What is rate rebasing?

IN PRINCIPLE, the setting of basic water rates for customers of Manila Water Co. and Maynilad Water Services Inc. is easy enough to understand. Of course, the key phrase there is “in principle.”

According to the 1997 Concession Agreement between the Metropolitan Waterworks and Sewerage System (MWSS) and its two concessionaires: “… the rates for water and sewerage services … shall be set at a level that will permit the Concessionaire to recover over the 25-year term of the Concession operating, capital maintenance and investment expenditures efficiently and prudently incurred, Philippine business taxes and payments corresponding to debt service on the MWSS Loans and Concessionaire Loans incurred to finance such expenditures, and to earn a rate of return on these expenditures for the remaining term of the Concession.”

The process is repeated at least once every five years, in what is called a rate rebasing review, to take into account long-term changes in business conditions such as the cost of capital as well as modifications in future investment plans in response to new laws or policies.

For example, in 2009, the Supreme Court mandated the MWSS and its concessionaires to help clean up Manila Bay to ensure it is good enough for “swimming, skin-diving and other forms of contact recreation.” That decision meant the water firms had to invest more in sewerage facilities sooner than expected, raising future tariffs. In 2009, the Concession Agreement was extended by another 15 years, which helped ease water rate hikes.

Other regular rate adjustment mechanisms — the Consumer Price Index (CPI) and Foreign Currency Differential Adjustment (FCDA) — take care of annual changes in consumer prices and quarterly changes in the foreign exchange rates, which have a significant impact on payment on the MWSS’s mostly foreign loans. Financial consequences of unforeseen events such as a major drought are address through the Extraordinary Price Adjustment (EPA).

But the rate rebasing review is a complex process that often takes the MWSS Regulatory Office an entire year to finish. Unlike rate changes due to inflation and foreign exchange rates, which can be easily calculated by anybody because the consumer price index and currency data are available in the public domain, rate rebasing involves examining the two water companies’ past and future cash receipts and expenditures. While verifying the cash flows is hard enough, the tougher part of the job is making a judgment if each and every item was “prudently and efficiently incurred.”

MWSS regulators said they and the auditors they hired have gone through tens of thousands of transaction records and documents over the past six or seven months.

That’s not all, though. Alongside an extensive audit of the water firms’ cash flows, the MWSS Regulatory Office also calculates the applied discount rate (ADR), which effectively serves as the water companies’ guaranteed rate of return on its expenditures. The ADR is derived based on the cost of debt in international and domestic markets, the cost of equity for utilities in the Philippine and abroad, adjusted for country risk, currency risk, and other project risks.

Though there is a formula for calculating the ADR, deciding the scope of data to be used in determining the variables that are plugged into the formula can be contentious. For example, should domestic interest rates this year, after the Philippines got an investment grade credit rating, be included in the data? What utilities and from which countries should be included in estimating the cost of equity for utilities?

The discussions between the MWSS regulators and the water companies could be technically difficult and obtuse, but never irrelevant for consumers. Each percentage point change in the ADR means an adjustment of P1.40 per cubic meter in water rates while a P10-billion increase or decrease in allowable expenses translates to about half a peso per cubic meter change in water rates, according to data from water regulators.

The current ADR is 9.3 percent, agreed back in 2007, and the water companies are proposing a new discount rate of 8.99 percent for the next five years. Water regulators believe it should be much lower. For one, 91-day Treasury Bill rates have fallen sharply from 5.39 percent in 2008 to just 1.58 percent in 2012, and further to 0.22 percent in May 2013.

But after the past and future cash flows are determined — presumably excluding those that were not efficiently and prudently incurred — and the ADR is calculated, the MWSS regulators just plug in all the numbers in a huge electronic worksheet. The computer then basically solves for the basic rate adjustment needed that will allow the water companies to earn enough revenues in the next 24 years to meet past and future expenses. — PCIJ, July 2013

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