Case 1 Panama - Queen's U

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April 25, 2003 (Edited by World Bank)

Case 1. Restructuring the Water and Sewer Utility in Panama

Alberto Barreix, Glenn P. Jenkins, and Mario Marchesini

In the 1980s, investments in Panama’s water supply and sanitation sector centered on expanding

the system capacity to meet the growing demand. However, once the facilities had been

constructed, maintenance was neither fully performed nor properly programmed. As a result, the

water supply and sanitation systems at the time of this study, were inefficient and have

functioned under serious constraints.

To remedy these shortcomings, in 1992 the Panamanian government, with the support of

the Inter-American Development Bank (IADB), launched the Public Enterprise Reform Program

for the water supply and sewerage sector. The program’s objective was to scale back the public

sector’s role and to promote participation of private operators in service delivery. Specifically,

the program’s aim was to strengthen the Instituto de Acueductos y Alcantarillados Nacionales

(IDAAN), the public utility responsible for providing water supply and sanitation services by (a)

rationalizing its staff, (b) outsourcing support activities to the private sector, and (c) collecting

outstanding accounts.

By 1996 the government had only partially achieved the Public Enterprise Reform

Program’s targets. In response, it launched a more comprehensive reform program to promote

competitive market structures and encourage private sector delivery of services. To this end, the

government passed specific legislation, which included the following:

• Law 26 of January 1996, establishing the Public Utilities Regulatory Agency. This agency

was created as a financially and operationally independent body. It is responsible for

ensuring compliance with the law and its regulations, protecting consumers, promoting

service under competitive conditions, preventing IDAAN from abusing its monopolistic

position, approving and monitoring compliance with tariff regimes, controlling the quality

of service, and reporting regularly to the Ministry of Health and other parties.

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• Decree-Law 2 of January 1997, which established a regulatory and institutional

framework for the provision of water and sewerage services.

• Law 29 of February 1996, which pertained to unrestricted competition and consumer

affairs.

The Restructuring of IDAAN

Several factors contributed to IDAAN’s poor performance, including:

• Restrictions on IDAAN’s financial autonomy, which had a negative impact on its

capacity to administer and apply tariffs and budgets efficiently, deliver efficient service,

and comply with maintenance plans;

• Difficulties at the political level in applying a tariff structure that would allow IDAAN to

recoup the costs of service and to generate sufficient funds to finance the investment

programs needed to meet the growth in demand for service;

• Unreliable and chronically outdated technical and customer records, which hampered

business and operational activities and initiatives to curb inefficiency;

• Deficiencies in the commercial area, resulting in ineffective metering (only 45 percent of

connections had meters) and low account collection rates (always less than 85 percent of

the amounts outstanding);

• Excessive numbers of staff;

• Ineffectual coordination to protect water resources and receiving bodies.

The core component of the reform intended to resolve these shortcomings was the

restructuring and privatization of IDAAN. The government planned to reduce IDAAN’s work

force, provide training to the remaining staff and help those made redundant with worker

outplacement services, and bring in a strategic operator from the private sector. IDAAN would be

transformed into a corporation (sociedad anonima), with the private sector controlling at least 51

percent of the share capital. The corporation would be responsible for planning future

investments.

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Most important, after the process to restructure and privatize the public utility had started,

the water supply systems would be rehabilitated on a priority basis so as to facilitate efficiency

improvements once the private-sector operator had taken over. Estimates suggest that between

1997 and 2002, an investment of approximately US$200 million would be required in Panama’s

water supply and sewerage systems. IDAAN's current financial situation does not permit it to

finance investment of this magnitude. The IADB program proposed here provides support for

both the creation of a mixed capital corporation and the rehabilitation of water and sewerage

systems.

The IADB Program

The project area, designated as Metropolitan Panama, includes urban zones, suburban areas, and

neighboring rural communities along the strip from Arraijan to Chorrera to the west of the

Panama Canal, and in the corridor extending from Colon to Panama City east of the Panama

Canal (see figure 1.1). This is a high-priority area, because nearly half of the country’s population

and 70 percent of its urban population are concentrated here. In theory, IDAAN serves 100

percent of the urban population and 94.4 percent of the rural population in the project area. In

practice, given IDAAN’s inefficiency and poor-quality service, its coverage is not as wide.

Figure 1.1. Map of Panama

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Water Supply in the Project Area

In 1995 IDAAN’s water treatment plants and facilities and those of the Panama Canal Authority

that served the project area had an available supply of 206 million gallons a day. Given a

population of about 1.2 million people, the gross availability of water was about 166 gallons per

person a day. Given these figures, the net daily supply of water available per person should be

more than sufficient if the high levels of physical and commercial losses were reduced, and if

systems functioned optimally.

Program Description

The program’s mains aims are to

• Support the restructuring of IDAAN and involve the private sector in managing and in

funding future investments,

• Rehabilitate and optimize the water supply systems,

• Provide technical cooperation.

To achieve these objectives, the program has been divided into three subprograms.

SUBPROGRAM 1: RESTRUCTURING THE PUBLIC UTILITY. This subprogram includes downsizing

IDAAN and establishing the Sociedad Anonima de Panama Metropolitano, and the sale of at

least 51 percent of the corporation’s capital stock to a strategic private sector operator.

SUBPROGRAM 2: REHABILITATION WORKS. This subprogram consists of rehabilitation works on

the systems supplying water to Arraijan, Chorrera, Colon, and Panama City. On the technical and

operational side, it entails upgrading the distribution networks and developing geographic

information systems, technical records, system metering, and operating and control units for the

entire Metropolitan Panama area. On the commercial side, it involves upgrading or developing

customer records, end-user metering, flow measurement, and detecting and reducing water losses

in each of the four targeted systems. The scope of the physical works in each of the systems is as

follows:

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• Arraijan system. This includes the purchase and installation of approximately 5,800

customer meters and 4 stations for macro-metering; the rehabilitation of the Miraflores

pumping station, a 1 million-gallon storage tank, 15 kilometers of water mains and pipes,

and household connections; and the replacement of 83 control valves.

• Chorrera system. This includes the purchase and installation of approximately 8,200

households meters and 8 stations for macro-metering; the rehabilitation of the El Caimito

treatment plant, groundwater pumping plants, an 800,000-gallon storage tank, 33

kilometers of water mains and pipes, and household connections; and the replacement of

90 control valves.

• Colon system. This includes the purchase and installation of approximately 7,000 meters

and 4 stations for macro-metering, the rehabilitation of a 300,000-gallon storage tank, and

the replacement of 99 control valves.

• Panama City System. This includes the purchase and installation of approximately 34,000

household meters and 36 stations for macro-metering; the rehabilitation of pumping

stations, the Chilibre treatment plant, 66-inch and 60-inch transmission pipelines, booster

pumping stations and storage tanks; and the replacement of 946 control valves.

SUBPROGRAM 3: ADDITIONAL ACTIVITIES. This subprogram includes improving interinstitutional

coordination and the authority responsible for protecting water resources and the water quality of

receiving bodies, and developing feasibility studies and updating the master plan for Panama

City’s sewerage system.

Program Costs and Financing

The estimated total cost of the three subprograms is almost US$65 million in (1998 prices). The

estimated total cost of subprogram 2, the focus of this case study, is US$44 million. The

projected cost in domestic currency of subprogram 2 is B21 million, or about 47 percent of the

total.1 The cost estimates are based on contracts with similar characteristics recently awarded in

1 The Panamanian currency unit is the balboa. The exchange rate is B1 = US$1.

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the region following international bidding. Table 1.1 shows the costs of the various components

of subprogram 2.

Table 1.1. Costs of Subprogram 2

(1998 prices)

Category Foreign exchange (US$ thousands)

Domestic currency (B thousands)

Engineering and administration n.a. 3,534 Direct Costs Panama UFW reduction New physical infrastructure System rehabilitation Colon UFW reduction System rehabilitation Arraijan UFW reduction New physical infrastructure System rehabilitation Chorrera UFW reduction New physical infrastructure System rehabilitation

3,168 2,991 7,615

1,100

67

744 2,835 693

784

3,120 95

5,393 1,408 3,373

1,290

79

874 1,467 250

836

1,468 51

Concurrent costs n.a. 630 Total investment costs 23,212 20,653

n.a. Not applicable UFW Unaccounted-for water

The IADB will provide financing for 70 percent of the total nominal cost of the program,

which at the government’s request will be drawn on the Single Currency Facility. The proposed

terms of the financing are a 20-year amortization period, a 4-year disbursement period, 4-year

grace period, and variable interest rates.2 The government will provide local counterpart funding

from the national budget.

METERING AND CONSERVATION. About 55 percent of the residential connections in Metropolitan

Panama are currently not metered. To implement a volumetric tariff system, metering is a

necessary initial step. Under the current system of fixed monthly charges for water service,

unmetered consumers do not face any incremental costs when they consume additional water.

With project implementation, consumers who switch from a flat-fee to a volumetric tariff will

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have to pay more for higher levels of consumption, and are therefore likely to reduce their

consumption. Thus metering would provide an incentive for water conservation by reducing the

relatively low-value uses of water and diverting it to higher-value uses elsewhere. In addition,

because more water will be made available to the rest of the system, less water will be tapped

from the distribution system’s sources of bulk supply. Metering will also give IDAAN much

better operating information both for efficient management of the system and for better planning

of its expansion.

WATER LEAKAGE. The current distribution network in Metropolitan Panama experiences a

substantial water leakage. The working assumption is that the current level of physical water

losses is approximately 15 percent of the water supplied. If the level of water pressure and hours

of operation were increased, the water losses would be much greater. The project includes a

comprehensive leak detection and repair program with the objective of reducing the rate of the

leakage to 10 percent of water supplied.

UNREGISTERED CONSUMERS. Estimates indicate that the financial revenues from about 30 percent

of the water produced are lost due to the consumption by unregistered connections and

commercial inefficiency in billing and collection. The project includes a component to reduce

this figure to 15 percent.

Financial Analysis

The financial analysis is the first component of the integrated analysis of this project. The

principal focus of this analysis is to see whether the project is financially feasible.

Assumptions

In addition to the assumptions about water issues outlined earlier, our financial analysis is based

on the following assumptions (for more detailed information see appendix 1.1):

2 For the sake of our analysis, we will consider the terms of IADB debt financing to be a 19-year amortization period, a 4-year disbursement period, a 1 year grace period, and a 7 percent nominal interest rate.

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• Subprogram 2 aims at reducing the percentage of residential connections without meters

from the current 55 percent of all households to about 9 percent. Of those residential

customers who will be provided with meters, 35 percent are assumed to receive an

adequate, 24-hour per day supply of water. The remaining 65 percent will receive water

intermittently. Of this later group, 40 percent will cope by using devices such as

hydropneumatic systems and overhead tanks to store water, while 25 percent will have to

obtain additional water from public standpipes and water vendors. Subprogram 2 does not

add new connections to the existing water system.

• Subprogram 2 is expected to reduce the cost of personnel, electricity, marketing, and

administration by 20 percent. The costs of operating inputs, excluding labor, are expected

to remain constant in real terms throughout the life of the project.

• We assume that IDAAN will continue to be exempt from paying corporate income taxes.

• Capital costs during the construction period exclude interest payments.

• The current tariff structure has remained unchanged since 1982. Unmetered residential

customers pay, on average, a flat-fee of B 7.00 per month. Metered residential customers

pay a volumetric tariff: B 0.80 per 1,000 gallons for consumption up to 10,000 gallons per

month, B 1.51 per 1,000 gallons for consumption of 10,000 to 30,000 gallons a month,

and B 1.67 per 1,000 gallons for consumption of more than 30,000 gallons per month.

Industrial customers pay B 1.51 per 1,000 gallons, and government customers pay B 1.36

per 1,000 gallons. Following program implementation, we assume that the tariff structure

will be increased by 10 percent and adjusted annually thereafter to reflect the rate of

inflation.

• We assume that unmetered residential customers (both those who receive a 24-hour

supply of water and those who face intermittent water supplies) consume 20 percent more

water than residential metered customers. Unmetered customers without coping devices

are assumed to consume 45 gallons per person per day (see appendix 1.1 for detailed

information about consumption per connection by different categories of water users). As

the program entails an increase in the tariff structure, we expect water users to reduce

their consumption levels depending on the price elasticity of demand for the different

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categories of customers. We assume that the elasticity of metered residential customers is

-0.35, of industrial and commercial customers is -0.60, and of government customers is –

0.50.

• We estimate that the project will have a useful life of 30 years, and fixed assets will be

depreciated by 90 percent in real terms by the end of the project's life.

• We assume a 1 percent annual real increase in wages throughout the life of the project.

• The average collection time for the bills is currently 140 days. The program aims to

reduce this period to 70 days.

• Only about 65 percent of bills sent to residential water customers are actually collected.

The program is expected to increase the collection efficiency to 85 percent. We assume

that 100 percent of water bills sent to industrial and government customers are collected.

• The accounts payable are assumed to be equal to two months of operating expenses,

excluding the labor expenses.

• The desired level of cash balances to be held as working capital is assumed to be one

month of all operating expenses, including labor expenses.

• Even though the nominal exchange rate is fixed, the real exchange rate may vary over

time when rates of inflation in the United States and Panama differ. We use a nominal

exchange rate of B 1 to US$1 in the starting year of the analysis.

• We take the real opportunity cost of equity to be 15 percent.

Perspectives

We developed the cash flow statement for subprogram 2 from both the total investment and

equity perspectives. The analysis from the total investment perspective does not take into

consideration the financing decisions associated with the project, i.e. the loan financing. This

perspective enables an analyst to assess the project’s ability to generate sufficient cash flows to

repay the loans. In contrast, the equity perspective looks at the project’s cash flow profile when

financial leverage is employed. The cash flow statement from equity perspective includes the

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loan facilities as sources of funds and the loan repayments as cash outflows (for a full discussion

see Harberger and Jenkins 2000, chapter 3).

Methodology

As the project entails rehabilitation of existing facilities, the benefits and costs relevant to the

analysis are those that are incremental to what would have occurred in the absence of the project.

We have developed cash flow statements “with” and “without the project” to derive the

incremental cash flow statement (obtained by subtracting the cash flow statement “without the

project” from the cash flow statement “with the project”).

We have conducted the financial analysis of the project in both nominal and real prices to

account for the different impacts of inflation. Inflation has both direct and indirect effects on the

financial viability of a project. The direct impact of inflation on returns to the project takes place

through changes in the real value of accounts receivable, accounts payable, and cash balances

(for a full discussion of the impacts of inflation on the financial analysis of projects see

Harberger and Jenkins 2000, chapter 6). The indirect impact of inflation, also known as the tax

impact, is not relevant in this case, because IDAAN does not pay corporate income tax. We

deflate the nominal incremental cash flow statement item by item to arrive at the real incremental

cash flow statement.

Then, we estimate the project’s financial viability by calculating its net present value

(NPV), and by considering the sensitivity of the project’s financial performance to its key

variables. By discounting the real, incremental, net cash flow profile of the project from the

equity holder’s perspective at the real rate of return on equity of 15 percent, we arrive at the NPV

of subprogram 2.

Results and Ratios

Tables 1.2 and 1.3 show the projected real cash flow statements for the proposed project from the

total investment and the equity holders’ point of view, respectively. The net present value of the

project from the equity perspective is extremely robust: more than B 86 million. The

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sustainability of the project and of the proposed financing structure also appears to be solid. The

average of the annual debt service coverage ratios is 9.03, with a minimum value of 6.93 in 2003

(the first year of repayment) and a standard deviation of 1.14 (table 1.4). The sensitivity analysis

section that follows contains as evaluation of the responsiveness of the debt service coverage

ratios for the first three years of repayment (2003 through 2005) to different financing structures

with respect to the loan repayment period.

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Table 1.2. Cash Flow Statement: Selected Years (1998-2022)

(total investment in B thousands, real 1998 prices)

100010011002100310041005100610071008100910101011101210131014101510161017101810191020102110221023102410251026

A B C D E F G H I P Z AAÑategory 1998 1999 2000 2001 2002 2003 2004 2011 2021 2022RECEIPTSSales revenuesResidential unmetered customers - - - - 203 302 311 321 321Residential metered customers Metered customers w/o project - - - - 1,697 2,716 2,800 2,882 2,882 - Unmetered customers with 24-hour supply w/o project 1,716 2,005 2,077 2,143 2,143 - Unmetered customers with intermittent supply w/o project (cope with tanks) 1,961 2,292 2,374 2,449 2,449 - Unmetered customers with intermittent supply w/o project (do not cope with tanks) 1,226 1,432 1,483 1,531 1,531 - Commercial and industrial customers - - - - 518 536 555 573 573 - Government - - - - 224 228 232 236 236 - Total sales revenues - - - - 7,546 9,512 9,832 10,135 10,135 - Revenues from recoup of commercial losses - - - - 9,490 10,446 10,774 11,095 11,095 - Cost savings from reduced bulk water purchase - - - - 578 578 578 578 578 - Change in accounts receivable - - - - 3,350 (309) 141 62 62 (3,084) Liquidation value - - - - - - - - - 4,387 Cash inflow - - - - 20,964 20,227 21,325 21,870 21,870 1,303

- - - - - - - - - - EXPENDITURES - - - - - - - - - - Investment cost - - - - - - - - - - Engineering and administration 1,049 1,322 1,049 114 - - - - - Direct costs - - - - - - - - - Panama - UFW reduction 1,349 2,022 3,842 1,348 - - - - - New physical infrastructure 642 1,284 2,152 321 - - - - - System rehabilitation 1,604 3,208 5,374 802 - - - - - Colon - UFW reduction 478 717 717 478 - - - - - System rehabilitation 29 116 - 1 - - - - - Arraijan - UFW reduction 324 485 485 324 - - - - - New physical infrastructure 860 1,721 1,291 430 - - - - - System rehabilitation 189 566 188 - - - - - - Chorrera - UFW reduction 341 425 512 342 - - - - - New physical infrastructure 918 1,835 1,376 459 - - - - - System rehabilitation 29 116 - 1 - - - - - Concurrent costs 180 180 180 90 - - - - - Contingency 799 1,400 1,717 471 - - - - - Total investment cost 8,791 15,397 18,883 5,181 - - - - -

Operating costs - - - - - - - - - - Personnel - - - - (2,118) (2,209) (2,302) (2,543) (2,809) - Electricity - - - - (1,367) (1,411) (1,456) (1,500) (1,500) - Chemicals - - - - (231) (239) (246) (254) (254) - Materials - - - - - - - - - - Marketing and administation - - - - (1,020) (1,030) (1,040) (1,115) (1,232) -

- - - - - - - - - - Income tax liability - - - - - - - - - - Change in accounts payable - - - - 266 14 14 6 6 (286) Change in cash balance - - - - (395) (20) (21) (12) (13) 473 Cash Outflow 8,791 15,397 18,883 5,181 (4,865) (4,896) (5,052) (5,418) (5,801) 187

- - - - - - - - - - NET CASH FLOW (8,791) (15,397) (18,883) (5,181) 25,829 25,122 26,377 27,287 27,671 1,116

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Table 1.3. Cash Flow Statement, Selected Years (1998-2022)

(equity holder in B thousands, real 1997 prices)

Category 1998 1999 2000 2001 2002 2003 2004 2011 2021 2022

Net cash flow before financing (8,791) (15,397) (18,883) (5,181) 25,829 25,122 26,377 27,287 27,671 1,116

Debt financing 6,154 10,778 13,218 3,627 - (3,628) (3,557) (3,096) (2,540) -

Net cash flow after debt financing (2,637) (4,619) (5,665) (1,554) 25,829 21,495 22,820 24,191 25,131 1,116

NPV @ 15.0% 86,381

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Table 1.4. Ratios of the Loan Repayment and Net Cash Flows, Selected Years (1998-2022)

(in B thousands)

A B H I J K L M N O P Q R S T U V W X Y Z

2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 2021

Real interest rate 4.90%

Net cash flow in real terms before debt financing 25,122 26,377 27,162 27,110 27,144 27,180 27,215 27,251 27,287 27,324 27,361 27,399 27,436 27,475 27,513 27,552 27,591 27,631 27,671 Debt repayment in real terms 3,628 3,557 3,487 3,418 3,351 3,286 3,221 3,158 3,096 3,035 2,976 2,918 2,860 2,804 2,749 2,695 2,643 2,591 2,540 PV of remaining net cash flows @ 4.90% 329,983 321,037 310,397 298,451 285,971 272,845 259,040 244,523 229,258 213,209 196,336 178,599 159,955 140,360 119,766 98,124 75,381 51,485 26,378 PV of remaining debt repayments @ 4.90% 38,244 36,491 34,723 32,938 31,135 29,309 27,460 25,585 23,681 21,746 19,777 17,770 15,724 13,634 11,498 9,312 7,074 4,778 2,421

RatiosAnnual debt service coverage ratios 6.93 7.42 7.79 7.93 8.10 8.27 8.45 8.63 8.81 9.00 9.19 9.39 9.59 9.80 10.01 10.22 10.44 10.67 10.89Debt service capacity ratios 8.63 8.80 8.94 9.06 9.19 9.31 9.43 9.56 9.68 9.80 9.93 10.05 10.17 10.29 10.42 10.54 10.66 10.78 10.89 PV Present value

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Sensitivity Analysis of the Financial Results

A sensitivity analysis identifies the variables most likely to affect the project’s financial

performance and it quantifies the extent of these impacts. Tables 1.5 through 1.13 present the

results of the sensitivity analysis for the following variables: the domestic inflation rate (table

1.5), changes in the tariff structure (table 1.6), divergence from the estimated consumption per

connection and investment cost overruns (table 1.7), commercial and technical losses after the

project (table 1.8), average collection period and price elasticity of demand (table 1.9), the real

exchange rate (table 1.10), increased real labor costs (table 1.11), changes in the assumed saving

and operating and maintenance expenses (table 1.12) and the income tax rate (table 1.13). Table

1.14 shows the impact of different amortization periods for the loan on the debt coverage ratios.

As table 1.5 shows, the overall impact of inflation on the project’s NPV is relatively

small. A more than threefold increase in both domestic and foreign inflation (which would keep

the real exchange rate constant) from 2 to 6.5 percent would increase the project’s NPV by B 3

million to about B 89 million, a change of 3.5 percent. This atypical impact of inflation on the

project’s financial NPV reflects the fact that the project will significantly reduce the amount of

accounts receivable the utility requires. Therefore, an increase in the inflation rate has a positive

impact on the project’s returns, because the negative real changes in accounts receivable without

the project are larger in absolute terms than the real changes with the project. In addition, with

the interest rate on the loan being fixed in nominal terms, a higher inflation rate will increase the

real value that the proposed debt financing adds to the project from the equity standpoint.

Table 1.5. Sensitivity of Financial NPV to the Inflation Rate

Inflation rate, domestic and foreign (percent)

Financial NPV (B thousands)

0.5 84,905 2.0 86,381 3.5 87,556 5.0 88,493 6.5 89,243 8.0 89,843 9.5 90,322

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The financial returns to the project, and therefore the change in the financial NPV of the

utility, are extremely sensitive to the tariff structure. Table 1.6 shows, however, that the projected

overall improvement in efficiency brought about by the project is such that IDAAN could reduce

the tariff structure by 50 percent and be no worse off financially than it is today.

Table 1.6. Sensitivity of Change in Financial NPV to a Change in Tariff Structure

Change in tariff structure (percent)

Change in financial NPV (B thousands)

-60 -8,122 -50 8,630 -40 24,150 -30 38,578 -20 51,983 -10 64,405 0 75,866

10 86,381

If water users consume 20 percent less water than expected, the project’s NPV would

drop by almost B 22 million, indicating that changes in consumption per connection have a

significant impact on the financial NPV (table 1.7). The project’s financial performance is not

very sensitive to the likelihood of a higher than anticipated investment cost: a cost overrun of 20

percent reduces the financial NPV by only B 8 million (table 1.7).

Table 1.7. Sensitivity of Financial NPV to Divergence from Estimated Consumption per

Connection and Cost Overruns

Divergence from estimated consumption per connection (percent)


Cost overruns (percent)


-30 54,085 0 86,381 -20 64,787 5 84,388 -10 75,559 10 82,394 0 86,381 15 80,401

10 97,238 20 78,408 20 108,123 25 76,415 30 119,028 30 74,421 40 129,950 35 72,428

The utility’s ability to reduce commercial losses has a substantial impact on the financial

returns to the project. If the commercial losses after the project were not at the level of 15 percent

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as planned, but were in the order of 24 percent of water generated, the project’s NPV would be

reduced by about 30 percent to B 60.6 million (table 1.8). Clearly this is a critical variable that

IDAAN should not ignore. By contrast, a divergence from the targeted reduction in the technical

losses (10 percent of water generated) does not affect the financial viability of the project

significantly (table 1.8). This is because a reduction in the technical losses would only reduce the

operating and maintenance costs, while water users with illegal connections that are detected and

metered with the implementation of the program would also become subject to the new

volumetric tariff.

Table 1.8. Sensitivity of Financial NPV to

Commercial and Technical Losses after the Project

Commercial losses with project (percent)


Technical losses with project (percent)


30 43,349 4 88,441 27 51,956 6 87,752 24 60,562 8 87,065 21 69,168 10 86,381 18 77,774 12 85,698 15 86,381 14 85,016

If the average collection period does not fall from its current level of 140 days to its target

level of 70 days, but instead declines only to 110 days, the project’s NPV would experience a

modest decline of about B 4 million (table 1.9). If the consumption of residential metered

consumers was more price elastic, the project’s NPV would drop because of the larger reduction

in water consumed and billed. Table 1.9 shows, however, that assumptions about the elasticity of

water consumption do not have a critical bearing on the project’s financial viability because the

range of likely price elasticities of demand is between –0.25 and –0.95 and the proposed increase

in the real price of water is only 10 percent.

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Table 1.9. Sensitivity of Financial NPV to Average Collection Period with Project

and Price Elasticity of Demand by Metered Residential Consumers

Average collection period with project (days)


Price elasticity of demand by metered residential consumers


70 86,381 -0.25 87,363 80 85,378 -0.35 86,381 90 84,375 -0.45 85,398

100 83,373 -0.55 84,415 110 82,370 -0.65 83,433 120 81,367 -0.75 82,450 130 80,365 -0.85 81,468 140 79,362 -0.95 80,486

Since Panama maintains a fixed nominal exchange rate to the U. S. dollar, an increase in

the domestic inflation rate with respect to U. S. inflation will bring about an appreciation of the

balboa in real terms (a fall in the real exchange rate balboa per US$). A real appreciation of the

balboa has a positive effect on the project’s financial viability, as the utility generates revenues in

domestic currency, while about 50 percent of the investment cost is denominated in foreign

currency, and the loan is also denominated in U. S. dollars. Table 1.10 shows, however, that the

impact of changes in the real exchange rate is relatively small.

Table 1.10. Sensitivity of Financial NPV to the Real Exchange Rate

Domestic inflation rate (percent)

Real exchange rate (B/US$)a


1 1.01 85,157 2 1.00 86,381 3 0.99 87,463 4 0.98 88,425 5 0.97 89,282 6 0.96 90,048 7 0.95 91,357

a. The real exchange rate shown is for one period only. It is equal to nominal exchange rate * (1 + foreign inflation

rate) / (1 + domestic inflation rate).

Labor costs are typically a prominent component of a water utility’s operating and

maintenance costs. Because Panama’s water utility is currently overstaffed, the proposed

program aims at reducing labor costs by 15 percent. Hence, the higher the wage rate, the greater

the potential benefits created by the project. Table 1.11 shows, however, that the impact of labor

costs on the project is relatively small.

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Table 1.11. Sensitivity of Financial NPV to Increases in Real Labor Costs

Increase in real labor cost (percent)


1 86,381 2 87,909 3 89,614 4 91,519 5 93,654 6 96,048 7 98,740

Table 1.12 shows that divergences in the estimates for savings in operating and

maintenance expenses brought about by the project do not significantly affect the project’s

financial viability.

Table 1.12. Sensitivity of Financial NPV to Changes in Assumed

Savings in Operating and Maintenance Expenses

Change in assumed savings in operating and maintenance expenses (percent)


-15 85,721 -7.5 86,051

0 86,381 7.5 86,710

15.0 87,040 22.5 87,370

As noted earlier, we assume that IDAAN will continue to be exempt from paying the

corporate income tax after the implementation of the program. Table 1.13 shows, however, that

should the partially divested utility be required to pay income tax, this would have a bearing on

the project’s financial NPV.

1-20

Table 1.13. Sensitivity of Financial NPV to the Income Tax Rate

Business income tax rate (percent)


0 86,381 5 81,118

10 75,995 15 70,802 20 65,609 25 60,417 30 55,224

Table 1.14 shows that the project’s ability to repay debt financing is extremely robust in

all possible scenarios with respect to the loan’s amortization period. Even assuming a repayment

period for the loan of nine years, the annual coverage ratio for the first year of debt repayment

(the one with the minimum value) would drop from almost 8.0 to a still comfortable 4.4.

Table 1.14. Sensitivity of Debt Coverage Ratio for First Three Years of

Debt Repayment to Loan Amortization Period

Loan amortization (years) Debt coverage ratio for 2003

Debt coverage ratio for 2004

Debt coverage ratio for 2005

19 8.63 8.80 8.94 17 8.15 8.31 8.44 15 7.60 7.75 7.88 13 6.98 7.11 7.23 11 6.26 6.38 6.49 9 5.44 5.55 5.64 7 4.50 4.59 4.66

Conclusions from Financial Analysis

With the financial structure as proposed by this reform plan, we find that a 13 million Balboas

(13 million US $) equity investment by the prospective private sector investors yields a net

present value of US$ 86 million. This is in addition to earning a 15 percent real rate of return and

the full return of the original amount invested to the investors. If this were a competitive

industry, this kind of a return would almost certainly never occur. However, this is a public

utility monopoly. As shown in Table 1.6 of the sensitivity analysis, if the restructuring of the

1-21

utility was carried out according to plan the water tariff rates could be reduced by up 50 percent

from their initial level and still give the private operator a 15 percent real rate of return on the

equity investment. Hence, from the financial analysis alone it would appear that the financial

proposal of the institutional restructuring plan is seriously flawed.

Economic Analysis

The second component of an integrated investment appraisal is the economic analysis. The

measurement of economic benefits and costs is built on the information developed in the

financial appraisal, using the domestic currency at the domestic price level as a numeraire. The

economic analysis of the project requires calculating the value of the national economic

parameters (capital and foreign exchange), the economic value of water, and the economic

conversion factors for all the inputs used. Then we use these to convert the financial cash flow

statement into a statement of economic benefits and costs.

National Parameters

Because Panama maintains a fixed nominal exchange rate to the U. S. dollar and is a major world

financial center, the project's use of foreign exchange will not have a significant impact on the

demand for or supply of foreign exchange available to Panama’s economy. Most of the

adjustment will take place elsewhere in the dollarized world. Hence, in this study we take the

economic exchange rate (Ee) to be equal to the market exchange rate.

We estimate the economic opportunity cost of capital for Panama to be equal to 9.3

percent. The economic cost of capital is calculated as a weighted average of the rate of time

preference to savers, the gross-of-tax returns on displaced investment, and the marginal cost of

foreign capital inflows (for a full discussion of this topic see Harberger and Jenkins, chapter 12,

2000).

1-22

The Economic Value of Water Service

The water supply component of this project will affect three groups of water users supplied by

IDAAN: residential metered and unmetered customers; industrial and government customers;

and nonrevenue water, which comprises both consumption by unregistered consumers and water

that physically leaks from the system. Different types of water consumers will place a different

value on the IDAAN service they receive, depending on the price they are willing to pay and on

the implicit costs of the coping measures, if any, they currently undertake to obtain a regular

supply of water.

METERED CUSTOMERS. As mentioned earlier, metered customers are those residential customers

with meters, and also all industrial and government customers that currently receive water 24-

hours a day. As the program entails a 10 percent increase in the tariff structure their level of

consumption is likely to fall, depending on their price elasticity of demand. Figure 1.2 shows the

economic loss incurred with respect to these customers after the implementation of the project.

Figure 1.2. Demand for Water by Metered Customers

Price

P0

Demand

1,000 gallons per day

A

B

0

PMeter

Q0 Q1

Z

1-23

The water users reduce their consumption by the quantity (Q0 – Q1). The economic value

lost corresponds to the area under the demand curve Q1ABQ0. The estimated economic loss per

connection per year per category of consumers is as follows:

Residential metered customers B 5.5

Commercial and industrial customers B 145.4

Government customers B 374.3

The loss in consumer surplus by the metered customers is shown by the area PmeterABP0

in figure 1.2. This income loss is created by the higher price they will pay for the water currently

consumed Q1, plus the consumer surplus lost on the amount they no longer consume (Q0 – Q1).

Of all the customers serviced by IDAAN at the present time, the residential customers constitute

39.5 percent, and commercial and industrial consumer make up 2.6 percent of the total.

UNMETERED CUSTOMERS. Our assumptions about unmetered customers who will be metered

under the project were stated earlier. Figure 1.3 presents the economic rationale for the

unmetered consumers who currently receive a 24-hour a day supply of water, and who will have

to pay a new volumetric tariff with the project. Suppose, these customers obtain a supply Q0 at

the current flat-fee rate and zero marginal cost. Once they are metered and facing a tariff

schedule with a higher marginal tariff of Pmeter, then the quantity they consume would decrease

from Q0 to Q1. This would result in a loss of economic benefits, which is illustrated by the area

Q1AQ0. At the same time, these consumers will forgo a total amount of consumer surplus equal

to OPmeterAQ0 which is equal to the economic loss Q1AQ0 plus the amount they must now pay to

IDAAN, OPmeterAQ1.

1-24

Figure 1.3. Demand for Water by Unmetered Customers Who Receive

24-Hour a Day Service without the Project

Figure 1.4 shows the situation for those customers who currently cope with an

intermittent water supply by using overhead tanks and who will now have to pay a new

volumetric tariff with the project. These customers currently pay the flat-fee and zero marginal

tariff, but they incur a marginal running cost equal to the electricity required to fill up the tanks.

Once they are metered and facing a tariff schedule with a higher marginal tariff of Pmeter, the

quantity they consume would decrease from their current consumption of Q0 to Q1. This would

result in a loss of economic benefits, which is illustrated by area Q1ABQ0. However, because of

their reduced coping costs, these customers would realize benefits arising from the resources

saved of OC0BQ0. The savings in electricity, maintenance, and depreciation of tanks foregone

because of the project should be considered at their economic values. These people represent

approximately 10.6 percent of all the people who obtain water from IDAAN.

Q1


Pmeter

Price

Q0

A

O

1-25

Figure 1.4. Demand for Water by Unmetered Customers Who Cope with Intermittent

Supply Using Overhead Tanks without the Project

The economic analysis for the consumers who are not able to cope with the intermittent

water supply by using tanks is influenced by the alternative methods they use to obtain water and

by the associated costs. Figure 1.5 shows the project’s economic benefits as a result of supplying

these customers. Typically these people obtain water for at least part of their consumption from

public standpipes. They have to incur heavy coping costs of time and effort to bring water to their

homes. An estimate of such coping costs, C0, these customers incur is B 2.69 per 1,000 gallons of

water, which is higher than the average water tariff that IDAAN charges residential consumers

even after the 10 percent price increase proposed by the project.

The economic value of the benefits from the project for this category of consumers

includes the additional consumption (QD – Q) resulting from the reduced cost of obtaining water,

Q0ABQD, plus the time savings resulting from not having to obtain water from public taps,

Marginal cost without project C0 Demand


A

B

0

PMeter

Q0 Q1

Price

1-26

OC0AQ0. This group gains in consumer surplus from the project an amount represented by the

area C0ABPmeter. This group accounts for 6.6 percent of all customers.

Figure 1.5. Demand for Water by Unmetered Customers Not Coping with

Overhead Tanks without the Project

NONREVENUE WATER. Nonrevenue water is separated into two categories: pilfered water and

water lost to leakage.

A large quantity of water in the IDAAN system is pilfered through illegal connections.

Although obtained via illegal means, this water will have economic value to its users. We have

estimated the value of this water in figure 1.6. IDAAN’s improved policing measures will

decrease the quantity that is pilfered, and the area Q1AQ0 shows the resulting economic loss

associated with consumers who have illegal connections. The income loss to those pilfering the

water is much larger. It is equal to their total loss in consumer surplus as a result of the project

OPmeterAQ0. Of the total number of people now consuming IDAAN's water, 27.2 percent fall into

this category.

Demand

Coping costs (C0)

Pmeter

QD Q0 0 1,000 gallons per day

Price

A

B E

1-27

Figure 1.6. Pilfered Water

Unlike pilfered water, that actually has an economic value even thought it does not

generate revenue for the utility, the water leaking out of the distribution network does not

generate any economic benefits. The project’s leak detection component will retain more water

for distribution to consumers.

Economic Value of Water Saved

We estimate that the water savings from the decrease in consumption brought about by the

increase in the tariff structure and the sharp reduction of unmetered connections would amount to

about 17 billion gallons per year. The corresponding reduction in the utility’s operating and

maintenance costs, taken at their economic values, provides a measure of the economic value of

these savings.

The project will also reduce the water produced at the Miraflores (27 million gallons per

day) and Mount Hope (20 million gallons per day) plants. The economic benefits arising from

these savings are the reduced economic cost of pumping raw water, estimated to be 20 percent of

the total operating and maintenance costs.

Pmeter

Price


Q1 Q0

Demand

A

O

1-28

Conversion Factors for Inputs

Before calculating the economic cost of the project’s inputs, we must compute the conversion

factors for the basic components of its investment and operating costs. These items are first

divided into tradable goods (including equipment, machinery, cement, fuel, steel, and chemicals)

and nontradable goods (including freight, handling, and electricity). We estimate the economic

cost and conversion factors for each of these items following Harberger and Jenkins, 2000,

chapters 7-9. We also calculate the conversion factors for different types of labor–

administrative, skilled, unskilled, and foreigners employed in the project (for a full discussion of

the methodology for calculating the economic opportunity cost of labor see Harberger and

Jenkins 2000, chapter 13).

After estimating the basic conversion factors, we calculate the economic cost of the

project inputs as the weighted average of the economic value of the basic components. The

weights are given by the share of the cost of the basic items in the total cost.

The conversion factors for changes in cash balances are taken to be equal to 1. The

conversion factor for changes in accounts payable, equal to 0.931, the weighted average of the

conversion factors for operating and maintenance costs.

Results

The statement of the economic benefits and costs for the subprogram 2 is obtained by adjusting

the real incremental cash flow statement from the total investment perspective. The profile of

economic values for each line item in the incremental statement of economic benefits and costs is

obtained by multiplying each line item in the real incremental cash flow statement by the

corresponding conversion factors. As table 1.15 shows, the economic NPV of the project using

an economic cost of capital of 9.3 percent is equal to about B 12.6 million.

Up to this point we have not considered the possibility that if this water concession is

awarded to a foreign owned company, it will result in an increased outflow of profits abroad.

This additional outflow of profits abroad is an economic cost in terms of Panama's economic

resources to the extent that this outflow is greater than the normal economic cost of funds for

1-29

Panama. In this case the outflow is far above the economic opportunity cost of the funds used by

the project. The economic net present value of B 12.6 million would be the outcome of the

project only if all the "excess" profits were paid to residents of Panama. Even these, Panamanians

we would need to be indifferent to this large transfer of income from water consumers to the

private owners of the concession. These aspects will be considered later when we evaluate the

economic cost of foreign financing.

30

Table 1.15. Statement of Economic Benefits and Costs, Selected Years (1998-2022) (B thousands, real 1998 prices)

Category Conversion factors 1998 1999 2000 2001 2002 2003 2004 2011 2021 2022ECONOMIC BENEFITS Sales revenuesResidential unmetered customersResidential metered customers Metered customers w/o project (649) (669) (690) (710) (710) - Unmetered customers with 24-hour supply w/o project (530) (548) (567) (585) (585) Unmetered customers with intermittent supply w/o project (cope with tanks) 2,773 2,869 2,966 3,059 3,059 Unmetered customers with intermittent supply w/o project (do not cope with tanks) 5,091 5,267 5,444 5,616 5,616 Commercial and industrial customers - - - - (741) (767) (794) (821) (821) - Government - - - - (262) (266) (271) (275) (275) - Total sales revenues - - - - 5,683 5,885 6,089 6,285 6,285 Economic value of reduced commercial losses (4,429) (4,570) (4,714) (4,854) (4,854) - Cost saving from reduced bulk water purchase 0.998 577 577 577 577 577 - Change in accounts receivable 1.000 - - - - 3,350 (309) 141 62 62 (3,084) Liquidation value 0.896 - - - - - - - - - 3,930 Total Benefits - - - - 5,181 1,583 2,093 2,069 2,069 846

ECONOMIC COSTSInvestment cost Engineering and administration 913 1,156 913 91 Direct costs - - - - Panama - UFW reduction 1,213 1,818 3,455 1,212 New physical infrastructure 589 1,178 1,975 295 System rehabilitation 1,441 2,883 4,829 721 Colon - UFW reduction 430 645 645 430 System rehabilitation 26 103 - 1 Arraijan - UFW reduction 291 436 436 291 New physical infrastructure 787 1,575 1,181 393 System rehabilitation 170 510 169 - Chorrera - UFW reduction 307 382 460 308 New physical infrastructure 842 1,683 1,262 421 System rehabilitation 26 104 - 1 Concurrent costs 162 162 162 81 Contingency 720 1,264 1,549 424 Total investment cost 7,918 13,899 17,037 4,669

Operating costsPersonnel 0.971 - - - - (2,057) (2,145) (2,236) (2,469) (2,728) - Electricity 0.998 - - - - (1,364) (1,408) (1,452) (1,496) (1,496) - Chemicals 0.900 - - - - (208) (215) (222) (228) (228) - Materials 0.885 - - - - - - - - - - Marketing and administation 0.903 - - - - (920) (930) (939) (1,007) (1,112) - - - - - - - - - - - Income tax - - - - - - - - - - Change in accounts payable 0.931 - - - - 248 13 13 5 5 (267) Change in cash balance 1.000 - - - - (395) (20) (21) (12) (13) 473 Total costs 7,918 13,899 17,037 4,669 (4,696) (4,705) (4,857) (5,207) (5,571) 207

NET ECONOMIC BENEFITS (7,918) (13,899) (17,037) (4,669) 9,878 6,288 6,950 7,276 7,640 640 NPV @ 9.3% 12,622

UFW Unaccounted-for water w/o without

31

Sensitivity Analysis of the Economic Results

A sensitivity analysis is conducted to identify the variables that are most likely to affect the

outcomes of the project from an economic perspective. Tables 1.16 through 1.19 present the

results of the sensitivity analysis for the following variables: investment cost overruns, price

elasticity of demand by metered residential customers, monthly income per capita, time spent per

day to get water from public taps, and the divergence from estimated savings in coping costs per

household.

The project’s economic viability is sensitive to the likelihood of higher than anticipated

investment costs. As table 1.16 shows, a cost overrun of 30 percent would turn the economic

NPV negative.

Table 1.16. Sensitivity of Economic NPV to Investment Cost Overruns

Divergence from original cost estimate (percent)

Economic NPV (B thousands)

0 12,622 5 10,697

10 8,773 15 6,848 20 4,924 25 3,000 30 -849

If water consumption by residential metered consumers were more elastic, the project’s

economic NPV would drop because of the reduction in the volume of water consumed caused by

the increase in the tariff structure. As table 1.17 shows, the overall impact on the project’s

economic NPV is, however, small.

32

Table 1.17. Sensitivity of Economic NPV to Price Elasticity of

Demand by Metered Residential Customers

Price elasticity of demand by residential metered consumers


-0.25 14,528 -0.35 12,622 -0.45 10,715 -0.55 8,808 -0.65 6,901 -0.75 4,995 -0.85 3,089

As mentioned earlier, households that do not cope with irregularities of service by means

of overhead tanks typically resort to public standpipes and other measures. We use both the

average monthly income per capita and the time spent per day to obtain water from public taps in

order to estimate the value of the time these households would save with the implementation of

the project. Table 1.18 shows that the project’s economic viability is extremely sensitive to

divergences from the assumptions about the monthly income per capita and the time spent per

day to obtain water from public taps. A 30 percent increase in income would bring about a

doubling of the project’s economic NPV to B 24 millions. Similarly, a 50 percent increase in the

time spent per day to fetch water, from one hour per day to one-and-a-half hours per day, would

raise the economic NPV to almost B 30 million.

Table 1.18. Sensitivity of Economic NPV to Monthly Income Per Capita and Daily Time

Spent to Fetch Water from Public Standpipes

Monthly income per capita (B thousands)


Time spent per day to fetch water from public taps (hours)


40 1,400 0.5 -4,210 60 12,622 0.75 4,206 80 23,843 1.00 12,622

100 35,064 1.25 21,038 120 46,286 1.5 29,454 140 57,507 1.75 37,870 160 68,728 2.00 46,286 180 79,950 2.25 54,702

33

Table 1.19 shows that the project’s economic viability is sensitive to changes in the

estimates about the households’ resource savings from the reduction in coping costs for those

now using tanks. A divergence of 20 percent would improve the project’s economic NPV by

about 40 percent or some B 17.8 million.

Table 1.19. Sensitivity of Economic NPV to percent Divergence from Estimated

Savings in Coping Costs for Households with Water Tanks

Divergence from estimated saving in coping costs for households with tanks, per household

(percent)


-40 2,300 -30 4,881 -20 7,461 -10 10,041 0 12,622

10 15202 20 17,782

Stakeholder Analysis

We now turn to the third component of an integrated investment appraisal, the stakeholder

analysis. A stakeholder analysis is employed to identify the segments of society that reap the

benefits of the project and which, if any, lose from the implementation of the project. The

stakeholder analysis of any project builds on the following relationship:

Pe = Pf + ΣEi, (1.1)

where Pe is the economic value of an input or output, Pf is the financial value of the same item,

and ΣEi is the sum of all the externalities that make the economic value of the item different from

its financial value.

In other words, the economic value of an item can be expressed as the sum of its financial

price plus the value of externalities, such as taxes, tariffs subsidies, and consumer or producer

surplus. On the basis of identity (1.1), the following relationship also holds:

NPVee = NPVf

e + ΣPVe (EXTi), (1.2)

34

where NPVee is the net present value of the net economic benefits at the economic discount rate,

NPVfe is the net present value of the financial net cash flow discounted by the economic discount

rate, and ΣPVe (EXTi) is the sum of the present values of all the externalities generated by the

project, also discounted by the economic discount rate.

All projects generate two types of net benefits: (a) financial net benefits, which accrue

directly to those who have a financial interest in the project; and (b) distributive impacts or

externalities, which are allocated to different segments of society. Relationship (1.2) holds for

any discount rate, and in this case we use the economic discount rate of 9.3 percent.

The stakeholder analysis requires the following steps:

• Identifying the stakeholder impacts of the project item by item, by subtracting the total

investment cash flow statement from the economic statement of benefits and costs,3

• Calculating the present value of each line item’s flow of distributive impacts, using the

economic cost of capital as the discount rate,

• Allocating the present value of the externalities to the relevant groups in the economy.

Project implementation affects the following stakeholders: the government, commercial

and industrial customers, residential metered consumers with and without the project, residential

unmetered customers with and without the project, illegal consumers without the project, and

residential unmetered customers without the project who are metered as part of the project

implementation. This last category is further broken down into customers with a 24-hour supply

of water without the project, customers with an intermittent water supply without the project who

cope with overhead tanks, and customers with an intermittent water supply who resort to public

standpipes and water vendors. Tables 1.20 and 1.21 show the distributive impacts of the project.

3 As both the economic and financial analyses are conducted at the domestic price level, the stakeholder impacts of a project can be calculated as the difference between these two net resource flows.

35

Table 1.20. Distribution of Project Net Benefits (B thousands)

Category NPV externalities (B thousands) Metered government before and after the project 760.00 Metered customers both with and without the project -23,603.00 Metered customers who were unmetered with 24-hour supply without project -18,236.00 Metered commercial and industrial customers before and after the project -9,398.00 Metered customers who were unmetered with intermittent water and cope with tanks without project 4,301.00 Illegal consumers without project -107,258.00 Metered customers who were unmetered but with intermittent water supply and who cope with public standpipes without project 27,675.00 Unmetered customers without project and remain unmetered -2,105.00

36

Table 1.21. Allocation of Externalities (B thousand)

1977197819791980198119821983198419851986198719881989199019911992199319941995199619971998199920002001200220032004200520062007200820092010201120122013201420152016201720182019202020212022202320242025202620272028

A B C D E F G H I J KAllocation of externalities

Present value of. Government Metered Metered Metered Metered Unmetered Commercial and Illegal externalities @ customers customers customers customers customers industrial customers

ECONOMIC BENEFITS economic discount also w/o (unmetered, (unmetered, (unmetered, (with and customers w/o projectSales revenues rate project 24-hr supply) tanks) no tanks) w/o project)Residential unmetered customers (2,105) (2,105) Residential metered customers - Metered customers w/o project (23,603) (23,603) Unmetered customers with 24-hour supply w/o project (18,236) (18,236) Unmetered customers with intermittent supply w/o project (cope with tanks) 4,301 4,301 Unmetered customers with intermittent supply w/o project (do not cope with tanks) 27,675 27,675 Commercial and industrial customers (9,398) (9,398) Government (3,479) (3,479) Total sales revenues (24,845) Economic value of reduced commercial losses (107,258) - - (107,258) Cost saving from reduced bulk water purchase (9) (9) Change in accounts receivable - Liquidation value - (54) (54) Total benefits (132,167) (3,542) (23,603) (18,236) 4,301 27,675 (2,105) (9,398) (107,258) - ECONOMIC COSTS - Investment cost - Engineering and administration (419) 419 Direct costs - - Panama - UFW reduction (751) 751 New physical infrastructure (319) 319 System rehabilitation (979) 979 Colon - UFW reduction (212) 212 System rehabilitation (15) 15 Arraijan - UFW reduction (143) 143 New physical infrastructure (327) 327 System rehabilitation (86) 86 Chorrera - UFW reduction (143) 143 New physical infrastructure (340) 340 System rehabilitation (14) 14 Concurrent costs (55) 55 Contingency (380) 380 Total investment cost (4,183) 4,183 - - Operating costs - - Personnel 486 (486) Electricity 24 (24) Chemicals 172 (172) Materials - - Marketing and administation 731 (731) - - Income tax - - Change in accounts payable (14) 14 Change in cash balance - - Total costs (2,784) 2,784 - - - - NET ECONOMIC BENEFITS (129,383) (759) (23,603) (18,236) 4,301 27,675 (2,105) (9,398) (107,258) w/o without UFW Unaccounted-for water

37

If IDAAN undertakes the project, the government would realize an overall loss of about

B 0.76 million (table 1.21). Government consumers would incur a loss of approximately B 3.54

million because of the reduction in water consumed as a result of the tariff increase (table 1.21).

The government would gain about B 4.8 million in duties on imports of investment cost items,

but would lose B 1.40 million in duties because of the reduced imports of operating cost items

brought about by the utility’s improved operating efficiency (table 1.21). The residential

customers who were metered before the project and the commercial and industrial consumers

also incur an economic loss related to the reduction in water consumed as a result of the tariff

increase of B 23.6 million and B 9.4 million, respectively. These two groups account for a total

of 42.1 percent of all IDAAN's customers.

In graphical terms, the project’s distributive impact on metered customers is shown in

figure 1.2. The economic loss is represented by the area Q1ABQ0. This is equal to the area

Q1ZBQ0 + ZAB. Consumers’ incremental financial outlay is P0PmAZ - Q1ZBQ0. A project’s

distributive impact on metered customers is measured by the Net Economic Impact less the Net

Financial impact. It is equal to the negative of the area (ZAB + P0PmAZ).

The residential customers, who were not metered before the project but now received a

24-hour per day water supply and pay the new water tariff, will realize a loss of about B 18.2

million. This group represents 9.2 percent of IDAAN's customers. The residential customers,

who remain unmetered even after the project, incur a loss of B 2.1 million because of the 10

percent increase in the monthly flat-fee. These represents 27.2 percent of all IDAAN's customers.

The clear losers from this project are the unregistered consumers who because of the project are

detected and billed. They will lose about B 107.3 million.

In graphical terms, the project’s distributive impact on unregistered consumers detected

and billed with the project is illustrated by figure 1.6. The economic loss is given by the area

Q1AQ0. Consumers’ incremental financial outlay is 0PmAQ1. Therefore the negative distributive

impact on unregistered consumers is (Q1AQ0 - 0PmAQ1) or OPmAQ0.

The major beneficiaries of the project are those residential consumers who received an

intermittent water supply before the project and, hence needed to incur coping costs. Consumers

38

who were able to cope with tanks gain about B 4.3 million, corresponding to the value of

resources saved because of the reduction in the coping costs, that are over and above the

economic losses incurred because of the reduction in water consumption brought about by the

tariff increase. This group makes up 10.6 percent of IDAAN's customers. Consumers who were

not able to cope with tanks gain about B 27.7 million. This gain reflects the value of time saved

because they no longer have to obtain water from the public taps or make purchases of water

from private vendors, plus the value of the additional consumption resulting from a reduced cost

of water. From this total, we need to subtract the amount they now pay for the water consumed.

This group is 6.6 percent of IDAAN's total customer base.

Reconciliation of Financial, Economic and Stakeholder Analysis

According to equation (1.2), we can state that:

economic NPV @ economic discount rate = financial NPV @ economic discount rate + present

value externalities @ economic discount rate

Using the information from tables 1.7, 1.15 and 1.20, we find that:

B 12.622 million (economic) = B 142.005 million (financial) – B 129.343 million (stakeholders)

Hence, the fundamental relationship expressed in equation 1.2 holds true. As summarized

in table 1.22, over 79 percent of IDAAN's current consumers will be hurt by this proposed

restructuring and privatization. This project will likely have considerable political difficulties in

being implemented, given the widespread negative impact it is likely to have on its customers.

Table 1.22. Proportions of Water Consumers Affected Negatively (–) and Positively (+)

Category Percentages of people affected Negatively (–) and Positively (+)

Metered government before and after the project 0.3 (–) Metered customers both with and without the project 39.5 (–) Metered customers who were unmetered with 24-hour supply without project 9.2 (–) Metered commercial and industrial customers before and after the project 2.6 (–) Metered customers who were unmetered with intermittent water and cope with tanks without project 10.6 (+)

39

Illegal consumers without project 27.2 (–) Metered customers who were unmetered but with intermittent water supply and who cope with public standpipes without project 6.6 (+) Unmetered customers without project and remain unmetered 4.0 (+)

The Economic Cost of Foreign Financing

As water systems have become privatized around the world, the private operators have frequently

been multinational companies. These companies have great expertise in improving the

operational efficiency of such public utilities. There is a need, however, to make sure that these

improvements are obtained at a reasonable cost. If the concession is incorrectly structured, the

economic cost to the country can be tremendous. This case illustrates such a situation.

Table 1.23. Calculation of Excess Returns

Equity Holder (in thousand Balboas) 1998 2002 2003 2004 2005 2017 2018 2021 2022

Net cash flow before financing -8791 25829 25122 26377 27162 27513 27552 27671 1116

Debt financing 6154 -3628 -3557 -3487 -2749 -2695 -2540

Net cash flow after debt fin. -2637 25829 21495 22820 23675 24764 24857 25131 1116

Share of benefits to makeNPV zero 12.161% -2637 3141 2614 2775 2879 3012 3023 3056 136NPV of Equity @15% 0Excess returns from proposal 22688 18881 20045 20796 21752 21834 22075 980NPV of Excess returns from proposal (economic D.R.) 144310

In table 1.23, the net cash flow accruing to the private equity of the project is stated in

row 1. Under the proposed arrangements the net present value at a 15 percent real discount rate is

86 million Balboas. In row 4 we calculate what proportion of the net cash would be required to

give the equity owners a real rate of return of 15 percent. We find that only 12.161 percent of the

current proposed net cash flow would be sufficient to achieve this target. Hence, 87.84 percent of

the net cash flow represents excess profits arising because of the way the restructuring plan was

designed.

If the owners of the equity were domestic residents of Panama then these excess profits

would represent a transfer from the water consumers to the private owners of the equity. This

would create no economic cost to Panama in aggregate. It would be financially unjustified and,

perhaps, politically explosive. On the other hand, if the private owners of the equity are foreign

1

2

3

4

5

6 7

40

residents, the results are very different. This flow of excess profits (row 6) represents a claim that

these foreign residents will have on the resources of Panama and, hence, there is an economic

cost. When the net present value of this flow of excess profits is discounted using the economic

rate of 9.3 percent, it has value of 144 million Balboas. Under the current design of the project

proposal, the country receives a 13 million Balboas contribution of capital on which it provides a

15 percent real rate of return and, in addition, the country incurs an economic cost of 144 million

Balboas. This is simply because the terms of the financial proposal are too much in favour of the

private operator.

If the excess profits are properly viewed as an economic cost, then the economic net

present value of the project turns from being a positive value of 12.6 million Balboas into

negative value of 131.4 million Balboas. It is unlikely that such on outcome is an objective of

anyone associated with this proposed project.

Risk Analysis of Financial and Economic Returns

The fourth component of an integrated appraisal considers the nature of the risk associated with

the project. The main drawback of the deterministic analysis is the implicit assumption that the

assumed single value used for all variables are known with a 100 percent certainty and,

consequently, that the estimated NPV for the project is 100 percent certain. To overcome this

drawback, we conduct a risk analysis in which we identify a number of risk variables on the basis

of the sensitivity analysis. Then, we determine the range and distribution of values for these risk

variables and specify the appropriate correlations between the variables. The expected values of

the distributions of the risk variables are the base values of the assumptions used in the

deterministic financial analysis. The output of the analysis is presented as a probability

distribution of the important performance variables and their occurrence.

Table 1.24 shows the identified risk variables, and their corresponding ranges of values

and probability distributions. In terms of relationship between the variables, a negative

correlation of -0.80 has been modeled between commercial and technical losses. As metering is

41

improved and commercial losses are reduced, an increase in the overall water pressure in the

system will be required. This is likely to give rise to an increased rate of water leakage from the

system.

Table 1.24. Risk Variables, Probability Distributions, and Range Values Base Probability Minimum Maximum Risk variable value distribution value value Commercial losses with project 15 percent Triangular 5 percent 25 percent Technical losses with project 10 percent Triangular 5 percent 15 percent Time per day to get water from public stand posts (hours) 1 Triangular 0.20 1.80 Monthly income per capita (B) 60 Triangular 20.0 100.0 Divergence from estimated savings in coping costs 0 percent Triangular -30 percent 30 percent Range value Probability (%) (%) Investment -15 – -5 15 cost overrun 0 percent Step -5 – 5 75 5 – 25 10 Annual consumption 125 – 145 30 per connection of 155 Step 145 – 165 50 residential metered customers (gallons) 165 - 205 20

The risk analysis presented here was done under the assumption that the financial returns

accrue to residents of Panama. Hence, the rest of the analysis refers to the situation where the

NPV economic in the base case is B 12.6 million.

The results of the risk analysis (figure 1.7) shows that the expected value of the financial

NPV (using the financial discount rate) is B 86,015 million, which is close to the computed

deterministic value of B 86,381 million. The risk analysis also confirms the project’s robustness

from the financial standpoint, with a zero probability of the project having a negative NPV.

42

Figure 1.7. Results of Risk Analysis: Financial NPV

Statistics Value Trials 1,000 Mean 86,015 Median 84,811 Standard deviation 15,363 Range minimum 51,820 Range maximum 137,530 Range width 85,711

Cumulative Chart

.000

.250

.500

.750

1.000

0

250

500

750

1,000

50,000 70,000 90,000 110,000 130,000

1,000 trials 6 outliers Forecast: Financial NPV

Expected NPV

43

The expected value of the economic NPV (figure 1.8) is B 12,471 million, which is also

close to the deterministic value of B 12,622 million. The analysis confirms the riskiness of the

project from the economic standpoint even before considering the impact of foreign equity

participants, because the probability of the project having a negative outcome turns out to be

equal to 25.9 percent.

Figure 1.8. Results of Risk Analysis: Economic NPV

Statistics Value Trials 1,000 Mean 12,471 Median 10,743 Standard deviation 18,172 Range Minimum -34,234 Range Maximum 77,279 Range Width 111,514

Cumulative Chart

Note: Certainty is 25.90 percent from -Infinity to 0.

.000

.250

.500

.750

1.000

0

250

500

750

1000

-40,000 -15,000 10,000 35,000 60,000

1,000 trials 5 outliers Forecast: Economic NPV

44

Conclusions

This study shows how the results of the appraisal of a project aimed at improving the overall

efficiency of the water utility with no expansion of coverage may differ greatly when viewed

from different perspectives.

The program to support the restructuring of the water and sewer utility is certain to have a

large positive impact on the utility’s financial performance. For an infusion of $13 million of

equity, the private operator is estimated to earn a NPV of B 86 million at a 15% real rate of

discount. Under the current proposal it is planned to increase tariffs by 10 percent above their

current level following the project implementation. This will increase almost certainly be

economically damaging to the country. Even though the project appears to be financially robust,

considerable political risk is present that could bring about a very different financial outcome.

Once the rate of return to the concessionaire becomes known, it is unlikely to be

politically sustainable. Over 79 percent of the current consumers will be made worse off by the

project. If the proposed restructuring is able to deliver the cost savings as planned, then a major

reduction in price of water is possible over time without hampering the financial performance of

the utility. We found that the utility could reduce the water tariff structure for the project by up to

50 percent and still it would remain financially viable. If this were to happen then the majority of

the customers could be made better off by the project. In such an event, the economic outcome

would also become positive.

45

References and Bibliography

Albouy, Yves. 1997. "Marginal Cost Analysis and Pricing of Water and Electric Power." Inter-

American Development Bank, Washington, D. C., USA.

Inter-American Development Bank. 1997. “Loan Proposal, Program of Support for Restructuring

the National Water and Sewer Utility.” Washington, D.C.

Harberger, Arnold C., and Glenn P. Jenkins. 2000. Manual for Cost Benefit Analysis of

Investment Decisions. Queen’s University, Canada. (Unpublished manuscript)

Porter, Richard C. 1996. The Economics of Water and Waste. Vermont: Ashgate Publishing.

46

Appendix 1.1. Table of Parameters

Inflation and exchange rates Working capitalDomestic inflation 2.00% Average collection period (without project) 140 daysU.S. inflation 2.00% Average collection period (with project) 70 daysNominal exchange rate (in year 1998) 1.00 Balboas/US$ Accounts payable 2 months of O&M (excl. person.)

Cash balance 1 month of O&M expensesOperating and Maintenance expenses (without the project)Personnel 60.5 '000 Balboas per '000 connections Tariff structureElectricity 66.5 Balboas per '000 gallons produced Without the projectChemicals 27.0 Balboas per '000 gallons produced Residential customersMaterials 16.2 '000 Balboas per '000 connections Flat-fee on umetered customers 7.00 Balboas per household per monthMarketing & administation 4900.0 '000 Balboas Volumetric fee on metered customers:

up to 10,000 gallons/month 0.80 Balboas per '000 gallonsReal increase in personnel and 10,000 - 30,000 gallons / month 1.51 Balboas per '000 gallons mark. &admin. expenses 1.0% per annum over 30,000 gallons/month 1.67 Balboas per '000 gallons

Commercial & industrial customers 1.51 Balboas per '000 gallonsSaving in Operating and Maintenance expenses (with the project - from year 2002) Government 1.36 Balboas per '000 gallonsPersonnel 15.0% of expenses without the project With the project (starting from 2002)Electricity 15.0% of expenses without the project % increase across the tariff structure 10%Chemicals of expenses without the project Rate on illegal users w/o project recouped 0.95 Balboas per '000 gallonsMaterials of expenses without the projectMarketing & administation 20.0% of expenses without the project Debt Financing (from IDB)

Nominal fixed interest rate 7% Bill collection efficiency Repayment period 19 yearswithout the project 70.0% of water billed to residential customers Grace period 1 yearAnnual increase with project 5.0% from 2001 to 2002With project 80.0% from 2003 Equity Financing (from IDAAN)

real return on IDAAN equity 15%Unaccounted-For Water (UFW)Physical losses (without project) 15.0% of water produced Utility income tax rate of earnings before taxesPhys. losses (w/project - from 2002) 10.0% of water producedCommercial losses (without project) 30.0% of water produced Useful life for tax purposesCom. losses (w/project - from 2002) 15.0% of water produced Depreciation Years

Engineering and administration 5Real residual value of investment 10% of original value (in 20 yrs) UFW reduction 10

New physical infrastructure 15System rehabilitation 10Concurrent costs 5Contingency 5

Documents

Case 1 Panama - Queen's U