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Financial Management and Analysis of Projects : 4. Financial Management of Executing Agencies : 4.3. Financial Analysis
4.3.3. Linkages with Cost Recovery and Tariffs
4.3.3.1. Introduction
4.3.3.1.1. Readers are recommended
to review the Table of Contents of ADB's Guidelines for Economic
Analysis when addressing Cost Recovery. In particular, reference
should be made to Appendix 22: User Charges, Cost Recovery, and
Demand Management: An Example for Piped Water.
4.3.3.1.2. Efficient cost recovery
impacts on economic and financial analysis of projects, and it is
essential for the financial analyst to have a comprehensive understanding
of the issues. Not least, the analyst must ensure that the cost
element of cost recovery is the lowest economic and financial cost
commensurate with the highest levels of efficiency of performance.
Recovery of unreasonable costs must be avoided.
4.3.3.1.3. Both financial and economic
project analyses are closely related, and in practice both involve,
among others, the calculation of internal rates of return. Both
types of analysis are conducted in monetary terms, the major difference
lies in the definition of costs and benefits.
4.3.3.1.4. Financial analysis evaluates
the commercial viability of a project from the viewpoint of the
project entity; that is, all expenditures incurred under the project
and revenues resulting from it are taken into account. This form
of analysis is necessary to assess the degrees to which a project
will generate revenues sufficient to meet its financial obligations.
4.3.3.1.5. In practice, it is typically
necessary to establish the financial viability and profitability
of the project and of its parent public or private sector enterprise
by determining all expenditures of the latter with the project,
and the total revenues earned (and collected) from all sources
4.3.3.1.6. The principles of
financial cost recovery should be based on one or more of the following,
as appropriate to the project, public or private sector enterprise,
and sector concerned: (i) full-cost recovery, (ii) cost reductions
commensurate with increased efficiency to reduce demands on revenues,
(iii) a need to generate contributions to ongoing and/or future
investments, (iv) achievement of income redistribution and/or generation
of additional income for specific beneficiaries, (v) minimization
of waste which low-cost recovery policies tend to promote, (vi)
containment of demand where essential goods and services are in
short supply, (vii) need to raise additional public sector revenues,
and (viii) encouragement of financial discipline and efficient management.
4.3.3.1.7. Factors or criteria to
determine full-cost recovery include: (i) recovery of long- or short-run
marginal costs, as appropriate to the EA and/or sector; (ii) need
to cover total financial costs where these exceed those above; (iii)
extent of additional fiscal resources requirements over and above
the two factors above, for purposes of income redistribution within
the sector, for related sectors, or for general budget support;
and (iv) incremental financial costs (and the reasonableness thereof)
for achievement of the third factor above.
4.3.3.1.8. Although ADB's cost
recovery principles center on full-cost recovery, it recognizes
that, in some cases, financial, distributional, and national fiscal
considerations may require a flexible approach, albeit compatible
with promoting efficient operation of the public sector enterprises
responsible. Such cases may involve health and other social sectors,
and projects involving the introduction of new techniques, etc.,
where less than full-cost recovery may be desirable in the short
or medium term. However, whenever less than full-cost recovery is
proposed, this must be disclosed and justified in the Aides Memoire
and BTORs of a fact-finding or appraisal mission, and in the RRP.
4.3.3.1.9. Where an activity, such
as sewerage operations, may appear to have difficulty in achieving
full-cost recovery, it should be linked whenever possible with an
allied activity or service of the enterprise to achieve such performance.
In the case of sewerage, its principal activity is wastewater removal,
which can be directly related to water consumption. An integrated
tariff policy to recover water supply and sewerage costs should
be developed which would achieve at least full cost recovery. Similar
activities include rural electrification for irrigation systems
which can be recovered through the overall tariff structure by cross
subsidies; rural roads which can be recovered through adjustments
to vehicle import or operating taxes.
4.3.3.1.10. These latter cases typically
give rise to valid concerns where the technical problems and costs
of installing and operating charging mechanisms could exceed benefits.
The Knowledge Management section of the web-based guidelines provides
a copy of the useful OECD publication Best Practice Guidelines
for User Charging for Government Services.
4.3.3.2. Cost Recovery Systems: Introduction
4.3.3.2.1. Private sector entities,
because their primary financial objective is to earn a return on
invested capital, would be expected to seek full-cost recovery,
albeit they may from time-to-time charge less-than-full-cost as
a means of encouraging development and introduction of new products.
4.3.3.2.2. For public sector entities,
there is no absolute rule as to a sector/subsector when less-than-full-cost
recovery may be acceptable. A useful guide is provided in ADB's
Subsidies Paper. This recommends sectors and circumstances when
subsidies may be acceptable, and therefore less-than-full-cost recovery
can be proposed for a project.
4.3.3.2.3. Generally there are two
options available for full cost recovery, namely the pricing by
user charges of products and services produced (typically using
tariff-structured charges); and benefit taxes that are levied directly
(wherever possible), or indirectly, on beneficiaries. Vehicle or
gasoline tax, and land taxes, are typical benefit taxes.
4.3.3.2.4. The selection and use of
the appropriate mechanisms should be a matter of practical convenience,
e.g., where a system is already in place and which either works
or could be made to work with minimum investment; rather that enforcing
a principle. In water supply utilities, it is frequently a principle
that domestic water consumers should always pay for water by measured
consumption.
4.3.3.2.5. However, where by local
practice a property value-based water tax can yield the necessary
revenues, this may be a more suitable mechanism. (This may occur
where the availability of groundwater is sufficiently abundant to
prevent the installation of metering systems, which are the most
effective form of recovering the cost of water supply benefits.)
4.3.3.2.6. Similarly recovery of domestic
refuse collection costs may be more readily recovered through a
general municipal property tax, but removal and disposal of trade
wastes can often be charged direct to beneficiaries, typically using
a price per container per collection. However, while expediency
for achieving efficient recovery as suggested above is desirable
(and useful in many cases), the use of pricing as a means of limiting
or redirecting consumption must be actively considered.
4.3.3.2.7. A property tax based water
charge will not inhibit consumption. Therefore, in conditions of
constrained supply and high long-run marginal cost, the recovery
mechanism adopted should contribute materially to the attainment
of objectives; in this case by charging on a consumption basis,
and restraining consumption and thus deferring the need for future
investments. This particular approach requires that (i) metering
systems are efficient, (ii) illegal connections are prevented, and
(iii) tariff structure effectively constrains high consumption levels
by incremental pricing.
4.3.3.2.8. In some sectors, traditional
arguments are sometimes used to claim that pricing of a commodity
is impossible for reasons of unacceptable costs. These must, however,
always be demonstrated. For example, failure of irrigation systems
to effectively measure and price water consumption continues to
result in overbuilding of such systems in some countries, with resultant
misallocation of resources.
4.3.3.2.9. It is frequently argued
that the costs of installation and maintenance exceed the building
costs, but these should be fully demonstrated during project fact-finding,
and justified in the Identification/Preparation Aides Memoire/BTORs
and the RRP.
4.3.3.2.10. It should be noted that
user charges might, in some cases, inhibit the attainment of objectives.
Charges for sewer connections, while having merits as a revenue
source, may deter potential users from making connections. This
may be overcome in some municipalities by imposing penal property
taxes payable until sewer connections are made. Excessive industrial
power line and connection charges have caused industrialists to
install generators with loss of the benefits of scale of production,
while high domestic connection fees typically encourage illegal
connections.
4.3.3.2.11. The equity principle must
be observed. Public utilities sometimes favor providing services
to the more affluent sections of a population, partly on the grounds
that cost recovery is likely to be more effective, and that delivery
to, and servicing of these domestic consumers is generally more
simple and cost-effective. However, research into these situations
often shows that the poor, ill-serviced population are paying, and
will continue to pay, considerably more per liter for their limited
supplies of water, either by bottles, or through tankers or venders,
than the more affluent sections who are already served (albeit insufficiently)
or will be provided with water supplies by the proposed project.
4.3.3.2.12. Social benefit must not
be sacrificed for financial expediency. Sound project design should
call for an equitable distribution of benefits, including the use
of cross-subsidies, where necessary, to provide the largest volume
of benefits to the most deprived sectors of the population concerned.
4.3.3.3. Cost Recovery Systems: Social Sectors and Services
4.3.3.3.1. In sectors that support
the delivery of social services, including poverty relief, health
services, education, agriculture extension, etc., cost recovery
is not normally sought because they have been regarded as public
services to be financed from general taxation. While this practice
is likely to continue for many years, particularly for the poorest
sections of a population, increasing pressures on national budgets
may force the development of forms of user charges.
4.3.3.3.2. While some may be introduced
to reduce budget deficits, others may be used to cut back demand
for frivolous or unnecessary services or to re-direct demand for
services for which a section of the population could pay. But because
user charges applied in such sectors will probably have the effect
of demand reduction, their introduction needs to be designed with
much care.
4.3.3.3.3. Income and social
studies may be needed to identify and to target the elements of
services and population groups to be addressed.
4.3.3.3.4. User charging assessment
and collection methods should be examined for feasibility and costs,
as part of cost/benefit studies to determine viability of such schemes.
Comparing the demand, supply, and costs of ongoing, parallel private
sector schemes that provide similar service can develop validity
tests of such studies. As an example, private sector fee-paying
education facilities sometimes rival state systems, which may be
of lower quality due to lack of funding.
4.3.3.3.5. Measurement of likely demand
for equivalent-level state schemes may reveal the feasibility of
charging for partial, or all, services in a particular stream of
training. without undue hardship, especially if the constraint is
lack of facilities instead of consumer resources.
4.3.3.4. Cost Recovery Systems: Summary
4.3.3.4.1. The financial analyst must
be aware of the underlying economic principles of cost recovery,
and:
- contribute
to the design of projects which achieve full cost recovery for
the sectors in which ADB specifies this criteria;
- be
prepared to participate in the design of appropriate recovery
systems, or utilize/modify existing systems to achieve efficient
recovery;
- keep
in mind the various impacts that cost recovery systems generate,
to avoid adverse side effects; and
- in
those sectors for which cost recovery has not normally been sought,
be prepared to develop charging systems which can enhance poverty
reduction and social development.
4.3.3.5. Tariff Policy
4.3.3.5.1. ADB does not have a prescriptive
policy on formulation and operation of tariffs for public and private
sectors. It relies on the skill and experience of ADB staff and
experienced consultants to develop appropriate tariffs for revenue-earning
EAs, and to report their findings and recommendations in RRPs and
Supervision Reports.
4.3.3.5.2. An October 2000 ADB Workshop
identified the following as the most intractable issues and problems
(in descending order of intensity) likely to be encountered in formulating
tariffs for electricity utilities: (i) country differences; (ii)
lack of commonality among definitions; (iii) achieving consensus
among politicians, administrators, economists, engineers, and financial
analysts, etc.; (iv) country political differences; and (v) ownership.
4.3.3.5.3. In 1985, the African Development
Bank published its policy on tariffs and cost recovery. While many
years have passed since its publication, much of the advice and
guidance relating to tariffs and cost recovery continues to be relevant.
The emphasis is primarily on the sufficiency of revenues to finance
operations and debt service, and perhaps there may be insufficient
reference to the need to develop means of cost reduction to avoid
increasing tariffs and rates.
4.3.3.5.4. Readers are also recommended
to review ERD Technical Note No. 9, Setting User Charges for
Public Services: Policies and Practice at the Asian Development
Bank (www.adb.org/Economics/erd_technical_notes.asp).
4.3.3.5.5.
The following materials are extracted from the Good Practice
Guideline (GPG): Financial Analysis of Revenue-Generating Entities:
Sector Analysis, and Financial Ratios and Covenants. The GPG
was prepared by the MDB Harmonization Technical Working Group and
was finalized in February 2003.
Tariff
and Competition Policy
Tariffs for infrastructure services should cover the full cost
of service provision, including capital cost, operations and maintenance
expense, and the cost of negative environmental and social externalities.
The level and structure of tariffs should offer incentives to
service providers to minimize costs, and to customers to consume
services efficiently. When tariffs are inadequate, Bank projects
should (a) identify a plan for improving cost recovery, and (b)
identify sources of financing for the full cost of service provision.
The Asian Development Bank has commissioned a study aimed at developing
a framework for tariff setting that will integrate financial,
economic and institutional issues. The results will be incorporated
into future editions of this guideline.
It
generally costs more to serve small users and users in remote
areas than to serve larger, urban users. Incumbent service providers
may be unwilling to extend service to such users if they are unable
to recapture the additional cost through higher tariffs. Competition
policy should provide opportunity for alternative providers to
serve customers who do not have access (as well as those who do).
Unbundling of infrastructure sectors provides such an opportunity.
Introducing competition through unbundling implies a need to consider
the following: (i) tariffs for each segment of an "unbundled"
sector (e.g., wholesale, retail); (ii) applying price cap regulation
vs. rate-of-return regulation; (iii) open access to "natural
monopoly" segments at appropriate prices; and (iv) limiting
the duration of any monopoly concessions.
Subsidies
If full-cost-recovery tariffs exceed affordable levels, subsidies
may be justified on the grounds of equity (subsidies targeted
to poor people who cannot afford cost-recovering tariffs3
), positive externalities (subsidies to encourage individual
use, if it gives rise to environmental or social benefits to the
public) or efficiency (subsidies to support a transition to the
market).
Financial analysis should do the following:
- Fully
identify existing and proposed subsidies,4considering the following
aspects: (i) objectives of the proposed subsidy; (ii) effectiveness
of existing subsidy programs in meeting their objectives; (iii)
appropriate duration of the program; (iv) transparency in regard
to the amount and source of financing; and (v) feasibility of
financing the proposed subsidy.
- Justify
a proposed subsidy on the grounds listed above.
- For
a subsidy justified on the grounds of equity, ensure that the
borrower puts in place credible mechanisms to ensure that the
proposed subsidy is targeted explicitly to poor people (a transition
period for existing subsidies is permissible)-for example,
direct payment to consumers through fiscal relief (preferred
alternative), or indirect payment, via below-cost tariffs.
- Identify
a plan for fully financing the subsidy-for example, (a)
tariff increases (preferably as a precondition to a financing
operation); (b) industry levies that can be tapped by providers
who serve poor areas; (c) limited cross-subsidies from other
consumer groups, such as lifeline block tariffs (generally,
a less preferred alternative to industry levies) or Ramsey pricing;
and (d) output-based payments to the provider.
- Identify
ways to eliminate unfunded subsidies, i.e. those based on systematic
underpricing of service.
Affordability
Poor households without access to network infrastructure services
often pay high unit costs for infrastructure substitutes-such
as batteries, kerosene, and vendor-supplied water-in terms
of both financial costs and externalities (such as negative impacts
on public health). This fact challenges the conventional wisdom
that poor people cannot afford to pay for infrastructure services,
and suggests that more attention should be paid to identifying
the services that poor people want and are willing to pay for,
through social assessments of income, consumption patterns, and
willingness to pay. Such assessments should include analysis of
(a) how low-income households purchase infrastructure services,
(b) whether nontraditional supply is available, and (c) to what
extent low-income households are willing to pay for alternatives
and for improved access and quality. Financial analysis should
contribute to the collection of the socioeconomic data required
to conduct such analyses-for example, by formulating questions
for formal social assessments.5
When it is not feasible to obtain such data,
rules of thumb can be applied.
Service
and Quality Alternatives. Since different types of service
may be appropriate for small, poor or rural users than for higher-volume
users, the data gained from such analysis should be used, with
the data from the technical analysis of the proposed project,
to consider alternative service and quality standards. For example,
technical innovations that yield declining minimum efficient scale
of technologies-such as pico-hydro and small-scale sewage
treatment-can make services more accessible to poor, remote
areas, and less costly than network-connected alternatives. Other
alternatives could include, for example, community water delivery
instead of in-house water connections, using tankers, community
standpipes, or low-cost piping; different quality standards for
water for drinking vs. washing; access to telecommunications via
prepaid wireless phones or privately owned phone booths; and off-grid
renewable rural electrification as an alternative to grid extension.
It is also important to consider regulatory incentives for serving
small or remote users-for example, water quality standards,
open market entry, and unregulated tariffs for water delivered
by tanker. Facilitating entry by new service providers can help
expand the range of price and quality options in service provision
to low-income areas, thus improving quality and lowering prices.
_________________________
3
Studies have shown that infrastructure subsidies
benefit nonpoor people disproportionally; see World Development
Report 1992: Development and the Environment (New York: Oxford
University Press for the World Bank, 1992).
4
Financial and (where possible) economic
subsidies should be identified in project appraisal documents. Social/transitional
considerations should be identified in Country Assistance Strategies
within a country's Comprehensive Development Framework. Estimates
of financial subsidy and qualitative assessment of economic subsidy
should be reported in the Report and Recommendation of the President
(for both projects and country strategies); see Guidelines for the
Financial Governance and Management of Investment Projects Financed
by the Asian Development Bank, op. cit.
5
"Better Household Surveys for
Better Design of Infrastructure Subsidies," Public Policy
for the Private Sector, Viewpoint No. 213, June 2000, which provides
recommendations for adapting Living Standard Measurement Study to
yield the information required for affordability analysis and subsidy
design.
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