US-AEP Urban Program - Full Cost Recovery: A Key to Water Sector Reform in Indonesia

By Jim Woodcock, US-AEP/USAID Environmental Infrastructure Adviser, Indonesia

Background

In many Asian countries, the municipal water systems are going through a period of reform to adjust to declining central government participation in the provision of municipal water. The recent experience of the USAID-assisted Local Government Water Services Project suggests that full cost recovery is the fastest, most efficient and direct way to effect reform in Indonesia's water sector. Its approach may be useful for speeding water sector reforms in other countries, as well.

The USAID-assisted Local Government Water Services project approach was designed in late 2000 to demonstrate beyond any doubt that, without the addition of any funds, any water enterprise can achieve sustainable full cost recovery and efficiency if only it wants to. It needs only a source of water, enough customers, and the cooperation of the owner.

Actually, this proposition is self-evident. A municipal water enterprise is a government-owned monopoly with the sole right to sell through its pipes the most essential substance for life -- a substance for which there is no substitute. One can rightly ask how it is possible for such a monopoly to lose money unless it lacks the desire to do otherwise.

For purposes of this discussion, full cost recovery is defined as the average annual revenues being equal to or greater than the average annual cost of operations, maintenance, depreciation, and interest.

In 1998, the Indonesian water sector was ready for reform because of the effects of the Asian financial crisis, the reduction in loans for investment in infrastructure, and the coming of regional autonomy. Regional autonomy gave local governments more responsibility for the provision of local services. It also reduced the role of central government agencies, so after the establishment of regional autonomy in 2001, central government agencies no longer provided subsidies to water enterprises, either directly or indirectly.

For example, before the beginning of the Asian financial crisis in 1997/98, an average of about 30% of the revenues of Indonesia's 300 water enterprises came from central or regional government sources in the form of development grants or loans that often were not repaid. Today about 100% of water enterprise revenues come from tariff payments.

As the Asian monetary crisis of 1997/98 began to settle in to Indonesia, water enterprises were saddled with debt for often unproductive investments. Water enterprises were unable to repay loans because they were trapped in a vicious circle of high unaccounted-for water, rising energy costs, low water pressure, too many employees, poor public relations, low tariffs, and consumers who were facing financial hardship. Previous investments in plant and equipment were unable to produce income to repay the loans.

Water enterprises had to reform to adjust to the need to rely completely on tariff income from consumers and political support from local governments and local parliaments. Many reforms had to be effected all at once in order to fulfil the local government's obligation to provide convenient and affordable piped water to all citizens who want it.

Many practices need to be re-formed or changed all at once, causing confusion in prioritization. Full cost recovery solves the problem of where to start first. It makes it easy to measure progress and success because the simple and final measure is the bottom line. Full cost recovery also makes it easy to prioritize implementation of improvements in water enterprises. This is because the common sense steps to achieving full cost recovery are the steps most appropriate to improving the local situation in each water enterprise.

The Logical Steps

There are easy ways and hard ways to go through all of these steps. All water enterprises may not undertake these steps in same sequence but the following are the logical steps toward achievement of full cost recovery:

1. Commitments. The first step is a commitment to achieving full cost recovery by the water enterprise and the owner. In Indonesia, the owner is the local government together with the local parliament. Usually the formal commitment is a memorandum of understanding in which the water enterprise undertakes to keep proper financial accounts, publish them annually, and make a plan for achievement of full cost recovery. The local government undertakes to support the commitment to full cost recovery, mainly by not taking funds out of the water enterprise for off-budget purposes.

2. Common goals. Second, everyone in the water enterprise thinks about and agrees on why he is doing what he is. Everyone agrees to a common vision and the mission of the water enterprise. This agreement is best achieved in a one- or two-day retreat led by professional facilitators. Everyone from top to bottom must understand his role in the common effort and why it is important. When everyone agrees on common and shared goals, those who emphasize their own priorities instead of the common goal will be seen to be destroying the group’s efforts.

3. Accounting System. Third, in order to generate a reliable bottom line, there must be an accurate accounting system. The present (usually manual) accounting system has to be transcribed to a computerized accounting system that provides for rapid billing, follow-up, trouble-shooting, transparent accounts, and most important of all, cost accounting to enable managers to really manage. Managers mainly manage resources such as human resources and money. They have little to manage if they don’t know where their money is going and where their costs are.

4. Customer satisfaction survey. The fourth step usually is the preparation and implementation of a customer satisfaction survey. While municipal water managers feel they know what their customers want, they usually are surprised by the results of statistically significant customer satisfaction surveys. A survey is the only way to find out important information with scientific accuracy. The customer satisfaction survey, developed in Indonesia in 1999 through the US-AEP-assisted WISE (Water Indicators for Satisfaction Evaluation) project, is a simple, fast and inexpensive tool to arrive at the truth. It tells exactly what consumers feel about service, what they are willing to pay, and for what improvements in service.

To date customer satisfaction surveys have been conducted by about 30 of Indonesia’s 300 water enterprises. With every repetition, the survey instrument has become cheaper and more efficient. Now the average total cost is between 50 cents and US$1 for each questionnaire. According to statistical sampling techniques, no matter what the size of the survey population, the maximum number of questionnaires is about 350. Surveys for long range planning purposes would be conducted about once every 5 years. Each water enterprise can modify the standard customer satisfaction survey, adding and deleting questions. College students usually fill in the questionnaires, spending about 20-30 minutes with each interviewee. The results are coded, entered into a computer, and processed using a statistical package. These results tell us a lot about the surveyed areas, and they form a baseline for measurement of progress.

5. Corporate plan. The fifth step usually is preparation of a corporate plan. The corporate plan uses the results of the customer satisfaction survey, vision and mission agreements, and goals for expansion and improvement of services. All of these elements combine to result in achievement of the goals within full cost recovery. The planners may include customer relations, incentives, training, and promotion policies with the financial plan in the final draft of the corporate plan.

Good corporate plans are neither thick nor complicated, but they are well thought-out. Preparation of a corporate plan by a water enterprise with the guidance of the Local Government Water Services team typically takes about 8 months. As the plan is being put together, the team usually arranges for training for all managers at all levels. In fact, the team found that the greatest leverage for increasing efficiency came from training managers in the lower and middle levels. Training typically is given in the areas of financial management for non-financial managers, customer service, water processing operations, and facilities maintenance.

The most enthusiastic response to training in Indonesia was to customer service training. Probably because of Indonesia’s long period of central government control, most employees in the provinces were unaware of customer service principles or techniques. Implementation of customer service principles has brought increased community support and increased income to participating water enterprises.

The corporate plan contains targets or benchmarks along the path to full cost recovery. The benchmarks may include unaccounted-for water, speed of billing, and reduction of staff required per thousand connections. As they reach and then go beyond these intermediate targets, the members of the water enterprise will work as a team, feeling pride in the effectiveness of their joint efforts.

6. Tariff increase. Because tariffs usually are comparatively low (and the standard of service, too, is comparatively low), the sixth step usually is to request a tariff increase from the local government or regulatory body. Local governments are willing to listen to a water enterprise that has a vision backed up by a carefully thought-out corporate plan that is based on hard data such as the results of customer satisfaction surveys. After they consider the proposal, local governments usually are attracted to the idea that they will not have to subsidize the water enterprise if it recovers costs. Ideally they will realize that ultimate responsibility for provision of piped water rests with the owner—in most cases the local government.

In Indonesia, local governments want to avoid public demonstrations against increased tariffs, so their first inclination is to refuse requests for enhanced tariffs. It is important for water enterprises to have ongoing contact with local groups who can lend their support to tariff increases tied to improvements in service. A community relations program should allocate some budgetary funds to building up relations and two-way communications with consumers. The results of the customer satisfaction surveys inform the water enterprises what improvements the customers are most willing to pay for.

7. Maintenance. Once the tariff increase is granted and the corporate plan benchmarks are presented to the local government, the water enterprise must fulfill its commitments on the road to full cost recovery. If local governments, the people, or their local parliament feel disappointed by the water enterprise’s inability to fulfill promises, everything will go back to square one.

Sustainability

Because reforms are new, most reforms need a home institution to ensure that they become a part of the new system. Full cost recovery benefits local governments, but sometimes it is hard for local governments to resist the temptation to tap into the profits of its enterprises—especially when there is a financial crisis. Such an act of expropriation would take away a water enterprise’s pride, incentives, and sense of accomplishment. This could send the water enterprise back into apathy and dependency. A watchdog institution must nurture the reforms until they are strong enough to be self-sustaining. In the case of Indonesia, the ideal home for reforms in delivery of municipal water is the Indonesian Water Supply Association (PERPAMSI), a member-supported professional association, together with its training arm, Yayasan Pendidikan Tirta Dharma. With assistance from the World Bank, PERPAMSI maintains a program of benchmarking, and Yayasan Pendidikan Tirta Dharma offers training courses that incorporate the lessons learned by the first few water enterprises that achieved full cost recovery.
PERPAMSI maintains the pace of reforms by maintaining continuous contact with its member water utilities and by acting as an information center and an advocate to government.

As water enterprises achieve full cost recovery, they can help the movement become sustainable by implement programs to help train their neighbours to achieve full cost recovery.

The Result

Because the Government of Indonesia and the Local Government Water Services LGWS) project intended to prove that any water enterprise could achieve full cost recovery if only it had the desire, the project began working only with smaller, failing water enterprises that were technically bankrupt. The (LGWS) project is now beginning its third and last year. To date, of 18 water enterprises receiving advice and encouragement, five have moved from technical bankruptcy to full cost recovery, and several more are coming close.

In these successful water enterprises, workers have become proficient, and managers are providing more training and thinking of incentives to keep their best people. They are discovering that development of human resources is the fastest way to increase productivity. As star-performing managers get results, it is expected that a nationwide market will develop for their outstanding management talent. In short, professionalism is growing logically and naturally out of full cost recovery, and PERPAMSI is nurturing and enhancing professionalism.

Professionalism and full cost recovery in turn enhance the chances for successful sustainable privatization that provides not just investment capital, but also lowest-cost services to consumers. Too often in the past, privatization has been used as a quick-fix for failing policies in ailing water enterprises. Privatization companies needed a risk premium in order to protect against surprises coming from opaque bookkeeping practices, poor labour relations, and unseen costs. Sustainable privatization is a healthy enhancement of healthy water supply businesses with clear and transparent finances and operating procedures.

The full cost recovery experiment in Indonesia has proven beyond a doubt that the full cost recovery thesis is correct. It has shown that any water enterprise having a water source, enough customers, and support of the owner can achieve full cost recovery if only it wants to. In most cases, water enterprises can achieve full cost recovery using their own resources without the addition of cash.

The confirmation of the full cost recovery thesis in Indonesia has forced us to think again about some of the common statements that we hear every day:

Statement 1. "The water enterprises are so poor, we have to grant their requests for money so they can regain their footing and become more efficient." The full cost recovery program has demonstrated that, "Efficiency brings income"--not the other way around.

Statement 2. "Water enterprises are so poor and disorganized that we should make loans based on their fulfilling our conditions. That'll give them incentives to improve." In fact, conditionality rarely achieves results with sovereign governments. The experience in Indonesia shows that subsidized cash flow is an incentive not to improve, but to stay inefficient until well after the flow stops.

Statement 3. "The consumers are so poor that they can't afford to pay tariff increases." In fact, statistically significant WISE customer satisfaction surveys repeatedly show that consumers are able and willing to pay higher tariffs for improvements in service. They are able but not willing to pay higher tariffs for continuing poor service.

Statement 4. "Indonesians are so poor that less than 20% of them have access to piped water, so we must give them credits to construct more facilities." The reason so few have access is not lack of capital (US$3 billion invested in Indonesia’s water sector so far); it is clearly lack of efficient management. Right now, no commercial bank would touch a water enterprise without government subsidy, but when management improves, commercial banks will rush to loan money. Therefore, in both cases, whether management is efficient or inefficient, subsidized cash flow is an expensive and unnecessary evil.

Statement 5. "The water enterprise should sell water to the unconnected poor at a discount." That's usually the local government talking. If anyone should pay the subsidy, it’s the local government, not the water enterprise. But in many cases, by not charging the unconnected poor the market-clearing rate, the local government is forcing them to pay even more to water vendors because no water enterprise can afford to extend pipes to poor neighborhoods and sell at a loss.

Conclusion

Reform of municipal water enterprises is complicated because many interlocking changes must be effected all at once. There must be new targets, accounting systems, management systems, career paths, incentives, training, monitoring, community relations, and accountability mechanisms. They must go forward together, rather than one at a time. Full cost recovery is a convenient discipline for the ordering of these changes with a minimum of administrative headaches. It provides a simple measure of performance, and the steps to achievement and maintenance of the target are naturally ordered, requiring less monitoring by the owner.

The conditions are present for a truly consumer oriented and transparent local government water service to take root and grow in Indonesia. The experience of the USAID-assisted Local Government Water Services project has shown that any water enterprise having a source of water, a customer base, and the backing of the owner can achieve full cost recovery if only it wants to. It can do this without the addition of capital. The method of moving to full cost recovery is so generic that it should be replicable in most countries.

If accounts are accurate and the water enterprise is both businesslike and transparent, there are fewer risks, so privatization requires a lower risk premium, resulting in a lower unit price to the consumer. The owner benefits from full cost recovery because he doesn’t have to subsidize the water enterprise, and the community is satisfied with the provision of this urban service. Productive members of water enterprises benefit because they receive recognition and incentives. Most important of all, the members of the community benefit because they are receiving good value in exchange for tariff payments for an essential urban service.