaging 4.75 percent that month, “will not be sustainable in the long-term, over the remaining life of the concession,” according to the minutes of a meeting held in June 2007 obtained by the PCIJ.
Medalla insisted on using a shorter-dated instrument, either a 10-year or 15-year bond, pointing out that “current low interest rates are sustainable at least in the next five years due to excess liquidity in the Asian region,” according to the same document. “He also stated that looking backward for 25 years on local interest rates would reflect more the political turmoil of the past rather than the financial fundamentals of the country.”
As it happened, the real yield on the 10-year Philippine government bonds, though briefly shooting up after Lehman Brothers collapsed in the United States, has dropped further to below one percent six years later.
The steep fall in government bond yields contrasts sharply with the sluggish decline in the ADR, which is updated or recalculated only once every five years. That has prompted some experts to wonder if the water companies could earn above-market returns from the growing gap between the fixed discount rate and dropping bond yields.
Long vs. short duration
A professor at the UP College of Business Administration, one of the speakers during a forum on rate regulation on July 19, surmised that the long duration — usually four or five years — before regulators update utilities’ cost of capital could be giving water and electricity companies higher than market returns during periods of sharply falling interest rates such as the past five years.
Pointing to a graph showing a steep drop in dollar denominated Philippine government bond yields in the past few years, Helen Valderrama said: “We are wondering whether we should lock in the WACC (weighted average cost of capital) for a four or five year regulatory period or allow it to vary every year.
The last five years has shown the risk free rate has been continuously going down. If you lock in a WACC at the beginning, it is possible for you to give a return that is higher than what these investors would have gotten had they gone to the market outside the Philippines.”
The notion is appealing. The water companies’ ADR of 9.3 percent was appropriate in 2007 when the real yield on the 10-year Philippine government bond was hovering at around 4.75 percent. But the discount rate may no longer be aligned with the market trends when the yield fell just around one percent in early 2013, possibly giving the water firms higher than market-based returns.
How steep up, down?
But Romeo Bernardo, a former finance undersecretary who now sits as director of the Bank of Philippine Islands and who was part of the forum’s audience, raised an objection to the idea. He said that a longer observation period lasting at least five years “is the best practice in other regulatory regimes.”
Bernardo argued that shortening the observation period to just a year may introduce more uncertainty in rate regulation. “Most analysts are saying we are at an inflection point in interest rates, that it could actually go up,” he interjected. “The question now is how steep is the going up? Will it be as steep as the going down?”
As the UP forum shows, the issues being threshed out by the water regulators and the water companies, even the more complex financial questions, resonate among a broad audience of concerned and knowledgeable people. Perhaps the water regulators and the water companies need to engage with a wider crowd if only to hear more views beyond what they’re getting from their pricey consultants. — PCIJ, July 2013