Chapter 1: Rationale and Approach of the Toolkit, Danish Environmental Protection Agency

Water Prices in CEE and CIS Countries. Volume I: Main Text

Chapter 1
Rationale and Approach of the Toolkit

1.1 Background

The Danish Ministry of the Environment, DEPA, DANCEE and the European Bank for Reconstruction and Development, EBRD, initiated the work on this toolkit. The purpose is to make an operational toolkit to be applied in CEE and CIS countries, where investments in water and wastewater services are considered. With some modifications, the tool would also be applicable for use in water services for urban agglomerations in developing countries.

Large cities and small towns in the CEE and CIS countries presently face significant investments in water and wastewater services. The population wishes to have clean, potable water in their taps, and there is growing awareness on environmental issues, hence also of wastewater treatment. In addition, some CEE countries are upgrading the water services in order to meet EU standards.

The water and wastewater services provided should correspond to the preferences of the users and, therefore, detailed demand analysis is important when deciding upon the levels of investments. The toolkit provides a set of tools to assess the present and future demand for water and wastewater services, the willingness of the consumers to pay for these services and the political acceptability of the consumer charges. The resulting assessment is imperative for both policy makers and private investors, in order for them to choose the appropriate level and type of investment.

The tools are intended for use by the project sponsor (i.e. public administration, investor or daily operator), possible donors and international financial intermediaries, other lenders and their advisors / consultants. Specialists familiar with technical, economic, market research and policy analysis can use the toolkit when they need systematic methods to assess the consumers' willingness to pay, and the affordability and political acceptability of water prices in the context of investments in water services infrastructure in the CEE and CIS countries.

When specialists have applied the tools provided, a generalist with sound judgement and knowledge of the sector and the specific country/region should summarise the analyses into one overall assessment on risk and possible ways to mitigate the risk identified. This summary should be aimed at high level policy makers within the involved institutions.

1.2 Why?
Improved policies and projects through better assessment of the demand for services!

Thirty years back, even major infrastructure investments were often decided on the basis of detailed and systematic engineering analyses, but without much analysis of the prospective demand for the service. Today, an investor will not commit to a major infrastructure project investment until detailed studies of the future demand have been carried out.

Within the water services sector, the requirement for detailed demand analysis is now gaining ground. It is a mistake to assume that households always want lower prices for water and wastewater services. Households often want better services and are willing to pay for them. Detailed demand assessment studies can help inform policy-makers about this willingness to pay and the consequent scope for cost recovery and sustainability.

This is important because of the nature of the revenue risks in water services. Consumers may reduce their demand for water or chose not to pay their water bills, and the political system may regulate tariffs and enforcement of payment to the detriment of the water services provider. This toolkit is intended to guide policy makers and project sponsors to make choices that are sustainable and take account of the views of consumers.

1.3 When?
At the preparatory stages of investment projects and / or decision regarding publicprivate partnerships (PPPs)!

Demand analyses are needed at the identification, pre-feasibility and feasibility stages of any major investment project in order to reduce the revenue risk for the project sponsors. The analyses should become progressively more detailed as the project moves towards the feasibility stage and the final decision. Chapter 2 discusses the timing of the tools related to demand analyses, which are presented in this text, in relation to other project cycle planning tools.

The demand analyses will be highly useful no matter how the project investment is financed, whether through international development finance, commercial finance, public budgets or some publicprivate partnership arrangement (or a combination hereof).

Demand analysis using stated preference methods is frequently used when a major part of the financing comes from an international financial institution (IFI) such as the World Bank or the EBRD. These organisations tend to have a strong focus on project viability and will require some form of demand analysis¹. Some form of willingness to pay analysis is generally required by all major donors to demonstrate the long-term sustainability of any major infrastructure investment.

Private commercial financiers emphasise the assessment of project risk. Thus, comprehensive and reliable demand analysis is very important for limited recourse lending, but also when there is, for example, a municipal guarantee. In any case, good banking practice would suggest the lender to require that the borrower has carefully considered the revenue risk.

Investment projects funded from public budget transfers ought to be subject to the same rigorous examination of project viability as projects with IFI funding. The demand analysis tools provided in this toolkit may significantly enhance the quality of the individual projects in the public investment portfolio. It is recommended to use these (or similar) tools for major public-funded infrastructure projects.

Various forms of public-private partnerships are gaining ground within the water services sector. These are typically initiated at a point in time, when the public water utility in question needs to undertake a major investment programme and finds that it (or the backing public administration) is short of cash². For the private partner, there are different approaches to dealing with the inherent uncertainty in such a situation. The private partner may try to ensure a positive cash flow throughout the partnership period, to obtain guarantees for payments or to obtain a very flexible arrangement in relation to the future service delivery and tariffs. Explicit consideration of customer perceptions, affordability, demand and political acceptability reduce uncertainty by lowering revenue risk. This may be achieved by using the tools in this toolkit³.

The toolkit is applicable for small and large infrastructure investments. However, in view of the approximate total level of effort, the full toolkit is only expected to be used in connection with infrastructure investments of EUR 5 million or more. For smaller infrastructure projects, it will often make sense to reduce cost of preparation by using only a subset of the full toolkit. It is recommended that a case-by-case approach be used when selecting which tools to apply. A standard subset of tools is presented in Chapter 7

1.4 For whom?
Sponsors of marketed water services!

The toolkit is applicable and relevant for all marketed water services⁴. However, the tools have been specifically aimed at services where a large part of the consumers are households.

Household consumers account for by far the largest share of water demand for most utilities in Western Europe and CEE. In the CIS, industry was sometimes a very large water consumer and there were (and often still are) large cross-subsidies from the industry to the household consumers. As a consequence of the demise of traditional industry and the change in water use patterns by the remaining industry the households tend to account for a larger share of the consumption in the CIS, similar to the pattern in Europe.

A different approach should be applied to analyse the water demand of households and industry, respectively. For industry: changes in the composition of the sector, changes in the composition of production and the introduction of cleaner technologies are all major drivers of the demand for water and wastewater services. Proper analysis requires industry - and sometimes plant-specific - assessments of the alternatives to buying water from / discharging wastewater to the public system. This again means that guidelines for analysis need to be industry specific to be really useful. In this toolkit, we focus on the analysis of household demand.

Many well-run enterprises undertake regular analysis of customer perception and willingness to pay for the services they provide. The methodology suggested in Chapter 4 has proved useful for water utilities in the United Kingdom among other countries. The best water utilities in Central Europe also undertake regular customer satisfaction analyses. These enterprises may want to explore the methodology in Chapter 4.

The tools are intended for use by the project sponsor whether this is a national or municipal administration, a strategic investor, the daily operator of a water and wastewater utility or possible donors, IFIs and other lenders. While much information in this book may be of interest to policy makers, this toolkit has been written for their advisors / consultants. It is aimed at specialists who are familiar with technical, economic, market research and policy analysis, but who are looking for systematic and tested methods to assess consumers' willingness to pay (WTP), and the affordability and political acceptability of water prices in the CEE and CIS countries.

1.5 How?
As part of an iterative determination of supply of service and demand!

The toolkit provides a set of tools to assess the future demand for water services and the political acceptability of the related consumer charges. These tools should be used as part of an iterative assessment of service levels, technical options and related expenditure, on the one side, and the demand for services, tariffs and resulting revenues, on the other side. The toolkit provides a methodology and tools to consider the following issues:

The service level targets, which should be set by decision-makers with due consideration to environment and health regulations, service provider affordability and consumer demand for water and wastewater services;

The future infrastructure investment needs, which will be determined by the present technical profile, the available technical options and the service level targets;

The demand for water and wastewater services and affordability, which in turn determines the tariff level and collection both directly via consumers' consumption and propensity to pay the bills and indirectly via the influence of political acceptability of tariff level and enforcement of payment;

The political acceptability that influences the tariff level and collection rates via the institutional framework (utility autonomy, regulatory control incl. tariff setting, enforcement of payment etc.).

Each of the issues above will have an impact on the expected future revenues and expenditure of the project and of the responsible service provider. In this way, proper assessment of the issues is necessary to achieve proper assessment of project viability. The iterative nature of these factors is illustrated in Figure 1.1.

Figure 1.1:
Water and wastewater infrastructure investment. Issues considered in the toolkit.

The service provider affordability is determined by the duality of expenditure, and revenue, the latter consisting primarily of tariffs collected and public budget transfers.

It is essential to keep in mind the link between supply and demand and to consider that this link develops over time. Therefore, the toolkit emphasises the need for an iterative approach to determine the "appropriate" level of service, starting from a rough idea of technical options and demand for services and working towards narrowing the options through a funnelling process to a specific project implementation plan. The dynamic and iterative nature of the suggested approach is discussed further in Chapter 2.

The toolkit focuses on acceptability of water prices and demand for services!

The toolkit provides a set of tools to address the issues highlighted in grey colour in Figure 1.1. The focus of the toolkit is on the acceptability of future water prices and thus on the "demand side", i.e. the tools in the right column of the figure. Consideration of the "acceptability of water prices" is likely to require systematic consideration of the political acceptability of increased tariffs etc. Therefore, tools for the assessment of political acceptability have been included.

A practical toolkit - not a traditional consultant's report!

In addition to the "recipes" provided, there are other ways to address each of the highlighted issues. However, the purpose of this report is not to provide an overview of all possible methods of assessment, but rather a practical and generally accepted sub-set of these methods. The sub-set has been selected in dialogue with the EBRD, DEPA, the World Bank and commercial project sponsors. However, the responsibility for the final selection remains that of the consultant.

As any good cook knows, a recipe must always be adapted to the ingredients available and to the taste of customers. This is also the case for the present toolkit. The tools must be tailored to the data and information available and, in particular, to the specific issues that need to be addressed in each case.

1.6 Structure of the main text

The purpose of this toolkit has been to provide a thorough guide to a set of high quality tools, which would enable the user to provide robust answers concerning prospective future demand for the services provided by the infrastructure in question.

Each chapter includes:

A step-by-step recommended approach (the first text box of each chapter).

Pertinent considerations for the consultant who tailors the tool for use in a particular situation.

Text boxes with illustrative examples in support of these considerations.

Practical "tools" such as formats for the design of questionnaires, topic guides, standard information sheets etc.

Table 1.1 lists the tools provided for the highlighted topics in Figure 1.1 and indicates the chapter in which the tools are presented.

Table 1.1:
Overview of topics and tools included in the toolkit

Topic	Tool		Chapter / Appendix
An iterative approach to service, technical solutions, demand and tariffs	Tool:	The integrated approach	Chapter 2
	Tool:	Proposed Scope of Works for inclusion in Terms of Reference	Appendix 2
Service level targets, technical profile and options; and infrastructure and service levels	Tool:	Establishing a technical, service and expenditure baseline	Chapter 3
	Tool:	The technical profile summary	Appendix 3
Customer perceptions and willingness to pay	Tool:	Qualitative research approach	Chapters 4.3-5
	Tool:	Generic topic guide	Appendix 4
	Tool:	Quantitative research approach	Chapter 4.6
	Tool:	Estimation of willingness to pay	Appendix 9
	Tool:	Generic example of survey design	Appendices 5-7
Demand for water services	Tool:	Data requirements, statistical methods	Chapter 4.7
Household affordability	Tool:	Affordability assessment based on macro data;	Chapter 5.3
		Household affordability (quantitative survey)	Chapter 5.4
		Tariff design and transfers	Chapter 5.5
	Tool:	Example of a brief household expenditure survey	Appendix 8
Political acceptability	Tool:	Analysis of attitudes of political parties	Chapter 6.7
	Tool:	Analyses of attitudes and assumptions	Chapter 6.8
	Tool:	Screening of key actors	Appendix 10
General	Tool:	Example of Information Note	Appendix 11
General	Tool:	Glossary	Appendix 12

1.7 Preparation of the toolkit

The present toolkit is based on three types of information:
Best practice (based on existing studies);

Case studies and desk studies ;

Dialogue with key partners.

1.7.1 Best practices

Best practices were extracted from existing research and studies related to water and wastewater investments, and an initial set of "best practice tools" was collected. The information sources used included:

Articles published in academic journals;

Working papers from conferences etc.;

Studies carried out in preparation of water and wastewater investments.

The list of literature used is provided in Appendix 1. The list also includes a sub-set of suggested literature to provide a good introduction to the practical and theoretical issues at stake.

1.7.2 Case studies

Three case studies were undertaken, whereby these tools were tested in the field in the cities of Brno, Poznan, Kaliningrad. The case studies are reported in Appendices 13 - 15. The reader should note that the case studies were carried out in the years 1999 - 2000. The main purpose of the case studies was to improve the toolkit. Thus, case study facts may have changed since the studies were undertaken, and the case studies may not represent the current key revenue risk issues for the cities.

In addition, desk studies⁵ of existing material were undertaken for the cities of Lviv and Sevastopol in the Ukraine⁶, as well as for small towns in Estonia⁷, Ukmerge in Lithuania⁸ and for Borovichi, Novgorod Region, Russia⁹. While the main text and its text boxes refer to all these studies, only the two last mentioned desk studies have been written up as a separate appendix.

A number of criteria were applied, and the case study cities were chosen in order to cover:

Number of inhabitants

Operator ownership

Quality of future service and type of service to be provided, viz.:

Level of current water services

Investments in wastewater or water supply

Service improvements versus avoidance of service deterioration

History of price increases

Weak enforcement of tariffs in the past

The case-study cities are described in the table below.

Table 1.2:
Key parameters of the case studies

Case	Inhabitants	Description
Brno, Czech Republic	400,000	Focus on wastewater service investments. Existing private sector operator, history of significant water tariff increases.
Poznan, Poland	678,000	Focus on water supply, current services are good and hence focus on willingness to pay to avoid service deterioration. A concession is being planned.
Kaliningrad, Russia	450,000	Focus on water supply, current services are inadequate, there is a history of significant water tariff increases. The operator is the public sector.

Table 1.3:
Key parameters of the desk studies

Case	Inhabitants	Description
Estonia	1,500 - 20,000	A number of small towns in Estonia. Focus on water supply improvement.
Ukmerge, Lituania	31,000	Small town, focus on water and wastewater services.
Borovichi, Novgorod, Russia	60,000	Small town, focus on water and wastewater services.
Lviv, the Ukraine	790,000	Large town, focus on water supply improvement.
Sevastopol, the Ukraine	355,000	Large town, focus on water supply and wastewater services.

Based on the results of the field tests, the tools were revised.

1.7.3 Dialogue with key partners

Throughout the process, the team had discussions with colleagues in the following organisations:

The European Bank for Reconstruction and Development (EBRD);

The Infrastructure Department of the World Bank;

The International Finance Corporation (IFC);

The Danish Environmental Protection Agency (DEPA);

The Regional Environmental Centre (REC) Szentendre, Hungary;

Project sponsors including International Water Ltd., Severn Trent and Suez Lyonaise des Eaux;

Other consultants (notably the Paribas team advising the city of Poznan);

Municipalities and local utilities, in particular the City of Brno and BVK, the City of Poznan and PWIK, the city of Kaliningrad and the Vodokanal in Kaliningrad.

These partners all contributed with ideas and inspiration, and we are grateful to all discussion partners. Preliminary results of this project have been presented at international conferences in London, Prague and Wiesbaden. Feedback from these conferences has also been incorporated in the toolkit.

1.8 Use of the toolkit under different circumstances

Based on best practices, the case studies and the dialogue with key partners, we are able to make the following main observations in relation to each of the selection criteria above:

Number of inhabitants: The Small Town Toolkit

In order to assess the use of the tools in both large and small cities, cities of different size were chosen. On this basis, we can conclude that the tools may be used in both large and small cities. However, irrespective of the size of the city, the use of the full set of tools is prohibitively expensive in connection with projects of less than approx. EUR 5 million. We have found that the value of the investment is a better criterion than the number of inhabitants.

At the same time, in many small municipalities a substantial part of the project investment costs are covered through national or international (e.g. ISPA) grant programmes, where the project sponsors have acknowledged up front that they will not recover their contribution through user charges. In this situation the establishment of appropriate, affordable and not too ambitious service level targets becomes a key issue.

For small towns, we recommend specific parts of the toolkit to be used. Jointly these parts constitute what we may call "The Small Town Toolkit", see Chapter 7.

Operator ownership: Private versus public sector operator

In order to test the robustness of the methodology in relation to the question of private versus public operation, we choose to use the methodology in a city with public service provision (Kaliningrad), a city with public, but planned private service provision (Poznan) and a city with private service provision (Brno). The respondents in Poznan and Brno showed little awareness of the ownership structure of the enterprise. The field studies gave no indication that the customer perception study should be designed differently depending on ownership structure. The field studies indicated a much larger propensity to interfere in tariff and utility decisions in Kaliningrad with its public service provision. However, this may be as much a reflection of the traditions of Russian administration as the public ownership in itself. We do not have the material to make a judgement hereon.

Quality of future service and type of service to be provided

In order to test the robustness of the methodology in relation to key future service issues, we choose three different issues for the willingness to pay analysis. The issues are:

Level of current water services

Investments in wastewater or water supply

Service improvement versus avoidance of service deterioration

Level of current water services

The tools proved effective both in cities with current good quality water services (Brno and Poznan) and in cities with current poor quality water services (Kaliningrad and Lviv).

Investments in wastewater or water supply

The tools were robust both in relation to water supply (use value) such as in Kaliningrad and in a situation where the consumers should relate to environmental improvements and EU compliance as a consequence of wastewater treatment investments (non-use value) such as in Brno.

Service improvement versus avoidance of service deterioration

These two issues require different designs of the willingness to pay analysis. The methodology proved robust as it was able to deal with a situation where the consumers should relate to the risk of service deterioration in the future (Poznan).

History of price increases

The hypothesis has been advanced that significant increases in water tariffs would lead to a lower willingness to accept subsequent water tariff increases. This could be the case if the customers found that the service improvements did not justify the increase in tariff, or if the increase in tariff caused affordability problems for low-income households.

We chose two cities with a recent history of significant water tariff increases (Brno and Kaliningrad) and a city without such history (Poznan). Whereas the Kaliningrad case study seems to provide some justification of the hypothesis, this did not seem to be the case in Brno. In Kaliningrad, we conducted the survey only six months after a 150 per cent increase in price. The survey results may support the hypothesis - or they may simply be a consequence of low willingness or ability to pay. In any case, we recommend not to undertake a survey shortly after a major price increase.

Weak enforcement of tariffs in the past

Earlier use of the stated preference methodology in Lviv, the Ukraine, illustrated that consumers could relate sensibly to scenarios of future tariff increases, even in a situation where the current enforcement of payment was weak.

1.9 Resources required

The level of effort required for the analysis will depend on the characteristics of the project. To carry out the analysis suggested in Chapter 3 to Chapter 6, a total of 21 - 32 person weeks (excl. translators, interviewers etc.) and 20 - 26 calendar weeks will be required. This is illustrated in Table 1.4. More information on the appropriate level and timing of the suggested effort is given at the beginning of each chapter.

Table 1.4:
Resources required for the toolkit

Task	Person weeks	Calendar weeks
Technical, service and expenditure baseline	2-3	2-4
Customer perceptions, willingness to pay and demand for water	12-16	14-18
Household affordability	3-7	6-8
Political acceptability	3-5	6-8
Communication with recipient	1	4
Total	21-32	20-26

Disclaimer:

The resource requirement has been estimated by COWI and is not necessarily endorsed by DEPA or EBRD.

Note:

Total person weeks represent the sum of person weeks for each task. In calculating total calendar weeks, we have assumed that the technical baseline is carried out first, and subsequently the next three activities are carried out in parallel. We have assumed that the recipient needs time to give directions to the advisor / consultant. This response time has tentatively been set at four weeks, but may, of course, differ from project to project.

In small municipalities, where the total level of investment cannot justify the use of the full range of tools, we recommend the use of a subset of tools. We have developed a standard subset called the Small Town Toolkit. The resource requirement for this is illustrated below. More information on the appropriate level and timing of the suggested effort is given in Chapter 7. It is recommended to decide on the actual set of tools to be used on a case-by-case basis.

Table.1.5:
Resources required for the Small Town Toolkit

Task	Person weeks	Calendar weeks
Technical, service and expenditure baseline	1-2	4
Customer perception, willingness to pay and demand for water	2-3	4
Household affordability	1	2
Political acceptability	2	4
Communication with recipient	1/2	2
Total	6-8	10

Disclaimer:

The resource requirement has been estimated by COWI and is not necessarily endorsed by DEPA or EBRD

¹	For example: The World Bank recommends stated preference analyses of customers' perceptions and willingness to pay (see Chapter 4) whenever financing a transport infrastructure project. There is not (yet) a similar formal recommendation for water and sanitation projects. The Inter American Development Bank requires the use of stated preference analysis for water and sanitation projects on routine basis.
²	This is the situation in the CEE and CIS countries today, but a quite similar situation was seen in the UK in the nineteeneighties.
³	For example: The World Bank "Toolkits for Private Participation in Water and Sanitation" Volume 3: "What a Private Sector Participation Arrangement Should Cover" p. 30 f. (World Bank Water and Sanitation Group, Washington D.C. 1997) discusses the revenue risk at length. The methodologies of this toolkit may be used to address a number of the issues raised as key issues by the World Bank in the above mentioned publication.
⁴	This publication includes both water supply and wastewater services under the wording "water services". The key distinction is not whether the service provider is private or public, but rather whether the service is marketed or not.
⁵	The desk studies were carried out under other contracts. They have been included because they have utilised one or more of the tools suggested in this toolkit. However, none of the desk studies have used the full palette of tools suggested. Only the studies in Lviv and Sevastopol used stated preference methodology.
⁶	See, COWI (1997) and COWI (1999)
⁷	See Rambøll (1999). Additional work by Estivärki
⁸	See Milieu Ltd and APPC (2001)
⁹	See CarlBro Management (2001)

	The European Bank for Reconstruction and Development (EBRD);
	The Infrastructure Department of the World Bank;
	The International Finance Corporation (IFC);
	The Danish Environmental Protection Agency (DEPA);
	The Regional Environmental Centre (REC) Szentendre, Hungary;
	Project sponsors including International Water Ltd., Severn Trent and Suez Lyonaise des Eaux;
	Other consultants (notably the Paribas team advising the city of Poznan);
	Municipalities and local utilities, in particular the City of Brno and BVK, the City of Poznan and PWIK, the city of Kaliningrad and the Vodokanal in Kaliningrad.

	Level of current water services
	Investments in wastewater or water supply
	Service improvement versus avoidance of service deterioration