[Type text] FINAL TECHNICAL NOTE RTS/01/2012 DETAILED METHODOLOGY FOR SABESP S TARIF REVISION PROCESS FIRST TARIFF CYCLE

Transcription

1 FINAL TECHNICAL NOTE RTS/01/2012 DETAILED METHODOLOGY FOR SABESP S TARIF REVISION PROCESS FIRST TARIFF CYCLE April 2012

2 LIST OF CONTENTS 1 PURPOSE DETAILED METHODOLOGY FOR SABESP S TARIFF REVISION PROCESS General Characteristics Maximum Price Mechanism Tariff Cycle Duration Economic Breakeven Cost of Capital (r wacc ) Net Regulatory Remuneration Basis (BRRL) Depreciations (Dt) Investments (CAPEX) Working Capital Variation (VarWK) Operation and Maintenance Expenses (OPEX) Taxes (T) Ratio between Demanded, Produced and Billed Volume: Regulatory Treatment of Technical Losses Methodology to Estimate Projected Water and Sewage Volume Demand Regulatory irrecoverable revenue Financial Breakeven Non-manageable Costs Treatment of Non-Regulated Activities Efficiency Factor (X Factor) X Factor Estimate Company Productivity Gain Estimate x Factor Determination Annual Adjustment Rules Quality System Introduction Quality Incentive Mechanism Implementation Stages Revenue Variation Adjustment Tariff Structure Guidelines Subsidies... 36

3 2.9.2 User Categories Tariff Structure Type Binary Structure Extraordinary Revisions Attachment I: Summary of the Estimated Cost of Capital in Accordance with ARSESP Technical Note RTC/01/ Attachment II: Methodological Guidelines to Project Water and Sewage Demand by Type of User Methodological Guidelines to Project Water Demand Projected Residential Demand Projected Non-Residential Demand Projected Licensee Municipalities Demand Projected Self-consumption and Special Use Demand Projected Total Water Demand Methodological Guidelines to Project Sewage Demand Projected Residential Demand Projected Non-residential Demand Projected Licensee Municipalities Demand Projected Total Sewage Demand LIST OF TABLES Table 1: SABESP s Weighted Average Cost of Capital...9 Table 2: Q ua lity S y ste m Imp le menta tio n Sta ges Du ring Sabe sp s Se cond T a rif f Cyc le Table 3: Debt Cost...43 Table 3: Efficient Equity Cost...44 Table 4: SABESP s Weighted Average Cost of Capital List of Charts Chart 1: Rationale of the Projected Demand Estimate... 19

4 1 PURPOSE As of December 2007, with the enactment of State Supplementary Law 1025, ARSESP is responsible for regulating and inspecting basic sanitation services. The purpose of this Technical Note is to present and justify the bases for defining the methodology to be used in the calculation of tariffs and tariff structure to be established for SABESP s Second Tariff Cycle. In general terms, the methodology defines a maximum price mechanism based on efficient costs projected for the tariff cycle, a system of incentives to improve service quality and annual tariff adjustments to adjust tariffs based on efficiency, in accordance with monetary restatement, according to a price index and based on the quality system.

5 2 DETAILED METHODOLOGY FOR SABESP S TARIFF REVISION PROCESS 2.1 GENERAL CHARACTERISTICS The regulatory system proposed for SABESP is characterized by the following basic elements: A constant maximum tariff during the tariff cycle; A periodic revision of this tariff with a fixed term previously established; Definition of an efficiency factor that transfers part of the productivity gains to users through lower tariffs; An incentive system to improve service quality; An annual adjustment mechanism that includes: Monetary restatement by price index; Adjustment by efficiency factor; Adjustment by quality level. Extraordinary revision system This methodology defines a maximum price mechanism (P 0 ) based on the company s efficient costs projected for the tariff cycle. This strongly encourages the company to reduce its costs, as any reduction automatically translates into higher profitability. In this second cycle, the average tariff will be determined based on SABESP s economicfinancial breakeven. In the medium and long term, there is the objective of making progress in the determination of tariffs that reflect the balance of each one of SABESP s services and each region and/or concession. This means that all the efficient costs associated with all the regulated services rendered by SABESP in all the concessions will be considered in the calculation of the breakeven price. This way, an average tariff (expressed in reais per cubic meter) is obtained and reflects the economic cost of the provision of water and sewage services for a tariff cycle and which will only be adjusted based on the criteria presented in this technical note every year. The regulation proposed is based on the establishment of a limit for the average tariff that may be charged by SABESP and on the definition of guidelines for the establishment of the tariff structure. In principle, the structure is to follow the principles of allocative efficiency, which implies that the tariffs should reflect the relative costs of each service; equity, seeking to guarantee access to the service, particularly to lower income groups; and simplicity, seeking to establish tariffs without complexities and which are easily understood by users.

6 Based on these general principles, SABESP is to propose and submit for the approval of the São Paulo State Sanitation and Energy Regulatory Agency (ARSESP) a tariff structure to be applied in the tariff cycle under study, based on the average tariff (P 0 ) defined by ARSESP. During the cycle, the maximum average tariff will be adjusted annually through the following mechanism: an adjustment factor based on price index trends that prevents the inflationary erosion of the company s revenue; an efficiency factor (knows as X factor) that transfers part of the productivity gains to users through lower tariffs in real terms and an adjustment factor for variations in service quality. The latter factor is intended to prevent cost reduction incentives from compromising service quality. The main information basis for the calculation of the cycle tariff is the business plan to be presented by the company as part of the tariff revision process. This plan should contain at least: Projected demand for the revision period broken down by user number and type, average consumption, type of service and area. Investment plan to be implemented during the cycle. The plan should contain an appropriate level of detail identifying large projects, broken down by activity and service, and separating investments into physical and monetary components. Projected operating costs associated with the regulated services and which are in line with projected demand and minimum quality standards required. The data contained in SABESP s business plan will be supplemented by the company s own historical information and data of comparable companies and systems that will assist to define SABESP s relative efficiency and help define efficiency targets and standards to be achieved in the tariff cycle. The elements that make up the tariff revision system are as follows: Maximum Price Definition Mechanism Tariff cycle duration Economic breakeven Financial breakeven Treatment of Non-Regulated Activities Efficiency Factor Annual Adjustment Rules Quality System Treatment Tariff Structure Guidelines Extraordinary Revision Rules Each of these elements will be discussed in detail in the corresponding sections of this technical note.

7 2.2 MAXIMUM PRICE MECHANISM TARIFF CYCLE DURATION In June 2012, SABESP had operations in 364 of the 645 municipalities in São Paulo state. Of the municipalities where SABESP operates, 218 had entered into Program Agreements. Of these municipalities, 215 had delegated the regulation and inspection of the provision of sanitation services to ARSESP. Most of these program agreements consider a four-year Tariff Cycle duration. As a result, we propose the adoption of a fouryear tariff period. 2.2 ECONOMIC BREAKEVEN To determine the maximum price, we propose the use of a discounted cash flow methodology that enables to ensure the company's economic sustainability regarding the activities related to the provision of water and sewage services. This approach, also known as building blocks, is the traditional approach adopted by UK regulators for tariff revisions. In general, the maximum average tariff (P 0 ) equation to be used is as follows: (i) 1 P 0 = maximum average tariff that ensures SABESP s economic-financial breakeven, BRRL 0 = Net Regulatory Remuneration Base (i.e., net of depreciations), at the beginning of the cycle, to be fixed by the study established by ARSESP Resolution 156/2010. This basis includes the Initial Working Capital Inventory. BRRL T = Net Regulatory Remuneration Base (i.e., net of depreciations), at the end of the tariff cycle. T = Tariff Cycle duration in years. V t = Total billed volume for year t (corresponds to the sum of water volume and sewage volume). OPEX t = operating, administrative and selling costs in year t CAPEX t = investments disbursed in year t VarWK t = Variation of the Remunerable Working Capital (CCR) in year t w = income and social contribution (CSLL) tax rates = Accounting depreciations 1. = Cost of Capital determined pursuant to ARSESP Resolution 227/2011. Note that, for tax purposes, in addition to the depreciation of tangible assets, the amortization of intangible assets must also be considered, both related to the provision of basic sanitation services.

8 The monetary elements involved in the previous formula for the entire Tariff Cycle will be estimated in real terms at prices at the beginning of the cycle. The calculation of each component in real terms enables a more appropriate estimate of expenses and projections of inflation and macroeconomic variables to safeguard economic consistency are not required. If there is a time difference between the implementation of SABESP s Second Tariff Cycle and the end of the current cycle, ARSESP will take the necessary measures not to affect the concessionaire s economic-financial balance. The main elements (or blocks) to be evaluated as part of the tariff system derive from the previous equation. The principles that will be applied to determine and evaluate each of these elements are detailed later on C O S T OF CAPITAL (R WACC ) Technical Note RTS/01/2011 established the methodology for the calculation of Weighted Average Cost of Capital which resulted in 10.71% for nominal WACC and 8.06% for real WACC. The methodology applied to estimate the WACC is widely used in tariff revision processes in different sectors and its conceptual fundamentals arise from finance theory 2. Basically, the WACC is a convex combination between debt cost and equity cost: (ii) r e : : equity cost in %; r d : debt cost in %; E: equity capital that finances the company; De: debt capital that finances the company; w: rate of taxes and contributions on the company s taxable income. Based on the application of this formula, ARSESP estimated SABESP s cost of capital and obtained the amounts in Table 1 below 3. 2 See Technical Note RTS/01/2011 (May 2011) for a summary of the international experience and the conceptual grounds of the chosen methodology. 3 Attachment I presents a summary of the estimated cost of capital, according to Technical Note ARSESP RTS/01/2011.

9 Table 1: SABESP s Weighted Average Cost of Capital SABESP s Regulatory WACC Rd 9.94 Re De/(E+D 0.47 E/(E+De e) 0.53 w ) 0.34 WACC Real WACC 8.06 Source: Technical Note RTS/01/2011 May 2011 In principle, this methodology is compatible with the proposed regulatory system regarding focusing the analysis on the company s breakeven rather than the shareholders and the adoption of a real term modeling criterion to reflect the adoption of an annual indexation mechanism as part of the tariff model NET REGULATORY REMUNERATION BASIS (BRRL) It is necessary to distinguish between two elements: Initial Net Regulatory Remuneration Basis Adjustment Rule for the Net Remuneration Basis INITIAL REGULATORY REMUNERATION BASIS (BRRL 0 ) The initial regulatory remuneration basis should reflect the economic value of the goods needed to provide services. In light of the change in the regulatory system, as this is the case of SABESP, the initial basis reflects the conditions of the past system rather than those of the new one. From this point of view, the initial Capital Basis is a monetary value that can be determined fully independently from the new tariff methodology. In Resolution 156 of July 7, 2010, ARSESP established the methodology and general criteria to define the regulatory remuneration basis of SABESP s assets, seeking both to develop the tariff revision process and define the initial parameters for the audit processes to be conducted by ARSESP. Also note the following guidelines established in said Resolution:

10 The replacement cost methodology will be used, considering the asset s new value as the basis to determine its market value in use. 4 Only the assets related to the provision of sanitation services and used in the catchment of untreated water, supply, treatment, water reservation and distribution, collection, sewage treatment and final disposal of sludge for the sanitation sector are considered in the calculation of the remuneration basis 5. In order to apply the eligibility criteria for inclusion in the Regulatory Remuneration Basis (BRR), it is necessary to perform a qualified analysis of the use of the asset regarding its convenience or need, in its use in water supply and sanitary sewage activity VALUATION REPORT BREAKDOWN The initial capital basis valuation should correspond to the beginning of Sabesp s Second Tariff Cycle. Consequently, if there is a time difference between the attribution of the BRRL 0 value and the beginning of the tariff cycle, it should be corrected based on the rolling forward methodology, proposed as a capital basis updating method. The capital basis at the beginning of the tariff cycle is calculated based on the following formula: (iii) Where: = Net Regulatory Remuneration Base at the Beginning of the Second Tariff Cycle Net Regulatory Remuneration Base resulting from the asset valuation process (resulting from the asset valuation report) j = the period between the asset base valuation (BRRL AA ) and the beginning of SABESP s Second Tariff Cycle 4 See Resolution 156/2010, Article 3, paragraph 1 5 See Resolution 156/2010, Article 3, paragraph 2 6 See Attachment II of Resolution 156/2010.

11 = investments in period j 7 = Remunerable Working Capital Variation (CCR) in period j = Depreciations in period j. Note that all the amounts of the previous equation should be evaluated in a homogeneous currency (using the corresponding price index) REMUNERABLE WORKING CAPITAL (CCR) The Regulatory Remuneration Basis will also include the volume of material and financial resources to operate water and sewage systems. This permanent resource inventory constitutes the necessary Working Capital, to be assessed based on the characteristics of service operation and trading systems, operating under an efficiency system. Although, from a conceptual viewpoint, it is correct to include working capital in revenue requirements, its value may be positive, zero or even negative, depending on the collection and payment cycles. In accounting terms, current capital is associated with the difference between current assets and current liabilities. From the regulatory viewpoint, the definition is usually more selective, including only current operating assets and liabilities, which are directly involved in the business cycle. It refers to the accounts receivable associated with collected bills, inventories and payments to suppliers. Cash and cash equivalents and short-term loans are not considered in working capital. We propose the adoption of the accounting approach as the calculation method. Based on the criteria established by regulatory accounting, it applies the analysis of the book values of accounts receivable (current assets) and accounts payable (current liabilities) ADJUSTMENT RULE FOR THE NET REGULATORY REMUNERATION BASIS A permanent inventory system also known as rolling forward is proposed as a BRRL adjustment mechanism, throughout SABESP s Second Tariff Cycle. Basically, the capital basis at the end of each period t is determined by the following formula: Where: (iv) 7 Works in progress are recognized when they are disbursed, therefore, the interest of works in progress should not be included, as it is being recognized in BRRL.

12 = Net Regulatory Remuneration Basis (i.e., net of depreciations) at t. = N e t Regulatory Remuneration Basis (i.e., net of depreciations) at t-1 = investments disbursed in year t = Variation of the Remunerable Working Capital (CCR) in year t = Depreciations in year t. The capital basis at the end of each revision period (at the end of the Tariff Cycle under analysis) is determined as follows: Where: BRRL T = Net Regulatory Remuneration Basis (i.e., net of depreciations) T= Tariff Cycle duration in years BRRL 0 = Net Regulatory Remuneration Basis (i.e., net of depreciations) at the beginning of the Tariff Cycle CAPEX t = investments disbursed in year t VarWK t = Variation of the Remunerable Working Capital (CCR) in year t D t = Depreciations in year t The central element of the determination is the treatment of the investments made in the period. This is discussed in further detail in the section on treatment of investments (section 2.2.6). Note that all the amounts of the previous equation should be evaluated in a homogeneous currency (using the corresponding price index).

13 2.2.5 DEPRECIATIONS (DT) Although depreciations are not directly included in the tariff determination formula based on cash flow (see equation (i)), they are indirectly included in two ways. On the one hand, depreciation rules affect the company s tax costs when calculating income tax. On the other hand, they are necessary to determine the final capital basis (see equation (v)). Therefore, two criteria that should be differentiated are proposed for this element: 1. Accounting Depreciation: calculated by tax criteria whose amounts are reflected in the financial statements and which is determinant in the calculation of taxes on income (income and social contribution taxes); 2. Annual depreciation of capital basis evolution (rolling forward methodology): calculated in constant currency by a criterion based on the useful life of each asset and the criteria adopted in the valuation of the initial capital basis. Note that, for tax purposes, in addition to the depreciation of tangible assets, the amortization of intangible assets must also be considered, both related to the provision of basic sanitation services INVESTMENTS (CAPEX) INCLUSION CRITERIA P0 to be determined by ARSESP will include the CAPEX requirements of the Business Plan approved by ARSESP. The agency s experience in tariff revisions of other utility concessionaires indicates that future CAPEX projections tend to be more specific than OPEX in relation to system characteristics. This CAPEX characteristic is even more important given current conditions of the São Paulo state sanitation services operated by SABESP. It is a company where services will be substantially expanded in the next tariff cycle due to its target of providing its services to all state dwellers. Therefore, CAPEX will increase as a percentage of revenue. As a result, it is necessary to perform a detailed and precise evaluation of the projects included in the Business Plan presented by the Concessionaire. Thus, for the purposes of quality and transparency in the regulatory process, it is essential to ensure that the Business Plan presented by the Concessionaire be structured in such a way as to include clearly identified specific investment projects that are linked to concrete and measurable physical targets, so that ARSESP can effectively monitor the execution of this plan.

14 With this purpose, ARSESP prepared information sheets that the Concessionaire should present along with its Business Plan. These sheets contain the necessary elements to appropriately evaluate the technical and economic feasibility of projects with major impact on the provision of services included in the plan, as well as the reasonability of associated revenue, CAPEX and OPEX. During the tariff cycle, it is necessary to compare the investments projected at the beginning of the period with the investments actually made in the cycle 8. The differences between projected and actual amounts may derive from the following main causes: Failure to achieve physical targets Performance efficiency/inefficiency Errors in original estimates Unforeseen investments during the Tariff Cycle The following section addresses the necessary adjustment in view of the failure to achieve physical targets. The CAPEX efficiency/inefficiency issue is addressed. Accordingly, an incentive mechanism will be implemented whereby, if the company achieves the physical targets at a lower-than-expected CAPEX, it will receive the benefit of the return obtained from the additional capital and it will remain in the tariff until the end of the Tariff Cycle. Finally, an adjustment mechanism is considered, including the possibility that the company needs to make investments once the Tariff Cycle begins (this mechanism is known as logging-up) due to reasons not anticipated at the beginning of the Tariff Cycle. 8 The comparisons between projected amounts and realized amounts should be made based on the same measurement unit. As a result, projected amounts should be represented in each year s currency to verify if the amounts actually invested are equal to, higher than or lower than the projected amounts.

15 ADJUSTMENT MECHANISM PROPOSED There are two basic principles to be used to analyze and approve investments: Criterion of prudence: which comprises the following aspects: usefulness, use, and cost reasonability Criterion of achievement of physical targets. In principle, the investments in the Business Plan approved by ARSESP that meet these criteria will be incorporated into the Regulatory Remuneration Basis during the Tariff Cycle. At the end of each cycle, the Regulatory Remuneration Basis realized at the end of the cycle will be determined based on the behavior of the investments actually made during the cycle, as well as the eventual compensations to be considered in the calculation of the maximum price for the new cycle that begins as detailed below ACHIEVEMENT OF PHYSICAL TARGETS A preliminary analysis corresponds to the achievement of physical targets expected for SABESP s Second Tariff Cycle. In case of failure to achieve physical targets, a tariff adjustment should be considered in order to prevent the company from obtaining benefits due to strategic actions that overestimate investments. The adjustment mechanism proposed in the case of failure to achieve investment physical targets is as follows 9 : i) P0 should be recalculated, considering the investment projects actually made during the cycle, considering actual expenses and corresponding volumes in the calculation. ii) The difference between the P0 approved during SABESP s Tariff Revision (assuming that investment physical targets are achieved) and the P0 corresponding to the investments actually made is calculated. iii) The exceeding revenue obtained due to no investments made is calculated by applying the difference between the P0 calculated in (ii) and the volumes billed by the concessionaire. iv) Exceeding revenue should be adjusted at the beginning of the next Tariff Cycle (SABESP s Third Tariff Cycle) by the cost of capital rate used in the calculation of initial P0. v) The surplus obtained as a result of lower investment of revenues to be considered for the Third Tariff Cycle is discounted. The investments that are not made during the Second Tariff Cycle (underachievement of pre-established physical targets) must be made during the next Cycle if they were part of the CAPEX projected according to the criterion that ARSESP determines at the moment of the corresponding tariff revision. 9 Find below the established methodology for the piped gas sector in São Paulo.

16 ACHIEVEMENT OF TARGETS IN RELATION TO MONETARY TOTAL AMOUNTS The criteria of prudence are proposed to monetarily assess the total investment to be included in the BRRL. This means that ARSESP will perform ex post tests to evaluate the cost reasonability and the investment usefulness to be recognized in the BRRL at the end of the Tariff Cycle. If the invested amount is lower than the projected amount in monetary terms (the physical target is achieved) and the criterion of prudence is met, then the company will obtain a higher-than-expected return rate in the period from the moment of investment to the beginning of the new Tariff Cycle. This benefit is like an incentive to efficient investment management and will be removed from the BRRL at the beginning of the next cycle INCLUSION OF UNFORESEEN CAPEX (LOGGING-UP MECHANISM) In the case of easily identifiable CAPEX, a mechanism can be used to offset the company for investments not foreseen in the Investment Plan established for the Tariff Review (ex post record or logging-up mechanism). After the prudence analysis (once the need, cost reasonability and investment usefulness are evaluated) at the end of the Second Tariff Cycle, it is possible to recognize unforeseen investments so as to guarantee neutrality in terms of net present value (i.e. as if this investment had been planned since the beginning of the Second Tariff Cycle). Capital expenditures made during SABESP s Second Tariff Cycle and selected to be achieved by the logging-up mechanism (i.e., to be recorded in the BRRL at the end of the Tariff Cycle) should be incorporated into the initial BRRL of the next Tariff Cycle (i.e., SABESP's Third Tariff Cycle). The amount to be recorded in the initial BRR of the next Tariff Cycle is to be pre audited by ARSESP to check if the prudence requirement has been met. In addition, depreciation from the regulatory viewpoint should be counted as of the beginning of the next Tariff Cycle and the asset s remaining useful life will be used to calculate the depreciation amount WORKING CAPITAL VARIATION (VarWK) In addition to investments, the Working Capital variation needed to meet service demand growth should be incorporated into the Capital Basis every year. The amounts will be determined based on the efficiency parameters established by ARSESP, as previously mentioned (see section ).

17 2.2.8 OPERATION AND MAINTENANCE EXPENSES (OPEX) One of the requirements to determine the Operation and Maintenance Expenses (OPEX) that will be recognized in the tariff is to define: Which OPEX are strictly related to the provision of regulated services; and OPEX trends according to efficiency targets until the end of the tariff cycle. Regarding the first point, the regulatory action will be focused on evaluating whether the OPEX amounts provided by SABESP for the Tariff Revision are representative and reasonable 10 for the provision of water and sewage services. Consequently, ARSESP will analyze the breakdown of each expense (personnel, chemical, electricity, third-party service, etc.) and will exclude from OPEX the components whose contribution to the provision of water and sewage services is not reasonably justified. On the second point, section 2.5 describes the methodology proposed to define OPEX efficiency targets to recognize based on what was said previously TAXES (T) All taxes related to the provision of water and sewage services will be considered in the calculation of P0, either explicitly or as OPEX components, except for those related to PIS/COFINS taxes, whose treatment will be presented later on. For income and social contribution taxes, we propose to estimate the theoretical tax burden, regardless of eventual specific treatments (deferrals, etc.). The regulatory reason for using theoretical taxes is that this way the company is encouraged to efficiently manage its resources as any company in a competitive market. In practice, income and social contribution taxes will be treated through the adjustment of the cost of capital (see section 2.2.3) and the adjustment of cash flow as specified in the equation of section RATIO BETWEEN DEMANDED, PRODUCED AND BILLED VOLUME: REGULATORY TREATMENT OF TECHNICAL LOSSES The regulatory system to be adopted for SABESP defines a maximum price mechanism based on the company s projected efficient costs for the tariff cycle. 10 In the assessment of the reasonability and representativeness of OPEX amounts, supplied by SABESP. Additional attention will be paid to transactions with related parties. For these transactions, the company must demonstrate that the agreed prices reflect efficient market conditions.

18 In this regulatory system, the control of technical losses has a direct impact on production costs, as it reduces consumption of electricity, chemicals and others with a large share of the cost structure. The recognition of the efficient costs therefore implies the recognition of efficient technical losses (regulatory losses). Consequently, every year the regulatory body must define a maximum level of losses consistent with the efficient costs to be recognized in revenue requirements. In general, the difference between the volume of water produced and the volume of water consumed represents both physical and non-physical water losses. Formally, the water loss percentage represents the coefficient defined as follows: Where: %perda is the water loss ratio VolProdu Agua is the total volume of water produced by SABESP VolCon Agua is the total volume of water consumed (measured) VolOutrosUsos Agua refers to volumes related to social, operating and emergency uses. The estimates of annual regulatory losses can be defined based on the following steps: 1. Estimate of the initial loss level 2. Definition of the loss level trajectory during the tariff cycle The initial loss level is the amount of losses recognized during the first year of the tariff cycle. This amount will be determined considering SABESP s loss amounts in the past, which will be compared with the amounts observed in the different water companies in Brazil in order to analyze the reasonability of the amount to be adopted. The definition of the loss level trajectory during the tariff cycle will depend on the investments associated with these purposes. Consequently, ARSESP will verify the compatibility between the approved investment plan and the loss reduction targets. Based on this, production will be recognized based on the amount of water consumed, other water uses (see definition above) and the losses recognized every year, in accordance with the data presented by SABESP and the ARSESP analysis. Formally:

19 METHODOLOGY TO ESTIMATE PROJECTED WATER AND SEWAGE VOLUME DEMAND Infrastructure services are characterized by capital intensive items: irrecoverable costs and long construction periods. This makes demand projections essential for efficient planning and service provision. On the one hand, they are a critical element to guarantee efficient investment timing. On the other hand, demand estimates are crucial to define tariffs that reflect the economic costs of the service provision. Ideally, projected water and sewage demand should be based on a statistic analysis that estimates the trends for users and average consumption by each type of client. The chart below presents the general logical process used to estimate demand: Chart 1: Rationale of Projected Demand Estimates Urban population (t=0) Monthly Consumption (t=0) Urban population (t) TCP CC Average consumption growth Inhab/Un Served population (t) Monthly Consumption (t) System Units (t) Connect/ Un System Connections (t) Total Consumption (t) Peak Factor System Capacity (t)

20 The projection rationale is: in the case of connections, the first element to project is population at each moment t, using the population growth rates (TCP). Following, based on the coverage coefficient (CC), the served population is obtained, which is converted into units based on the number of people per domicile (Inhab/Um). The application of the connection/unit (Connc/Un) ratio allows us to obtain connections at each moment in time. The average consumption in each time period is estimated based on the average consumption growth rate: based on the available data arising from service micro-metering, and through behavior components, composed of household income growth rates, income elasticity, price elasticity, etc., we obtain projected average consumption by unit. Total consumption is simply the multiplication of average consumption by estimated units. What we have explained so far constitutes the general rationale of projected demand. However, it is necessary to take into account data availability and other specific characteristics of each category to be estimated: for example, in the case of industrial demand, user number trends are less relevant, as in general there are few users, but what matters is total consumption. As SABESP has different types of users, the behavior of each type of user cannot be aggregated and therefore will require a basic distinction for a more consistent projection: Residential Demand Non-residential Demand: divided into Commercial, Industrial and Public Licensee Municipalities Demand Self-consumption and Special Use The results of demand estimates (both for water and sewage) should be presented for each mentioned category, with the largest possible geographical breakdown (the business unit being the minimum level of detail required) and with a 10-year minimum projection. The data base used to estimate demand should be presented with the implemented econometric models (model results, conceptual description and programmed code to arrive at the presented results). Projected water and sewage demand by type of user must follow the guidelines in Attachment II.

21 REGULATORY IRRECOVERABLE REVENUE Irrecoverable revenue refers to the portion of billed and not received revenue as a consequence of the uncollectibility of user bills. In all companies, there is a level of client default. In the case of water and sewage companies, this default is aggravated as it refers to essential services that are provided in advance and whose bills fall due more than one month after the beginning of the service provision, when services have already been fully consumed or used by clients. As it constitutes, therefore, a time payment, it is legitimate to recognize a limit amount as a cost to be reimbursed by tariffs for bills considered as uncollectible, provided that the commercial system meets the desirable efficiency standards, mainly regarding billing and collection. This limit amount of irrecoverable revenue to be considered in tariffs is called Regulatory Irrecoverable Revenue. There are several approaches to estimate which should be the permitted level of irrecoverable revenue. For SABESP s tariff revision, the aging concept will be adopted. The aging concept allows the identification of the stable non paid percentage during a given period of time. As a result, in order to implement the approach, the amounts observed by SABESP for each user category (residential, non-residential, etc.) in the past will be analyzed and the amounts and the efficient trajectory of uncollectible debt losses will be determined The formula below shows the mechanism for the calculation of a priori irrecoverable revenue for a given year: Where: VRI = a priori irrecoverable revenue to be considered in the calculation of required revenue RR = net required revenue = share of each category in total revenue = percentage of regulatory irrecoverable revenue = taxes detailed in the bill and whose cancellation is based on the payable tax concept. Note that this revenue is a priori considered as irrecoverable, as there are additional policies that the company may adopt to intensify collection measures, such as the hiring of companies that work with doubtful collection.

22 Through this mechanism, the company hires another company that focuses on collection and remuneration is established as a percentage of recovered revenue (these agreements have termination clauses if the percentage recovered is lower than x% and establish bonuses if it is higher than y%). The amount of regulatory irrecoverable revenue is determined by the following stages: Calculation of a priori irrecoverable revenue (VRI). Estimate of a recovery percentage by the hired firms (PRS) 11 Estimate of hired firm costs (CS) as a percentage (PS) of recovered revenue 12 : CS = PS * (PRS * VRI) The cost associated with irrecoverable revenue to recognize in revenue requirements is added to costs incurred to reduce doubtful collection debt (CS) and the amount not recovered by the hired firms (1-PRS) * VRI. The PRS and PS estimate will be conducted by ARSESP based on the results of the programs executed by the company in the past FINANCIAL BREAKEVEN A set of financial indicators is specified to be evaluated as part of the tariff revision to verify if the proposed maximum tariff (P0) not only ensures economic breakeven, but also protects the company s financial feasibility. In order to so, the model to be used should project not only cash flow, but also balance sheets and income statements that enable the assessment of financing needs and financial ratios. The financial ratios to be used and their limits will be defined. In order to define these limits, it is necessary to analyze the characteristics of the market where the company operates (company size, financial market size, access to credit). The ratios to be used include at least: 1. Operating cash flow (FFO)/interest 2. Debt / Regulatory capital basis 3. Retained cash flow /Debt 4. Adjusted EBITDA/Adjusted ROL 5. Adjust Net Debt/Adjusted EBITDA 11 In the case of SABESP s previous agreements, this amount came to 70% (see: worldbank.org/intwss/resources/ WSS8fin4.pdf) 12 In the past, the amount observed including premium came to 15.3% of recovered revenue.

23 Where: Retained Cash flow: represents operating cash flow, after dividend payments, but before CAPEX variations. Adjusted EBITDA corresponds to the sum of (I) earnings before contributions, shareholding interest and taxes on income; (II) depreciation and amortization expenses; (III) financial expenses less financial revenue; (IV) other operating expenses less other operating revenue; and (V) construction costs less construction revenue. Adjusted NOR corresponds to net operating revenue less construction revenue. Adjusted net debt is equivalent to the sum of the loans, financing and debentures debt balance less cash and cash equivalents. 2.3 NON-MANAGEABLE COSTS Currently, the cost classification criterion adopted by ARSESP to determine annual tariff adjustments corresponds to the procedures previously adopted by SABESP, which classify costs into manageable and non-manageable. Pursuant to ARSESP Resolution 253, which provisionally validated the criteria then adopted by SABESP, the following costs are considered as non-manageable (portion A) under the current system: Electric power Treatment supplies Tax expenses (see details in Resolution 253) ARSESP considers that electric power and treatment supplies expenses have a strong manageable component. Total energy consumption is a direct function of the company s energy efficiency which is, in turn, determined by investment and equipment maintenance decisions made by the concessionaire. Although it is a function of some elements beyond the company's control (such as the quality of the extracted water), the consumption of treatment supplies also directly depends on the company s efficiency in the management of its treatment process. Regarding Tax Expenses, there is a portion that corresponds to taxes on the acquisition of inputs used in the provision of services, which are manageable through control of their calculation bases and therefore should be directly included in operating costs (OPEX) and will be subject to the productivity and efficiency rules established for that purpose. PIS/COFINS taxes will be excluded from the calculation of Po and explicitly transferable to users in the bill, as they refer to contribution on the billing of water and sewage bills.

24 For the other charges arising from the legal impositions of the different jurisdictions, it is proposed to consider them outside the average tariff and included, when supported from the legal viewpoint, in the bills of users in the specific jurisdiction where they originated. However, the transfer of these amounts to users depends on the legal opinion of the State Prosecutor s Office (Procuradoria Geral do Estado - PGE), which is studying this issue. 2.4 TREATMENT OF NON-REGULATED ACTIVITIES Non-regulated activities performed by the concessionaire correspond to those for which the prevailing legislation and rules do not establish mandatory regulation. Mechanisms should be created through regulatory accounting that enable the separation of costs, revenues and assets related to these activities so as to prevent them from contaminating regulated activities causing undue charges to the users of regulated services. The principles that should govern the establishment of a mechanism that allows an appropriate balance between the different regulatory goals are: Preservation of allocative efficiency Attesting the coverage of direct costs of the provision of each non-regulated service Preservation of incentives to production efficiency with a criterion that differentiates activities By level of innovation By development time Using a growing user participation standard in time While these mechanisms are not available, given the defined general regulatory goals, the treatment of non-regulated activities should conform to the same principles, particularly regarding: Preserving incentives to production efficiency; Avoiding distortions in competitive markets; and Promoting user participation in part of efficiency gains. Based on available information, the best estimates of cost, revenues and assets related to these activities should be obtained so as to exclude them from the calculation of P0.

25 2.5 EFFICIENCY FACTOR (X FACTOR) X FACTOR ESTIMATE The efficiency factor (or X Factor) is intended to transfer the company s efficiency gains to users through lower tariffs in real terms. These efficiency gains may be separated into two main sources: Inefficiency reduction (catch-up) Technological change The first aims to reduce the distance that separates a given company from what is considered to be the cost efficient frontier. The second tries to capture until which point the efficient frontier moves along time as a result of technological change COMPANY PRODUCTIVITY GAIN ESTIMATE In order to estimate the company s productivity gains, we propose the adoption of the Malmquist index. Firstly, the Malmquist index requires only data on the companies' input and product amounts in different time periods. Consequently, it does not require any price information or assumptions regarding the companies objectives. Note also that this methodology allows us to break down the productivity variation into technological change, technical efficiency change and scale efficiency change and to easily incorporate the effect of variables outside the company s control which affect its performance (environmental variables). This methodology s weak point is that it requires a relatively large sample in each period: the database must be balanced (the same companies must show in all periods). It is important to adopt a methodological option based on the characteristics of the available data and the analysis of the relative advantages of the different alternatives. The lower requirements in terms of types of data and assumptions, together with the possibility of breaking down the productivity variation and incorporating the effect of variables outside the companies control justify the use of Malmquist indices, in this case, specifically due to the existence of a database for water and sanitation companies (for example, the database of the Brazilian Sanitation Information System SNIS or other information sources with data on international companies).

26 MALMQUIST INDEX The Malmquist index measures the productivity variation between two observations by calculating the coefficient between the distances of each observation in relation to a common technology. Considering x as a company s input vector and y as its product vector. The Malmquist productivity variation index (input-oriented) between period s and t is given by 13 : Where, represents the distance from the observation of period t to the technology of period s. The index is, in fact, the geometric mean of two productivity indices: the first is evaluated in relation to the technology of period s and the second to that of t. The necessary distance functions to calculate the Malmquist indices can be obtained through different frontier methodologies. The main difference is whether the frontier is parametric or non-parametric. Parametric methods impose an a priori functional form over the frontier, unlike non-parametric methods. Parametric methods estimate frontiers through econometric tools ESTIMATE METHOD We propose an estimate of the two efficiency gain elements technological change and catch-up using a combination of methodologies. The first element would only reflect the expected technological change and would be calculated based on a study of Malmquist indices through DEA adjusted for environmental variables in a second phase regression using data from the SNIS and other international databases. The second component, related to catch-up, would be defined so that, at the end of the tariff cycle, the company reduces a percentage of its inefficiency inventories, calculated as the frontier s average distance in a cross section DEA using the last available period or, alternatively, a windows analysis that would allow reducing with movable averages atypical amounts inherent to the choice of a specific period to calculate efficiency. 13 Färe et al (1994) 14 See attachment for a detailed analysis of the different options

27 The frontier to be estimated has two parts: the model s core and the environmental variables. The core comprises inputs and products. The role of environmental variables is to capture external factors which may affect the companies performance and which are not directly controlled by them. The initial core specification is subject to theoretical considerations and that is how it is accepted or rejected as a whole, which implies that certain non-significant variables may remain in the final model. In water and sanitation, the following variables are more frequently used as inputs and products: Inputs: operating expenses, own personnel expenses, capital inventories, total expenses, AP network extension, AR network extension and headcount. Products: water connections, sewage connections, water volume produced, water volume billed, sewage volume collected, sewage volume treated, water economies and sewage economies. The environmental variables considered in previous studies of the water and sanitation sector include: population density, share of non-residential clients, surface source and underground water (% of untreated water), water losses, distance between the water source and consumers, average rainfall, average temperature, connection density (connections per km of network), topography, soil type, electricity consumption per connection and local regulations As environmental variables are not subject to purely theoretical considerations, they will or will not be included in the final model, provided that they are significant variables. The procedure to be followed at this stage is to begin with a general model (overparameterized) and eliminate all irrelevant variables through the stepwise technique until you arrive at a particular model. However, caution is necessary when choosing the variables that will be part of the initial overparameterized model. In order to verify the robustness of the results obtained, a consistency analysis will be carried out under different methodological approaches and/or under different variable choices (in order for the comparison between methodologies to make sense, efficiency studies must refer to the same sample of companies in the same time period and under the same efficiency concept).

28 2.5.3 X FACTOR DETERMINATION Based on the methodology described in and , the expected efficiency gains for operating and maintenance expenses (OPEX) and the amounts that they should reach at the end of the Tariff Cycle will be estimated using the following methodology: Firstly, the P0 breakeven tariff is estimated assuming that the efficiency level remains constant during the entire revision period. The expenses to be considered at P0 include only the components strictly related to the service provision. Secondly, the efficient P0 breakeven tariff is recalculated including efficiency levels in OPEX, defined in Finally, X Factor is calculated based on an interactive process, considering the following equation of the present value of revenues that links P0 to efficient P0 : Where: maximum average efficient tariff that ensures SABESP s breakeven (and includes efficiency levels in OPEX, pursuant to estimates resulting from section 2.5.2) maximum average tariff to ensure SABESP s breakeven, assuming that the efficiency level remains constant during the entire period and equal to the observed at the beginning of the cycle. Total billable volume for year t (corresponds to the sum of water and sewage volumes) is the WACC in accordance with ARSESP s estimate. is X Factor to be determined.