Economic Instruments - Charges and taxes

Water Charges (Chile)

Background

Over the last twenty years the Chilean Government has successfully privatised the water and sanitation sector and implemented a regulatory framework that has contributed to the sustainability of the reform. The service offered has greatly improved in quality and coverage.

Design

The process can be divided into three periods:

• The first (1977-88) was run by a government agency and involved successful attempts to improve the sectors performance through modernising management techniques, reducing costs and moving towards self-funding and eliminating cross-subsidies among customers and service areas. In the early 1980s, water rights were separated from landownership rights and water rights were made tradable, hence water rights markets increased across the main water courses serving large urban and agricultural areas (Bitran and Arellano, 2005).
• During the second period (1989-99) an institutional model was put in place where the regulatory and supervisory functions were separated from the investment, production and sale of service functions, the former carried out by the state, the latter by independent companies. The countrywide service moved from a centrally organised one to smaller regional independent utilities. The authority was no longer a state owned one but privately run ones adhering to rules governing private publicly traded corporations. A new regulatory regime was introduced for concessions to establish build and operate water and sanitation services. The openness and transparency of the reform by the government enabled them to achieve the necessary tariff increases.
• The last period (1999-2004) experienced the privatisation of the main water and sanitation utilities, attracting international investment into the sector.

Water supplies to consumers in urban areas in Chile are metered, and connections are almost universal. Gómez-Lobo (2000) points out that before the system was reformed, water tariffs covered less than 50 per cent of the true economic costs of the service. Steady tariff increases in the 1990s doubled the real charges for Empresa Metropolitana des Obras Sanitarias (EMOS), the service provider in the Santiago metropolitan area. In the absence of intervention, this reform would have posed major stresses on lower income households, and would have been very difficult to implement politically. Cross subsidisation, whereby poorer consumers are subsidised by above average charges to others, such as business customers, could have been implemented, but this creates perverse incentives, including encouragement to corrupt meter readers, illegal diversion of supplies, and the development of private wells. The wider the gap between what business has to pay and what it costs to supply them, the greater these perverse incentives are likely to be.

Rates

The tariff rates are set efficiency where price equals long-term marginal cost. Long-term infrastructural investment costs are included in the water and sanitation services tariff rates. Seasonal demand exists in the Chilean water services where summer demands are significantly higher than other times in the year. Tariffs are not a flat annual rate but reflect increases in demand throughout the year.

The rate is set according to what a fictitious model company would theoretically set the level at to meet demand efficiently over a five-year period (Bitran and Arellano, 2005).

Exemptions

In Chile, it was decided to provide subsidies directly to the most vulnerable. Families are classified in order of priority, with the poorest families receiving highest priority. The central government transfers the block subsidy to the municipalities; the latter use this to pay a share of the water bill for those eligible. Mideplan (The Ministry of Planning) uses household survey information for each region to determine the size the block subsidy needs to be in order to meet a benchmark of support. The share ranges from 15 to 85 per cent of the water bill, for up to 20 cubic metres per month, with the poorest families getting the highest share. The payment is made directly by the municipality to the water utility. In order to qualify for the subsidy, households must not have payment arrears with the service provider. The water companies bill the benefiting households for the net of subsidy amount, and then charge the municipality for the subsidies granted. The municipality will be charged interest for late payment, and the utility can discontinue service to benefiting households if there is non-payment by the municipality. In 1998, almost 13 per cent of households (450,000) benefited, at a cost of $33.6 million, and an average monthly subsidy per household of $10.

Performance

The privatisation of water supply and sanitation in Chile has led to a tripling of the average real tariff between 1989 and 2002 (Bitran and Arellano, 2005). Public criticism of these rate increases has occurred even though prior to the reforms those that benefited most were the higher-income households and most intensive users. This reform period coincided with an era of high economic growth (7% per annum) with real incomes rising significantly. It is highly unlikely that the transition would have occurred so smoothly during a period of economic stagnation (Williams and Carriger, 2006). Capital infrastructural investment expenditure has increased due to the privatisation; annual spending increased from $30million in 1974-1988 period to $150million per annum in the 1989-2002 period. This is mainly due to the increased rate of return on capital, due to increases in tariff rates. The tariff rates are determined so that investors will receive a low-risk return of at least 7% on capital expenditures and therefore these companies have the incentive to invest in wastewater treatment (Hearne and Donoso, 2005). The capital investment has led to vast improvements in water and sanitation services. Sewage treatment coverage increased from 17% in 1997 to 81% in 2005 and by 2010 almost all the countries sewage is likely to be treated (Williams and Carriger, 2006). The level of investment needed to attain this coverage could not have been reached if the Chilean Government were responsible for investment. With tariffs set centrally for water and sanitation, efficiency incentives exist for the companies to increase returns on investment. This has happened and these companies perform well on the Chilean Stock exchange (Bitran and Arellano, 2005).

Currently there are 44 potable water companies in Chile. They function as private companies although the state investment company, CORFO, still owns a considerable number of share in most companies (Hearne and Donoso, 2005). Five of Chile's 13 regional water companies were privatised with partial sale to multinationals in 1998. Over the four years since, the private companies water rates have risen by an average of 40 per cent, twice the level of increase in prices by public providers (World Development Movement, 2006).

‘The new regulatory scheme in the Chilean water and sanitation sector has provided the right signals for efficient allocation of resources. It has also proved to be a powerful magnet for private equity, attracting international operators as well as Chilean pension funds. …The Chilean model has attained the goals set for service coverage. But that achievement has come at the cost of severe price hikes. Thus even with the best political handling, the changes in the water and sanitation sector would have been unlikely to survive public scrutiny if not accompanied by vigorous and sustained economic growth, which has helped make it possible for households to pay the price’ (Bitran and Arellano, 2005, p.4).

With the reform in the water policy there was a significant shift of power from the government to water users, while also relieving the government of large investments in water infrastructure and operation and maintenance costs that are also shifted to users. A potentially large environmental benefit of water markets is the incentive they provide for greater water conservation, with the additional benefit of reduced investment requirements for constructing new water infrastructure that in itself can cause significant environmental disruption. On the other hand, large transfers and releases of water may alter temperature and flow conditions in ways that adversely affect fish and wildlife (O Connor, 1998).

One important outcome of Chile’s water policy has been the purchase of agricultural water by urban water suppliers without having to buy land or expropriate water from farmers through state intermediation. (O Connor, 1998).

Charging municipal users of water a price that pays for the full capital and operating costs of the system has yielded many advantages, relative to the situation where householders were paying 50 per cent or less of the full costs. These include (Convery, 2004):

• Improved quality of service. Customers get more reliable supplies, and faster response to complaints and problems.
• Continued near 100 per cent ‘coverage’ in that – with rapidly increasing urban populations – it has proved possible to get the increasing numbers connected to the system, and serviced with potable water supply. Where full cost recovery does not apply, most of the benefits are captured by higher income households; the poorest are left unconnected, and end up paying up to 20 times the amount per cubic metre (for water supplied by trucks) paid by those (richer) households who are connected.
• Reduction in demands on national and municipal budgets. With partial cost recovery, the difference has to be made up by some combination of poorer service and subsidy from other tax revenue.
• Increased conservation by users. With metered water, as prices rise, householders ensure that water is not wasted, and make investments in water saving devices. This in turn helps reduce the need for more reservoirs and increased abstractions, which in turn reduces the negative environmental impact of municipal water demands. The fact that municipalities can purchase bulk supplies of water from farmers and others, rather than develop their own, further facilitates this reduced pressure to expand own supplies.

The country’s public administration is relatively efficient and therefore a positive and responsible civilian attitude towards Chilean water policy exists which made it possible to implement complex policies, such as subsidizing drinking water for low-income families and ensuring competition for irrigation subsidies remains open and transparent. (Williams and Carriger, 2006). This has allowed its smooth operation, low debt level and increased capital expenditure in the system over the last two decades. The social consensus that was politically implemented has permitted acceptance of a threefold increase in the price of water services to achieve sufficient quality. The regulatory approach for the Chilean water and sanitation sector is based on price setting that conveys appropriate signals to economic agents, so that they make decisions as if they were operating in a competitive market (Bitran and Arellano, 2005).

References

Bitran, G. and P. Arellano, 2005, Regulating Water Services, Sending the Right Signals to Utilities in Chile, Public Policy for the Private Sector, World Bank, Note number 286, March 2005. Available at http://rru.worldbank.org/Documents/PublicPolicyJournal/286Bitran_Arellano.pdf

Convery, F.J., editor, 2004, USING ECONOMICS IN THE DESIGN AND IMPLEMENTATION OF ENVIROMENTAL POLICY – INSIGHTS FROM CHILE. Forthcoming

Gómez-Lobo, Andrés, 2000. Viewpoint- Incentive-Based Subisidies: designing Output-Based Subsidies for Water Consumption ( agomezlo@econ.facea.uchile.cl )

Hearne, R. and Guillermo Donoso, 2005, Water Institutional Reforms in Chile, Water Policy, 7 (2005), 53-69.

O'Connor, D. 1998, "Applying economic Instruments in Developing Countries: from theory to implementation", Environmental and Development Economics 4, 101

Williams, S. and S Carriger, 2006, Water and Sustainable development: Lessons from Chile, Global Water Partnership, Policy Brief 2, Technical Committee (TEC). Available at www.gwpforum.org/gwp/library/policybrief2chile.pdf.

World Development Movement, 2006, Water out of GATS: case studies, internet article. Available at: http://www.wdm.org.uk/campaigns/watergats/casestudies2.htm

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