A typical PPP project will consist of an initial construction phase followed by an extended operations phase. The financial model must capture the cash flows from both phases to assess whether the future revenue from the proposed project can justify the initial investment of capital.
The following items, shown in bold print below, are key inputs to water supply PPP financial models:
● Initial project costs. These include expenses associated with surveys, design, procurement, engineering, construction, land, etc., by the year incurred. Note that these are costs incurred by the private investor. If, for example, the land is provided at no charge by the LGU, it is recorded as a zero cash outflow in the model. Most projects may be developed in different ways, so it is important to be clear on exactly what assets are obtained with the initial capital expenditure. Subsequent revenues and costs must be consistent with the asset base that has been installed. For example, if a water supply project calls for the initial construction of a 10,000 cubic meter per day water treatment plant, with subsequent expansion to 15,000 cubic meters per day, the financial model should not show costs or revenue from the extra capacity until the relevant capital expenditure has been included. Project costs are valued in base year prices (base year refers to the time the analysis is undertaken) but price contingency will be added for each construction year, with revenues and costs inflated using an appropriate index.
● Demand forecasts. Demand forecasts used in the financial model should be the product of a thorough user survey. The study should address such issues as willingness to pay and cost of alternative water supply source. For example, households with existing deep wells will likely not choose to connect to the water distribution network.
● Tariff path. Tariffs are a key determinant of project revenue. Forecasts for the latter should be made in conjunction with the preparation of estimated usage, so that the two are consistent. That is, the forecasted use of the facility should be based on the estimated demand for the service at the forecasted tariff, thereby taking demand elasticity into account.
Although water supply tariffs are subject to regulation, this does not imply that current tariffs will apply in the future under PPP service delivery. The tariff path derived should be sufficient to achieve full cost recovery within the concession period. Total revenue is then derived from the usage expected at that tariff level. At full cost recovery, this product should cover depreciation of (initial and deferred) capital investment as permitted by law, operation and maintenance costs, debt service, plus a reasonable investment return to private investors. Where current tariffs are below this level, a tariff adjustment path should be set so that full cost recovery is achieved within a reasonable period of time. If the market is unable or unwilling to sustain the project at this level, the project will not be suitable for PPP implementation unless the LGU is prepared to provide direct support in the form of a capital investment grant or an operating subsidy.
● Operating and maintenance costs (O&M). O&M expenditures are outflows of cash needed to operate the service and maintain the assets over the term of the concession. Maintenance costs should include both routine and periodic (preventive) maintenance expenses. Future projections will be made from base year estimates, inflated by an appropriate index related to underlying cost drivers. Cost drivers should be identified for individual cost items rather than applying a general inflation index to all costs. For example chemical costs for water treatment would be related to water volume produced, and a rise in consumption should be reflected by a rise in the chemical costs. Costs can be calculated by building up direct, indirect and overhead costs based on historical data or, more usually, as a percentage of project costs or revenue.
● Depreciation. This is the allocation of asset cost over the life of the assets. Depreciation is not a cash item, but is an allowable tax deduction. Depreciation should be calculated based on national regulations.
● Debt service arrangements and costs. These arrangements include a number of items such as the types and amounts of debt (if originating from more than one lender), interest rates, associated fees payable to lenders and guarantors. Also included are the interest and principal payments, taking repayment and grace periods into account.
● Tax rates. The national corporate rates are used, including any incentives applicable to PPP projects.
● Currencies. Although not common for LGU projects, the financial model should be able to deal with foreign and local currencies. A foreign investor will assess the USD return in dividends on a PPP project, but a LGU investor will look for a peso return. Normally investors do not want to bear currency risks.
● Inflation. The values entered into the model for future costs and revenues include inflation. That is, they are the actual nominal amounts, expressed in pesos. The model therefore needs to include estimates of domestic inflation rates. Targeted indices, closely aligned with the project's cost structure should be used for this purpose, rather than a broad-based index such as the consumer price index (CPI).
All projects suffer from forecasting difficulties and this should be borne in mind at both the modelling stage and risk assessment stage where inaccuracies in demand forecasts may substantially outweigh uncertainties in other model inputs/assumptions.