Economic imbalances may be caused by either internal causes that are endogenous to the company or by causes external to it, and can affect revenue, costs or both. In turn, external causes may be the result of political decisions or changes in the conditions of service provision.
Table 30 provides some typical examples of the various causes affecting costs or revenue. The distinction between internal and external causes is critical, as the origin of the disequilibrium should be made a key element in designing the solution to the distress situation.
Table 30: Elements Affecting Economic Equilibrium
|
|
| Revenue | Costs |
| Internal |
| Commercial inefficiency causes an excessively high uncollectable rate | Operational inefficiency causes costs higher than the efficient costs accounted for in the tariffs |
| External | Political | Prohibition of service disconnection for nonpayment negatively affects collectability | Increases in specific taxes or costs as a result of environmental regulations |
| Natural | Lower demand than expected causes a reduction in expected revenue | Increases in the prices of raw materials (e.g. oil) |
Internal causes are primarily related to inefficiencies of the company itself and, accordingly, the firm must face the consequences -in terms of a lower return on its capital. The perception of negative effects by the company as a consequence of its low performance is fundamental to the entire system of incentives for productive efficiency. This does not mean that the problem can be ignored and that there is no need for corrective measures. Under certain circumstances, the authority's failure to take measures may cause the disequilibrium to spread to the remaining areas (financial and operational) negatively affecting service provision to the users.
On the other end are the situations brought about by external causes that are political in origin, such as modifications of the environmental regulations or the imposition of obligations or restrictions on the service due to political or social reasons. In these cases, the negative effect on the company's equilibrium is entirely due to changes in external conditions and, accordingly, the company should not bear the related costs.
In the middle ground lie the imbalances associated with natural external effects such as declines in demand or increases in the costs of inputs that are outside of the company's control and materially affect the service. In these cases, it is necessary to assess the extent to which such changes are ordinary risks underlying the business which, accordingly, should be assumed by the company (for which purpose they should have been accounted for ex ante in the cost of capital) or, alternatively, that they lie outside of ordinary situations and thus amount to a significant change in the conditions of service provision.
The allocation of risks in the contract establishes, from the very beginning, which party shall bear the variations in the conditions of service provision. In many cases, this risk may be allocated to third parties who are not parties to the contract through insurances that cover the variations in extraordinary events or key variables which may adversely affect the service. In such cases, the responsibility for acquiring said insurances and their financing represents a key aspect that should be determined in the original design of the contract.
In some cases, the distress situation arises due to a significant difference between the original assumption of the estimations and the effective values once the project is completed. In this case, the logic would indicate that the party that established the original values should bear all the costs linked to the estimation mistake (see BOX 38 including Transantiago case).
BOX 38: Transantiago
| PPP contracts may explicitly determine some business management variables. Many operative distress situations may originate in wrong estimations of such variables. That was the case which took place after the implementation of the newly public transport system known as "Transantiago" in the city of Santiago de Chile. After this system was implemented in February 2007, the concessionaires of buses services were unable to meet the citizen transportation demand that caused the whole system to collapse. The origin of the distress situation may be found in a significant demand underestimation by the system planning organization. The authorities revealed that the original calculation underestimated the demand by, at least, 14.5%. The bus fleets of the concessionaires were determined on the basis of the demand estimation made by the government before the bidding process. A total of 5,600 buses was estimated for the whole fleet. At the time of implementation, the system had 5,000 buses. In view of the problems affecting the system, the contingency measures adopted rapidly increased the number of buses until reaching the number pre-defined by the plan. Notwithstanding that, the system still provided a deficient service. Finally, once all original implementation conflicts were settled, a series of measures were addressed so as to alleviate the situation. Among them, the purchase of 1000 buses and the construction of 1700 additional bus stops stand out. Both measure entail extraordinary expenditures not originally contemplated in the financial analysis of the project and involve an injection of 290 million dollars by the government to Transantiago in order to cover the deficit of the system during the year 2007. |
Even though useful from the analytical standpoint, the distinction discussed above is not always easy to draw, as in the real world companies may suffer imbalances in their economic equation as a result of multiple causes affecting them simultaneously, with complex effects on costs and revenue.
Macroeconomic crises are a typical example of an external cause affecting both costs and revenue. Another distinguishing feature of such crises is that they cannot be easily attributed to the political and natural causes which, in most cases, converge in a series of elements triggering the crisis. Their main effects are discussed in BOX 39.
In view of the breach of equilibrium, it is then necessary to analyze different alternatives to reformulate economic equation under the new conditions.
The first issue to consider consists in identifying the risk allocation assumed by investors so as to evaluate to what extent the changes in the economic environment constitute a substantial deviation from the original economic equilibrium.
BOX 39: Macroeconomic Crisis
| Macroeconomic crises produce important negative effects on infrastructure sectors, as well as on the rest of the economy, breaking in the short run the equilibrium. In the first place, the strong impact of devaluation processes associated with these crises causes a sharp increase in the cost of imported inputs, which represent an important part of service costs. The rest of the costs also increase due to the rise of inflation coming along with devaluation and crises. Another highly important element lies in the increase of the cost of capital faced by the firm as a consequence of the rise of the country's sovereign risk. This has an immediate effect in the case of cost of service regulation or on the new tariff period in case of price cap regulation155. Crises strongly affect demand as well. The increase of unemployment and the fall of income per capita cause a negative effect on the demand faced by the firm. In many cases, collection problems may also appear, particularly in those sectors where service interruption for non-payment is limited due to social, political or technological reasons. Financing restrictions faced by the firm also affect its consumers and produces an indirect effect on service access. If imposed financing limitations, many users will not be able to afford the investments they need to make to connect to the network (internal pipes, for example) and therefore, will not access the service even when the infrastructure is completed. In addition to these general tariff-level-related problems and in the context of strong crises, other problems may arise more related to tariff structure. While in normal times, the regulator may opt to apply structures that privilege allocative efficiency, in a crisis context, he may find that they are particularly unsuitable to face affordability problems. At the same time, fiscal crisis causes that if transfers from Treasury are to be made in favor of the firm, the same will be disrupted or, at best, delayed by the government. The result of the impact of these combined effects represents such a breach of the firm's economic equation that equilibrium cannot be restored in the short run by applying the traditional regulatory mechanisms. Indeed, under a cost of service regulatory regime, the regulator cannot perform a tariff review due to the increase in costs. If governed by a price cap regulatory regime, the situation is not much better, since it is probably unfeasible to stick to the indexation rules originally agreed upon. Furthermore, if indexation is applied, the acceleration of inflation and both the direct and indirect effects of devaluation would most likely result in social and politically unviable tariff increases. |
In this respect, it should be pointed out that a direct mechanism to assess the risk assumed by investors at the time of investing is the analysis of the cost of capital approved by the regulator during the last tariff review process, if any. Following both international standard regulatory practices and generally accepted regulatory principles, the service provider remuneration includes a return on capital that reflects the risks assumed by investor.
Analyzing then the way in which the cost of capital was determined, we can get an objective answer to the question about the extent to which "the risk considered in the return on capital has been exceeded by the resulting conditions of risk or whether the current situation is still within reasonable conditions of risk?"156
It is worth mentioning that the nature of this problem is purely empiric and not conceptual. The idea is to identify the conditions of risk incorporated in the parameter values used to determine the cost of capital during the last periodic tariff review. This is a good example of a non-contracted situation, which requires of decisions to be made ex-post as part of the contract management process.
Typically -although this clearly differs in each particular case-, variations in the demand level and the possibility of facing an increase in collection problems are contracted variables. In some cases, these fluctuations are to be assumed by the firm as part of the business risk. This would be the case for sectors such as water or electricity distribution in which demand can be predicted with a relatively good degree of approximation and the company has some control over it. For other cases, such as traffic demand in a highway, in which demand is less predictable and the company has little or no control over it, the public party would assume the risk, at least in part.
However, in most cases each particular risk will affect the way in which the regulator determined the cost of capital. Devaluation constitutes an illustrative example of this (see BOX 7 ).
BOX 40: Currency Devaluation Costs
| In the event of an unanticipated change in the exchange rate, two different situations can take place. If regulator used a cost of capital in domestic currency in his estimation (which is generally higher than the cost in dollars), shareholders have to assume the effect since tariffs explicitly included the fact that their assets were remunerated in domestic currency. On the contrary, if regulator estimated a cost of capital in dollars (which assuming a proper analysis and all other relevant revenue and costs variables have been treated consistently is usually lower than the cost in domestic currency), users have to face the effect of devaluation. In this case, the firm is implicitly given foreign-exchange insurance since it is given a cost of capital in foreign currency, which results lower than the cost of capital in domestic currency. |
On the other extreme, measures such the non-application of the indexation rules included in the agreement or the regulator's refusal to perform a tariff review envisaged in the legal framework constitutes a change in the rules of the game and cannot be considered as business risks that the firm has to assume.
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155 The increase in risk also brings about credit restrictions leading to financial distress which in turn could become an economic problem.
156 This question was formally raised in a public hearing in the context of a renegotiation of concession contracts in San Juan, Argentina.