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Incomplete Contracts and Regulation: The Case of Water Regulation in Manila BSP UP Professorial Chair Lecture Joel C. Yu Associate Professor Cesar E.A. Virata School of Business University of the Philippines-Diliman Cesar E.A. Virata School of Business University of the Philippines-Diliman 1 1 July 2014 - 31 July 2017 Cesar E.A. Virata School of Business University of the Philippines-Diliman 2 Cesar E.A. Virata School of Business University of the Philippines-Diliman 3 Cesar E.A. Virata School of Business University of the Philippines-Diliman 4 Cesar E.A. Virata School of Business University of the Philippines-Diliman 5 Take-away 1 The notion of incomplete contracts • Contracts have gaps, missing provisions, and ambiguities. • Completing contracts Implications on regulation by contracts • Concession Agreement provides that MWSS shall arrange for the delivery to the RO a manual • Concession Agreement covers Dispute Resolutions to address all disagreements • Legal issues should be finally resolved in courts with proper jurisdiction. Cesar E.A. Virata School of Business University of the Philippines-Diliman 6 Take-away 2 The notion of social optimum vs maximum shareholder value • Public-Private Partnership is created to deliver a common purpose • Partners have different goals: social optimum vs maximum shareholder value Implications on regulation • Regulatory capacity building especially for smaller water districts Cesar E.A. Virata School of Business University of the Philippines-Diliman 7 Take-away 3 The notion of Implications on Implications on asymmetric regulation organization information • Standard government • Adverse selection • A party in an economic interventions such as • Moral hazard transaction has regulation of monopolies information that a to replicate a competitive counterparty does not environment are not possess sufficient to restore optimality Cesar E.A. Virata School of Business University of the Philippines-Diliman 8 Take-aways of a Regulator Service Obligations & Product Specifications 푃 − 푀퐶 1 = 푃 휀 Perfect 퐼푅푅 = 푊퐴퐶퐶 Imperfect information 푁푃푉 = 0 information 푄 퐶표푠푡 푊퐴퐶퐶 Cesar E.A. Virata School of Business University of the Philippines-Diliman 9 Agenda • The Context: The MWSS Story • Incomplete Contract Theory and Regulation • Addressing Incomplete Contracts: the MWSS Case • Reflections and Practical Recommendations Cesar E.A. Virata School of Business University of the Philippines-Diliman 10 THE CONTEXT: THE MWSS STORY Cesar E.A. Virata School of Business University of the Philippines-Diliman 11 The MWSS Source: Regulatory Office (2015) Cesar E.A. Virata School of Business University of the Philippines-Diliman 12 The MWSS Water Water Population NRW* Staff per 1,000 City Availability Coverage (millions) (% of prodn) connections (hours/day) (% of popn) Manila 10.6 16 58.7 63 9.8 Singapore 3.0 24 100.0 7 2.0 Hong Kong 6.3 24 100.0 36 2.8 Seoul 10.6 24 100.0 35 2.3 Kuala Lumpur 1.4 24 100.0 36 1.4 Bangkok 7.3 24 82.0 38 4.6 * NRW: Non-revenue water Source: Second Water Utilities Data Book, Asian and Pacific Region, Asian Development Bank, October 1997, as cited by Wu Xun & Malaluan (2011) Cesar E.A. Virata School of Business University of the Philippines-Diliman 13 The MWSS Privatization MWSS BOARD OF TRUSTEES Corporate Office MWSS Concession Agreements Cesar E.A. Virata School of Business University of the Philippines-Diliman 14 The MWSS Privatization EAST ZONE WEST ZONE Cesar E.A. Virata School of Business University of the Philippines-Diliman 15 The MWSS Privatization: Service Performance INCREASE IN IMPROVEMENT DECREASE IN SERVICE IN WATER NRW COVERAGE AVAILABILITY IMPROVED INCREASE IN BETTER CUSTOMER WATER SERVICES COMPLAINTS PRESSURE HANDLING UPGRADED BETTER IMPROVED AND EXPANDED MANAGEMENT HUMAN FACILITIES SYSTEMS RESOURCES Cesar E.A. Virata School of Business University of the Philippines-Diliman 16 The MWSS Privatization: All-in Tariff Evolution 50.0 45.0 40.0 35.0 30.0 25.0 20.0 15.0 10.0 5.0 0.0 1997 2000 2005 2010 2015 Maynilad Manila Water Cesar E.A. Virata School of Business University of the Philippines-Diliman 17 The MWSS Privatization: Water Rate Determination Water Tariff Adjustment EXPENDITURE AND OBLIGATIONS RECEIPTS “ RETURN Asset Management • Historical & Future Historical Receipts Obligation • OPEX and CAPEX Service Obligations • Future Billed Volume • Water Services Rate of Return • Customer Mix • Wastewater Services Cesar E.A. Virata School of Business University of the Philippines-Diliman 18 Incomplete Contracts Incomplete Contracts and Regulation INCOMPLETE CONTRACTS AND REGULATION Cesar E.A. Virata School of Business University of the Philippines-Diliman 19 Theory of the Firm Raw Input B Product A Consumers Material Spot Market Vertical Integration Long-term Contract Cesar E.A. Virata School of Business University of the Philippines-Diliman 20 Incomplete Contract Theory Raw Input B Product A Consumers Material Cesar E.A. Virata School of Business University of the Philippines-Diliman 21 Incomplete Contracts and Regulation Regulation by Agency Regulation by Contract Rules and Procedures Contract or Agreement Hybrid Model Cesar E.A. Virata School of Business University of the Philippines-Diliman 22 Mechanisms for Addressing Incomplete Contracts Incomplete Contracts and Regulatory Challenges ADDRESSING INCOMPLETE CONTRACTS: THE MWSS CASE Cesar E.A. Virata School of Business University of the Philippines-Diliman 23 Addressing Incomplete Contracts • Amendment of the Concession Agreement • Regulatory Office • Dispute Resolution Cesar E.A. Virata School of Business University of the Philippines-Diliman 24 The Third Rate Rebasing Petition vs Determination Alternative Rates March 2012 September 2013 Adjustment of the Petition of the Determination of the Concessionaires in the Concessionaire Regulatory Office Arbitration Php8.58/cu.m.* (Php1.46/cu.m.) Php4.06/cu.m. (28.35% increase) (4.82% decrease) (13.41% increase) Php5.83/cu.m. (Php7.24/cu.m.) Php3.60/cu.m. (22.79% increase) (29.47% decrease) (14.65% increase) *based on Maynilad’s Business Plan submitted on 23 May 2013 Cesar E.A. Virata School of Business University of the Philippines-Diliman 25 Dispute Resolution All disagreements, disputes, controversies or claims… which cannot be resolved through consultation and negotiation among the parties hereto shall be finally settled by an arbitration proceedings in accordance with the arbitration rules of the United Nations Commission on International Trade Law as in effect on the dates of this Agreement. Concession Agreements Cesar E.A. Virata School of Business University of the Philippines-Diliman 26 Arbitration: Disputed Items • Unauthorized disallowance of • The RO erred in its computation of Past Cash Corporate Income Tax. Flows, particularly in its treatment of • Incorrect estimate of the Appropriate Guaranty Deposits and in disallowing certain Discount Rate for Future Cash Flows. items from Manila Water’s past OPEX and • Unauthorized adjustments to the Opening CAPEX. Cash Position set during the last Rate • The RO erred in its computation of Future Rebasing. Cash Flows, e.g., disallowance of • Improper addition of Guaranty Deposits to Corporate Income Tax. Maynilad’s Historical and Future Receipts. • The RO erred in its computation of the • Unreasonable and improper disallowances in Appropriate Discount Rate. Other Expenditures in the Opening Cash • The implementation of the Regulatory Position. Office’s proposed Rate Rebasing • Unreasonable and improper adjustments to Determination unduly impairs Manila Water’s Other Expenditures in the Future Cash Flows. financial standing and would cause a negative impact on its ability to meet its future obligation targets. Maynilad Manila Water Cesar E.A. Virata School of Business University of the Philippines-Diliman 27 Arbitration: Disputed Items • The issues were eventually limited to the recoverability of the Concessionaire’s corporate income tax. • In the arbitration with Maynilad, the parties did not resolve all other issues; the Arbitral Panel applied the pendulum nature of the arbitration. • In the arbitration with Manila Water, the parties resolved all other issues. Cesar E.A. Virata School of Business University of the Philippines-Diliman 28 Arbitration: Maynilad Php5.52/m3 Php2.10/m3 Php3.42/ m3 “Others” Corporate Income Tax (Php1.46/m3) Php4.06/m3 Cesar E.A. Virata School of Business University of the Philippines-Diliman 29 Arbitration: Manila Water Php10.84/m3 Php4.47/m3 CIT Php3.60/m3 (Php7.24/m3) Php3.60/m3 Php2.77/m3 (Php2.77/m3) CIT Php0.00/m3 CIT: Corporate Income Tax Cesar E.A. Virata School of Business University of the Philippines-Diliman 30 Arbitral Award: A Regulatory Challenge By majority, finds that the Claimant is Corporate Income Tax is not an allowed entitled to include its Corporate Income Expenditure under the Concession Tax in its Future Cash Flows for each year Agreement of operations The Appropriate Discount Rate should By majority, upholds Claimant’s not be computed fully pre-tax alternative Rebasing Adjustment for the Fourth Rate Rebasing Period of 13.41%, which means an average basic water charge of Php30.28/cu.m., resulting in an adjusted rate of Php34.34/cu.m. for every Charging Year of the Fourth Rate Rebasing Period” Cesar E.A. Virata School of Business University of the Philippines-Diliman 31 Response to a Regulatory Challenge The Regulatory Office argued that it cannot fully implement the Final Award in the Maynilad Dispute for the following reasons: • The Regulatory Office has the moral and the legal