The combination of service standards (costs) and tariffs (revenues) determines the commercial viability of a project. Beyond that, the private operator has the chance to improve the ultimate financial outcome by being particularly efficient in investment and operations. Therefore, a private operator will only get involved in a project if it sees a fair chance to make a profit given a predetermined set of service standards and tariffs.
The internal rate of return (IRR) and return on equity (RoE) are the most commonly used measures to assess the financial attractiveness from a private operator's perspective (as described in section 3.5). A private operator will assess the potential IRR of a project against its own cost of equity, adjusted for the perceived risk of the project. A private operator may be willing to accept a lower IRR if some risks are reduced or mitigated through government actions or otherwise. Revenues are considered adequate if they enable an operator to maintain, replace, modernize, and expand its services and assets. (See Box 13 for Chile's experience in electricity pricing.)
Box 13: Electricity Pricing In Chile |
Chile's method of electricity pricing is distinctive because of the innovative approach to rate of return regulation. The price system includes regulated rates for consumers with peak demand of less than 2 megawatts and freely negotiated rates for the rest. The final price to regulated consumers has two components: a node price at which distribution companies buy power from generators and from the transmission grid, and the value-added of distribution. The value-added of distribution is calculated every 4 years. The procedure involves determining the costs of an optimally operated firm and setting rates that provide a 10% real return over the replacement value of assets. These rates are then applied to the real companies to ensure that the average return falls between rates of return on assets of 6% and 14%. If the average actual return falls outside this range, the rates are adjusted to reach the upper or lower limit, depending on whether they fall above or below. The operating costs of the benchmark "efficient firm" and the replacement value of assets are based on a weighted average of estimates made by the industry and the regulatory agency. |
Source: Kerf, Michel. 1998. Infrastructure Concessions: A Guide to Their Design and Award-Privatization Tool Kits. Washington, DC: World Bank. |
As a starting point for determining fairness, tariffs should reflect costs and different customer groups/classes should observe tariffs that reflect the cost of supplying them. For example, people in similar circumstances pay similar amounts or people accepting lower quality of services should have their bills lowered. However, some services, like water and wastewater services, are often considered a public service, and no customer should be denied access to water on the grounds of poverty (see section 6.4.4 on Subsidies). Specific subsidies or cross-subsidies built into the tariff system can address this situation.