Incomplete Contracts and Regulation: The Case of …...•ABAKADA-Guro Party List, represented by Atty. Florante B. Legaspi, Jr vs. Metropolitan Waterworks and Sewerage System, et

Cesar E.A. Virata School of Business

University of the Philippines-Diliman

Incomplete Contracts and Regulation:The Case of Water Regulation in Manila

BSP UP Professorial Chair Lecture

Joel C. YuAssociate Professor

Cesar E.A. Virata School of BusinessUniversity of the Philippines-Diliman

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University of the Philippines-Diliman 2

1 July 2014 - 31 July 2017

















Take-away 1

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The notion of incomplete contracts

• Contracts have gaps, missing provisions, and ambiguities.

• Completing contracts

Implications on regulation by contracts

• Concession Agreement provides that MWSS shall arrange for the delivery to the RO a manual

• Concession Agreement covers Dispute Resolutions to address all disagreements

• Legal issues should be finally resolved in courts with proper jurisdiction.





Take-away 2

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The notion of social optimum vs maximum shareholder value

• Public-Private Partnership is created to deliver a common purpose

• Partners have different goals: social optimum vs maximum shareholder value

Implications on regulation

• Regulatory capacity building especially for smaller water districts





Take-away 3

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The notion of asymmetric information

• A party in an economic transaction has information that a counterparty does not possess

Implications on regulation

• Standard government interventions such as regulation of monopolies to replicate a competitive environment are not sufficient to restore optimality

Implications on organization

• Adverse selection

• Moral hazard





Service Obligations &Product Specifications

Take-aways of a Regulator

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𝑃 −𝑀𝐶

𝑃=

1

𝜀

𝐼𝑅𝑅 = 𝑊𝐴𝐶𝐶𝑁𝑃𝑉 = 0

Perfect information

Imperfect information

𝑄 𝐶𝑜𝑠𝑡 𝑊𝐴𝐶𝐶





Agenda

• The Context: The MWSS Story

• Incomplete Contract Theory and Regulation

• Addressing Incomplete Contracts: the MWSS Case

• Reflections and Practical Recommendations

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THE CONTEXT: THE MWSS STORY

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The MWSS

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Source: Regulatory Office (2015)





The MWSS

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CityPopulation(millions)

Water Availability(hours/day)

Water Coverage

(% of popn)

NRW*(% of prodn)

Staff per 1,000 connections

Manila 10.6 16 58.7 63 9.8

Singapore 3.0 24 100.0 7 2.0

Hong Kong 6.3 24 100.0 36 2.8

Seoul 10.6 24 100.0 35 2.3

Kuala Lumpur 1.4 24 100.0 36 1.4

Bangkok 7.3 24 82.0 38 4.6* NRW: Non-revenue waterSource: Second Water Utilities Data Book, Asian and Pacific Region, Asian Development Bank, October 1997, as cited by Wu Xun &

Malaluan (2011)





The MWSS Privatization

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MWSS BOARD OF TRUSTEES

Corporate Office

Concession Agreements

MWSS





The MWSS Privatization

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EAST ZONE

WEST ZONE





The MWSS Privatization:Service Performance

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INCREASE IN SERVICE

COVERAGE

DECREASE IN NRW

IMPROVEMENT IN WATER

AVAILABILITY

INCREASE IN WATER

PRESSURE

BETTER SERVICES

IMPROVED CUSTOMER

COMPLAINTS HANDLING

UPGRADED AND EXPANDED

FACILITIES

BETTER MANAGEMENT

SYSTEMS

IMPROVED HUMAN

RESOURCES





The MWSS Privatization:All-in Tariff Evolution

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0.0

5.0

10.0

15.0

20.0

25.0

30.0

35.0

40.0

45.0

50.0

1997 2000 2005 2010 2015

Maynilad Manila Water





The MWSS Privatization:Water Rate Determination

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“Asset Management

Obligation

Service Obligations• Water Services• Wastewater Services

• Historical & Future• OPEX and CAPEX

Rate of Return

Historical Receipts

Water Tariff Adjustment

OBLIGATIONSEXPENDITURE AND

RETURNRECEIPTS

• Future Billed Volume• Customer Mix





INCOMPLETE CONTRACTS AND REGULATION

Incomplete Contracts

Incomplete Contracts and Regulation

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Theory of the Firm

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Raw Material

Input B Product A Consumers

Spot MarketVertical IntegrationLong-term Contract





Incomplete Contract Theory

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Raw Material

Input B Product A Consumers





Incomplete Contracts and Regulation

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Regulation by Agency Regulation by Contract

Rules and Procedures Contract or Agreement

Hybrid Model





ADDRESSING INCOMPLETE CONTRACTS:THE MWSS CASE

Mechanisms for Addressing Incomplete Contracts

Incomplete Contracts and Regulatory Challenges

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Addressing Incomplete Contracts

• Amendment of the Concession Agreement

• Regulatory Office

• Dispute Resolution

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March 2012Petition of the Concessionaire

September 2013 Determination of the

Regulatory Office

Alternative Rates Adjustment of the

Concessionaires in the Arbitration

Php8.58/cu.m.*

(28.35% increase)

(Php1.46/cu.m.)

(4.82% decrease)

Php5.83/cu.m.

(22.79% increase)

(Php7.24/cu.m.)

(29.47% decrease)



Regulatory Office



Php8.58/cu.m.*

(28.35% increase)

(Php1.46/cu.m.)

(4.82% decrease)

Php4.06/cu.m.

(13.41% increase)

Php5.83/cu.m.

(22.79% increase)

(Php7.24/cu.m.)

(29.47% decrease)

Php3.60/cu.m.

(14.65% increase)



Regulatory Office



Php8.58/cu.m.*

(28.35% increase)

Php5.83/cu.m.

(22.79% increase)

The Third Rate RebasingPetition vs Determination

*based on Maynilad’s Business Plan submitted on 23 May 2013

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Dispute Resolution

All disagreements, disputes, controversies or claims… which cannot be resolved through consultation and negotiation among the parties hereto shall be finally settled by an arbitration proceedings in accordance with the arbitration rules of the United Nations Commission on International Trade Law as in effect on the dates of this Agreement.

Concession Agreements

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Arbitration: Disputed Items

• The RO erred in its computation of Past Cash Flows, particularly in its treatment of Guaranty Deposits and in disallowing certain items from Manila Water’s past OPEX and CAPEX.

• The RO erred in its computation of Future

Cash Flows, e.g., disallowance of Corporate Income Tax.

• The RO erred in its computation of the Appropriate Discount Rate.

• The implementation of the Regulatory Office’s proposed Rate Rebasing Determination unduly impairs Manila Water’s financial standing and would cause a negative impact on its ability to meet its future obligation targets.

• Unauthorized disallowance of Corporate Income Tax.

• Incorrect estimate of the Appropriate Discount Rate for Future Cash Flows.

• Unauthorized adjustments to the Opening Cash Position set during the last Rate Rebasing.

• Improper addition of Guaranty Deposits to Maynilad’s Historical and Future Receipts.

• Unreasonable and improper disallowances in Other Expenditures in the Opening Cash Position.

• Unreasonable and improper adjustments to Other Expenditures in the Future Cash Flows.

Maynilad Manila Water

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Arbitration: Disputed Items

• The issues were eventually limited to the recoverability of the Concessionaire’s corporate income tax.

• In the arbitration with Maynilad, the parties did not resolve all other issues; the Arbitral Panel applied the pendulum nature of the arbitration.

• In the arbitration with Manila Water, the parties resolved all other issues.

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Arbitration: Maynilad

Php3.42/ m3

Corporate Income TaxPhp2.10/m3

“Others”

Php5.52/m3

Php4.06/m3(Php1.46/m3)

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Php3.60/m3Php4.47/m3

Php3.60/m3(Php7.24/m3)

Php0.00/m3

CIT

CIT

Php2.77/m3

Arbitration: Manila Water

Php10.84/m3

(Php2.77/m3)

CIT: Corporate Income Tax

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Arbitral Award: A Regulatory Challenge

By majority, finds that the Claimant is entitled to include its Corporate Income Tax in its Future Cash Flows for each year of operations

By majority, upholds Claimant’s alternative Rebasing Adjustment for the Fourth Rate Rebasing Period of 13.41%, which means an average basic water charge of Php30.28/cu.m., resulting in an adjusted rate of Php34.34/cu.m. for every Charging Year of the Fourth Rate Rebasing Period”

Corporate Income Tax is not an allowed Expenditure under the Concession Agreement

The Appropriate Discount Rate should not be computed fully pre-tax

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Response to a Regulatory Challenge

The Regulatory Office argued that it cannot fully implement the Final Award in the Maynilad Dispute for the following reasons:

• The Regulatory Office has the moral and the legal obligation to uniformly apply the General Rate Setting Policy under the Concession Agreements;

• As a government entity, the Regulatory Office has the overriding duty to protect and defend the constitutional guarantee to equal protection;

• The identical issues raised by Concessionaires involve matters of law and public policy; and

• The MWSS has the plain legal duty under its Charter to set “just and equitable rates”.

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Arbitration: Status

RO addressed the Regulatory Challenge

• Implementation of the Arbitral Award of Manila Water

• Non-implementation of the Arbitral Award of Maynilad

Maynilad filed a Petition for Confirmation and Execution of the Arbitral Award.

Concessionaires’ claimed damages, invoked the Letters of Undertaking issued by the National Government, and filed a cases before the International Court of Arbitration.

1

2

3

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Supreme Court Cases

• Waterwatch Coalition, Inc., et. al. vs. Ramon B. Alikpala, Jr, in his capacity as Chairperson of the Board of Trustees of the Metropolitan Waterworks and Sewerage System, et. al.

G.R. No. 207444

• Water for All Refund Movement, Inc., et. al. vs. Metropolitan Waterworks and Sewerage System, et. al.

G.R. No. 208207

• Virginia S. Javier, et. al. vs. Metropolitan Waterworks and Sewerage System, et. al.

G.R. No. 210147

• ABAKADA-Guro Party List, represented by Atty. Florante B. Legaspi, Jr vs. Metropolitan Waterworks and Sewerage System, et. al.

G.R. No. 213227

• Neri Colmenares and Carlos Isagani Zarate, Representatives of Bayan Muna Party-List vs. Hon. Cesar Purisima, in his capacity as Secretary of Finance, et. al.

G.R. No. 219362

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REFLECTIONS AND PRACTICAL RECOMMENDATIONS

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Reflections

• The mechanisms in the Concession Agreements to address issues arising from contracts incompleteness are key ingredients in sustaining the agreements. However, these mechanisms are themselves “incomplete”

• The two identical contracts that were entered into by the government are separate but not independent. Both agreements are bound by the Charter of the MWSS and governed by Philippine laws.

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Practical Recommendations

• Legal issues should be resolved with finality in courts with proper jurisdiction

• The contracting parties should accept the dependence of the two identical Concession Agreements and collectively resolve common issues on the interpretation of the provisions of the contracts to ensure just and equitable water tariff.

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SALAMAT PO…

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Documents

Incomplete Contracts and Regulation: The Case of …...•ABAKADA-Guro Party List, represented by Atty. Florante B. Legaspi, Jr vs. Metropolitan Waterworks and Sewerage System, et