Cash subsidies involve cash payments by the government to the private operator or project company. Payments may be made to cover a portion of investments or can be related to service delivery. Clearly, subsidies should be designed to ensure that the private operator has an incentive to achieve the desired public policy outcome. This is not always easy as subsidies may create perverse incentives for inefficient operations or other undesirable outcomes.
Where there are political constraints to increasing tariffs, a general cash subsidy could be paid to the private service provider to reduce the average tariff required from customers to cover the utility's operating expenses. In this case, setting the size of the subsidy in advance is essential. Not doing so will ensure that the private operator has little incentive to minimize operating expenses. In setting the size of the subsidy in advance, provision might be made for a gradual phasing out of the subsidy, through annual reductions in its size, as operating efficiencies are realized and tariff increases are phased in.
Where the rationale for the subsidy is to increase service coverage, rather than cushion the impact of increased tariffs, it may be more appropriate to link payment of the subsidy to an indicator, such as the number of new connections.
A fixed subsidy for each new connection, however, might be expected to provide the operator with an incentive to connect those premises, which would maximize the sum of expected revenues, less connection costs. Such a structure may limit the incentive to connect the poorest households. An alternative would be to subsidize the cost of new connections only in certain areas, such as in areas where poor households are concentrated.