Economic Regulation of Water Services in South Africa

March 2004


1. Introduction
Economic regulation may be defined as the protection of the public interest and consumers through the promotion of effective, efficiency, financially viable and sustainable water services providers, by
  The project sought to answer the following key research questions:
  1. How will a "regulator" (regulatory authority) determine if the average price level is appropriate?
  2. How will a regulator determine what level of investment is appropriate?
  3. How does the institutional/governance model affect the above two questions?
The scope of the study extended to both water and sanitation, to both bulk and retail water and sanitation, including on-site sanitation services and pit-emptying, water services for households, commerce, institutions and industry but not for agricultural use, focus on method (but take into account the policy and institutional context), focus on economic regulation of water services in the municipal context, focus on pricing and investments and not on price structures.
2. Outputs

The study produced the following outputs: an initial discussion paper, a Phase 1 draft report (findings of research), four working papers (details of research on specific topics), a draft guideline (practical application of economic regulation), and a final report1. Details of these outputs are given in the preface.

1A capacity building report was also produced but does not form part of the "content" outputs.

3. Recommendations arising from findings

3.1 Building blocks for improved economic regulation

National capacity needs to be strengthened to support the development of good contracts between water services authorities and water services providers (where these are external). There needs to be greater transparency in these contracts. A much greater understanding needs to be developed with respect to what constitutes best contracting practice (see capacity above). Greater clarity is need on the enforcement of (especially public-public) contracts.

Proper financial ring-fencing of water services, including proper accounting for the assets is a necessary pre-requisite for economic regulation of water services in South Africa.

Establishing an appropriate rate of return on water services assets when used for "economic purposes" is a good starting point for economic regulation in South Africa.

In order to implement rate of return regulation, it is necessary to separate out the community service or social obligations (CSO) of the water services provider. These social obligations are any services which are supplied at less that full economic cost, or services which are supplied for the benefit of the broader community (for example, municipal parks). The costs of the CSO should come from the national tax payer (in the case of universal service obligations determined nationally) and from the local tax payer (in the case of local community service obligations such as municipal parks.

A standard method for valuing water services assets in South Africa should be developed. A standard method for depreciation should be adopted and standard periods used for types of assets appropriately classified. This could be part of GAMAP.

The costs of externalities (typically environmental externalities) should be internalised into the costs of the service. These should only be included in allowed costs where actual payments are made (that is, where they have been internalised).

A better understanding of how to measure operating efficiencies is needed. This also entails developing measures for quality of service provided.

Ways to strengthen consumer voice need to be found. The requirement of customer or consumer charters is an important step forward.
3.2 Policy, legislative and institutional reform

Wherever external contracts are entered into, these should be on a competitive basis. There are no good grounds for excluding public agencies from competitive tendering requirements.

As a first step towards improving economic regulation of water services in South Africa, the economic regulation of water boards could be considerably improved and strengthened. Water Board regulation should be moved to a rate of return, with clear ring-fencing of any community service obligations and retail operations.

It is not clear that adequate or appropriate incentives exist at present for institutional and regulatory reform in the water services sector.

The case for vertical integration of water services providers (even on a selective basis) in South Africa needs to be examined more thoroughly.
3.3 A role for guidelines

There is a role for guidelines for water services authorities on the following topics related to economic regulation:

  1. Give practical guidance on how to go about ring-fencing water services.
  2. Given guidance on the establishment of an appropriate asset register for water services, including a standard method for valuing and depreciating assets.
  3. Given guidance on how to separate social and community services and obligations from "economic services", and to account for subsidies and grants.
  4. Present a standard reporting format.
  5. Show how prices should be structured and calculated.
  6. Describe a process for reviewing investment decisions and reporting.
  7. Guideline for practical application of economic regulation.
4. Guideline - practical application of economic regulation

As part of this project, a draft guideline (for discussion purposes only) on the practical application of economic regulation to water services was developed (see preface). This guideline sets out a detailed methodology for the application of rate of return regulation to water services and also briefly covers incentive-based regulation and the ideal company model method of regulation. This is a primary output of the project and should be read as a stand-alone document. For this reason, no summary of the guideline is presented here.
5. Implementing economic regulation in South Africa
5.1 Towards an economic regulation strategy

Before economic regulation can be effectively implemented in South Africa, it will be necessary to demonstrate more conclusively the benefits that can arise from the effective application of formal economic regulation in the South African context. A specific study aimed at quantifying the financial and economic benefits accruing from economic regulation of water should be undertaken.

The experience of economic regulation in the electricity industry (as well as the experience of the contracts management unit) suggests that it will take a number of years to effectively implement a formal economic regulatory framework in South Africa. Nevertheless, it is important to get started. Progress will be incremental and will need to take into account capacity constraints. However, the real learning and capacity development will occur through the process of implementing economic regulation and the associated institutional reforms.

The application of economic regulation should be strategic. Implementation should focus on these areas where the most gains can be made for a given level of effort (both in terms of learning and in terms of actual economic gains from the application of economic regulation). The most obvious starting points for the application of economic regulation are Johannesburg Water (the only truly ring-fence municipal water services provider)2 and Rand Water and Umgeni (the two most economically significant water boards).

2Excluding private water service providers providing services in terme of concesions or leases

The learning can inform the evolution of the economic regulation strategy and the economic gains demonstrated can help to build a stronger case for the wider application of economic regulation.

Economic regulation must also ensure that compliance with service standards is achieved cost-effectively. Service standards include the reliable provision of service; quality of supply and service; customer satisfaction and resolution of complaints and disputes. There is a direct relationship between the quality of standards imposed and the cost of meeting these standards.

When understanding economic regulation it is important that this be seen not as a parallel process to other areas of regulation (standards, environmental and so forth) but as an integral part of deciding on those standards. A better understanding between the different areas of "regulation" needs to be developed and ROR regulation, with a focus on allowable and required costs can foster this.

In the case of rate of return regulation there is little incentive to cheat on standards because all costs incurred by the utility for the provision of reliable services, quality supply and customer satisfaction, are allowed in the ROR methodology.

In the case of incentive-based regulation, utilities may have an incentive to cut costs at the expense of meeting service standards. The regulator will have to ensure that quality assurance programmes are undertaken by the regulated entities.

Rate of return regulation is the first stage of incentive-based regulation (IBR). It is therefore relatively academic at this stage which methodology is used. IBR has a higher incentive power for efficiency but is also more complex to implement and carries greater risk in the context of market uncertainties. Because of the proposed restructuring of the water services industry (as set out in the national Strategic Framework for Water Services) and the consequent uncertainty within the South African water industry, it is recommended that revenue and price reviews be done on an annual basis rather than in terms of a three to five year cycle. The annual application of economic regulation will also increase learning in the sector and help in the development of capacity. For these reasons, it is recommended that rate of return regulation be implemented initially with a view to evolving towards incentive based regulation. See Guideline for more detailed recommendations.

Where professional skills are scarce the opportunity cost of scarce human capital devoted to regulation is significant and should also be considered when developing an institutional reform and regulation strategy. Ultimately it is probable that effective economic regulation will only be achieved once an independent regulator with adequate capacity has been created. This is a position advocated by the South African Utility Regulator's Association (SAURA). However, it is not likely that an independent regulator for water services will be established in the short term. In this context, there are some intermediate steps that can be adopted with a future transition to independent regulation in mind.
5.2 Complementary initiatives

Probably the most pressing economic issue facing the water services sector is that inadequate resources are being made available for rehabilitation and maintenance of systems. The most important means of addressing this problem is the institutional reform of the sector with the view to professionalising the water services industry, especially for the major urban centres. The national Strategic Framework for Water Services sets out a policy framework for this reform which should be pursued as a matter of priority.

The decentralization to local government of decision-making with respect to the allocation of capital and operating subsidies poses particular challenges to the water services sector. It is important, from an economic regulatory point of view, to be assured that capital and operating subsidies are being allocated and used efficiently.

The best way of ensuring this is to insist on the proper ring-fencing of water services provision. In this way, formal economic regulation can be conducted and the efficiency of resource use in general, and subsidy use in particular, can be assessed. However, in many cases (particularly for the smaller rural municipalities), it will not be practical to ring-fence water services in this way. Methods to ensure efficient subsidy spending in this context need to be developed.

Improving contract regulation is an important complementary initiative to the development and implementation of this guideline. The most immediate priority is to review the Water Services Act and Section 19 regulation in light of the cabinet approved national Strategic Framework for Water Services. In addition to this, additional capacity in the national water services regulator (DWAF) is needed to review all contracts before approval and to assist with contractual amendments and disputes. The economic principles set out in this guideline can be used to inform the regulation of investments and tariffs within contracts.