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Performance-based pricing

“Effectively establishing a measurable grading system from which tariffs can be charged, discretionary pricing is reduced and politics and external influences are effectively exorcised.

Dean Dela Paz

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Public utilities typically carry out a function reserved for the government and are part of its responsibilities for which taxes are raised to operate, or as in the case of a franchise, services essentially state-empowered. In both, public interest is primordial and trumps even the bottomline. The public is the primary stakeholder — the equity holder as well as the principal market. The utility is contracted management, simply office rank and file, operators and mechanics.

View state concession and congressional franchises along those lines and the sudden paradigm shift may just jump out of the printed pages. Especially when we realize that for decades it seems that it is the public who’s been servicing the profit needs of these business interests, allowing them aberrant leeway and unconscionable profit.

While such scope of responsibility might vary depending on whether one is Keynesian or not, the general agreement is more or less universal for big-ticket,
high-capital enterprises.

The services that remain the responsibility of the state to provide are infrastructure from roads, ports, airports, bridges and waterways, to the provision of electricity, water and telecommunications. In each the basic asset from the airwaves to electrons and water remains as state resources.

Such asset model must be understood to analyze the current controversies surrounding the two concessionaires that the government of Fidel Ramos contracted where, integral to the choice of concession counterparts, their financial wherewithal to improve the utility’s brick and mortar infrastructure was part of the requisite considerations.

The pricing of the services rendered by the concessionaire involves a related paradigm. Because pricing is divorced from such basic concepts of returns on equity, a variation of return on investment, the financial ratio applicable is a fair return on assets (ROA) where a cap guards against excessive profiteering.

In utilities such as telecommunications and electricity distribution this limitation on ROA is determined by a company’s weighted average cost of capital (WACC) — the cost of raising capital by a company either through debt as determined by effective interest charged, or through shareholder capital determined by hurdle rates computed from opportunity costs and returns from other alternative investments and projected cash flows.

In the telecommunications sector in the United Kingdom, and in our electricity distribution industry, these ROA are limited only to fair returns on assets that generate either the telecommunications services or the electricity distribution services. Hence the ROA was once referred to as Returns on Rate Bases (RORB) where rate bases are specific assets used to directly generate revenues. This is important where conglomerates have other non-allied and non-utility businesses priced following simple and basic cost-plus models.

This is especially critical in the water concessionaire controversy where, apparently no risks to earnings have been worked into the contracts, while their pass on tax provisions complement as if these were expenses that form the basis of a totally unchecked cost-plus pricing model prior to the bottom line and not after earnings as is typical.

The UK telecommunications and the Philippine electricity distribution utilities are forced to be responsive and invest in expansion and efficiency by a set of complex pricing formulae that compel performance and modernization. Basically a set of performance benchmarks that measure aspects from timeliness, to efficiency and cost effectiveness, these measures compel investments in modernization and improved systems. Effectively establishing a measurable grading system from which tariffs can be charged, discretionary pricing is reduced and politics and external influences are effectively exorcised.

Called Performance-based Rating where WACC is predetermined, this self-regulating mechanism should be adapted to water concessionaires to make them more responsive to the public’s needs.

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