Introduction 59
Cost recovery/return on investment
The combination of service standards (costs) and tariffs (revenues) determines the com-
mercial viability of a project. Beyond that, the private operator has the chance to improve
the ultimate financial outcome by being particularly efficient in investment and operations.
Therefore, a private operator will only get involved in a project if it sees a fair chance to
make a profit given a predetermined set of service standards and tariffs.
The internal rate of return (IRR) and return on equity (RoE) are the most commonly used
measures to assess the financial attractiveness from a private operator’s perspective (as
described in section 3.5). A private operator will assess the potential IRR of a project against
its own cost of equity, adjusted for the perceived risk of the project. A private operator may
be willing to accept a lower IRR if some risks are reduced or mitigated through govern-
ment actions or otherwise. Revenues are considered adequate if they enable an operator
to maintain, replace, modernize, and expand its services and assets. (See Box 13 for Chile’s
experience in electricity pricing.)
Incentives for efficiency
Tariffs should give incentives to private operators and investors to achieve efficiency in operations
(supply-side efficiency) and make necessary and/or desired investments. A “cost-plus” pricing
regime, which guarantees the operator recovery of all costs plus a profit, does not provide an
incentive for efficiency and too low a tariff may not be sufficient to entice new investment.
Prices also need to send the correct signal to customers to use the service with appropriate
economy as a scarce resource (demand management or demand-side efficiency). Price–demand
elasticity should also be taken into account and optimized (e.g., for toll road usage).
Pricing structures should also reflect variations of marginal costs (investment, operation) by
location, customer type, period, etc. This can be achieved by effectively charging different
rates to different customers or by prescribing coverage and service levels and allowing overall
tariffs to cross-subsidize more costly customers.
Fairness
As a starting point for determining fairness, tariffs should reflect costs and different customer
groups/classes should observe tariffs that reflect the cost of supplying them. For example,
people in similar circumstances pay similar amounts or people accepting lower quality of
services should have their bills lowered. However, some services, like water and wastewater
services, are often considered a public service, and no customer should be denied access
to water on the grounds of poverty (see section 6.4.4 on Subsidies). Specific subsidies or
cross-subsidies built into the tariff system can address this situation.
PPP Preparatory Work 59
Box 13: Electricity Pricing In Chile
Chile's method of electricity pricing is distinctive because of the innovative approach to rate
of return regulation. The price system includes regulated rates for consumers with peak
demand of less than 2 megawatts and freely negotiated rates for the rest. The final price to
regulated consumers has two components: a node price at which distribution companies buy
power from generators and from the transmission grid, and the value-added of distribution.
The value-added of distribution is calculated every 4 years. The procedure involves determin-
ing the costs of an optimally operated firm and setting rates that provide a 10% real return
over the replacement value of assets. These rates are then applied to the real companies to
ensure that the average return falls between rates of return on assets of 6% and 14%. If
the average actual return falls outside this range, the rates are adjusted to reach the upper
or lower limit, depending on whether they fall above or below. The operating costs of the
benchmark "efficient firm" and the replacement value of assets are based on a weighted
average of estimates made by the industry and the regulatory agency.
Source: Kerf, Michel. 1998. Infrastructure Concessions: A Guide to Their Design and Award—Privatization Tool
Kits. Washington, DC: World Bank.