3. Robust water tariffs and charges
Indonesia has achieved impressive results in increasing access to improved water supply and sanitation. However, the financial and operational distress of water services providers, and the water sector as a whole, prevent universal access to water supply and sanitation. This chapter argues that commercial finance for the water sector can be unlocked through national tariff reforms, economic regulation, and enforcement of charges for pollution and abstraction. It discusses the advantages and disadvantages of a nationwide, uniform water tariff, and it concludes that such a reform is to be implemented with caution.
Water financing of drinking water supply services is a major agenda for Indonesia. As regards drinking water supply, the costs (including financial, environmental and resource costs) of water services are not fully recovered. As a consequence, many local water supply enterprises (PDAMs), are in financial distress. Limited opportunities for revenues, or “revenue risk”, constrain the access to private financing, such as PPP schemes, that could improve water services delivery. This chapter provides international examples and recommendations that Indonesia could consider in developing a robust system of tariffs and charges in the drinking water supply system.
In the last decades, Indonesia has achieved impressive results in increasing access to ‘improved water supply’1. However, barriers remain to delivering high quality services to all users across regions. In 2020, 90 per cent of the population had access to improved water supply, but only 23 per cent of Indonesians had access to piped water and only 11.9 per cent had access to “safe water”2 (World Bank, 2021[1]). Based on the 2020-2024 National Medium Term Development Plan, the Indonesian government aims to increase piped water supplies to 30 per cent by 2024 (Republic of Indonesia, 2020[2]).
Access to “improved water” varies across regions and has a positive correlation with regional income levels. As an illustration, Java, the region with the highest income level, also has the highest improved water coverage (95 per cent); whilst Papua, the region with the lowest income level, has the lowest access coverage (66 per cent) (World Bank, 2021[1]).
3.1.1. Limited capacity of water utilities to deliver drinking water
Drinking water is supplied by 388 water utilities (PDAMs). These are specialised region-owned enterprises (BUMDs) focusing on water supply. In the 2021 annual performance assessment, out of the 388 PDAMs, 225 were assessed as "healthy", 104 "unwell" and 59 "sick" (Ministry of Public Works and Housing, 2021[3]).
Inefficient operation and maintenance as well as limited access to bulk water supply aggravate service provision. Water supply systems are often inefficient, with low utilisation capacity and high rates of non-revenue water due to physical or commercial losses. One-third of the water that enters the distribution supply system ends up as non-revenue water (World Bank, 2021[1]).
Poor service provision, in combination with low tariffs (section 3.1.2) has led to low creditworthiness of PDAMs, therefore limiting access to commercial finance. Indeed, the PDAMs’ financial sustainability is affected by low operation and maintenance efficiency, non-revenue water, ageing infrastructure, inefficiencies and mismanagement, as well as the lack of skilled operators (World Bank, 2021[1]).
In addition, some PDAMs are too small to reach economies of scale, affecting their ability to recover costs and deliver adequate services (Figure 3.1) (World Bank, 2021[1]). USAID has conducted a detailed study on the consolidation of PDAMs, therefore this issue is not discussed in this report.
Note: Number of PDAMs that serve >100.000 households; >50.000-100.000 households; >20.000-50.000 households; >10.000-20.000 households; <=10.000 households. Total number of PDAMs: 388.
Source: Ministry of Public Works and Housing (2021[3]) Buku kinerja bumd air minum 2021. Executive summary.
3.1.2. Low tariffs lead to unsustainable water service delivery
Tariffs for water supply services for industrial and domestic use are in place. However, they inadequately contribute to cost recovery. By law3, tariffs are based on the principles of affordability and fairness, service quality, cost recovery, efficient use of water, raw water protection and transparency and accountability. The tariff can be used for operations and maintenance as well as on the return on previous investments (Questionnaire, 2022[4]). Regional authorities, commonly the mayor, oversee tariff setting, making tariffs prone to politically motivated decisions. Tariff setting can be delegated to PDAMs.
Drinking water tariffs in Indonesia range from Rp. 2,553/m3 to Rp. 8,239/m3 (Ministry of Public Works and Housing, 2021[3]). The PDAM tariffs increased on average 11 per cent per year from 2011 to 2015, twice the average rate of inflation in the same period. The MoHA Regulation No. 21/2020 on Tariff for Water Supply Services was intended to ‘force’ subnational governments to approve full cost recovery tariffs for PDAMs (World Bank, 2021[1]).
Without sufficient revenue to maintain, renew and extend water infrastructure, meeting the water supply development targets will remain a challenge as water service delivery falls into the hands of vicious circles of decline (Rouse, 2013[5]):
1. The inability to generate a solid revenue stream through tariffs hinders access to commercial finance of PDAMs. The Ministry of Finance indicated that the biggest issue facing PPP models and contracts in the water sector are tariff setting, collection and regulation. Financially healthy PDAMs are a requirement for advancing PPPs in the sector (Ministry of Finance, 2019[6]):
2. Limited revenue generation from PDAMs impact reservoir operators upstream, such as PJT. With unreliable revenues from PDAMS and other water users, reservoir operators resort to additional sources of income to recover costs, such as electricity production from hydropower, solar panels on the surface of reservoirs and sediment sales.
3. Low service provision discourages consumers to connect to the water supply system. This leads to lower revenues, and consequentially to lower levels of service in the long term. The drinking water supply service being considered unreliable, households use alternative water sources, mainly groundwater, being free and in practice not regulated by a permit system. Many urban users resort to groundwater and bottled water for drinking (Figure 3.2). PDAMS are also constrained by low water demand: only a fraction of all potential users is connected to the central water supply system.
Source: Republic of Indonesia (2020[2]) The National Medium-Term Development Plan for 2020-2024
An additional pressure is that some bulk water supply systems are not in use, as there turned out to be no demand within the distribution zones of these systems. Moreover, low-income households face challenges in connecting to the water supply system as they cannot afford the connection fees, and direct household subsidies, payment plans or micro-credits are mostly absent (World Bank, 2021[1]). Subsidies from local governments to PDAMs are in place to increase coverage to low-income households (Ministry of Home Affairs, 2016[7]).
3.1.3. An inadequate regulatory framework for water services
Currently, Indonesia does not have an economic regulator for water services. An economic regulator is normally tasked with assessing the performance of utilities, reviewing tariff methodologies and decisions, and reviewing expenditure programmes of utilities (OECD, 2015[8]). The 2019 Water Law does not contain provisions on how water services should be regulated. Water supply services are currently regulated through Government Regulation 122/2015, which provides only limited guidance on water utilities regulation. At the time of writing this report, it is not known if the new regulation on Clean Water includes a provision to establish an independent economic regulator (World Bank, 2021[1]).
Public performance reviews can be an incentive to improve operations. An annual performance assessment of PDAMS is carried out by the Ministry of Public Works and Public Housing and the Financial and Development Supervisory Agency (Ministry of Public Works and Housing, 2021[3]). The annual performance assessment comprises four aspects: finance, service, operations, and human resources (Table 3.1). The performance assessment ranks PDAMs according to their ‘health’ level, i.e. their performance on each of the four aspects, but does not have a formal role as economic regulator. Altogether, PDAMs report on almost 60 indicators to both entities. Drinking water quality, however, is regulated by the Ministry of Health (MoH) (World Bank, 2021[1]).
Indonesia has some experience with an economic regulator for water, namely in the Province of DKI Jakarta which has its own independent water regulator: “Badan Regulator Pelayanan Air Minum DKI Jakarta” (Jakarta Water Supply Service Regulatory Body). The independent Regulatory Body reports to the Governor of Jakarta (Badan Regulator, 2023[9]).
3.1.4. Absence of water fees and charges also affect the drinking water supply chain
Environmental taxes and charges remain largely underutilised in Indonesia at national as well as local level (ADB, 2022[10]; Lewis, 2019[11]). The low uptake of environmental taxes, water abstraction charges or pollution charges, affects the drinking water supply chain in several ways:
1. The absence of water permits and user charges leads to an inefficient use of water supply. This includes groundwater over-abstraction in areas where surface water could have been used. Moreover, raw water demand is expected to increase in the future (World Bank, 2021[1]), increasing the need for instruments that phase out overuse of water resources, address water scarcity and promote water use efficiency.
2. The absence of pollution charges can drive up operational costs for drinking water supply as more pollutants will need to be removed to make water fit for drinking (OECD, 2017[12]). While exact estimates of additional treatment costs have not been made in Indonesia, the Ministry of Finance recommended in 2019: “[…] to forecast raw water quality. This may impact significantly on chemicals cost and sometimes it also requires additional capital cost for additional treatment systems” (Ministry of Finance, 2019[6]).
The regulatory framework for implementing the ‘polluter pays’ principle is in place: by law4 polluters are obliged to cover the costs of wastewater treatment and they can be held accountable for the environmental and human health damage they caused. However, the enforcement of the polluter pays principle is weak (World Bank, 2021[1]).
Similarly, there is a regulatory framework in place to charge surface water uses. Large users must have an abstraction permit, but awareness and enforcement of this requirement are low. Groundwater abstraction also requires a permit, upon which a groundwater tax is triggered, but such a permit is only sporadically issued (ADB, 2022[10]). Illegal wells are common, and industrial water abstraction is not monitored (OECD, 2019[13]). Water abstraction permits are issued by district governments, unless the permits concern inter-jurisdictional water bodies, in which case the responsible authority is at the higher administrative level. (OECD, 2016[14]). Small water users are not regulated, which – given their overall number – could jeopardise groundwater resources in the long term (OECD, 2019[13]).
The Water Resources Law allows state-owned-enterprises to collect a Water Resources Management Service Fee in river basins5. To date, only two state-owned-enterprises managing infrastructure in six river basins introduced a Water Resources Management Service Fee to meet the costs of operations and maintenance of water infrastructure such as dams. In other words, all other 121 river basins do not make use of a Water Resources Management Service Fee to recover costs. Besides a missed opportunity for cost recovery, these river basins miss an opportunity to send price signals to incentivise water use efficiency.
Indonesia has a strong ambition to attract public-private partnerships (PPP) in the water sector. The first criteria to unlock commercial finance are operational efficiency and stability of revenue though water tariffs (Leckie, Smythe and Leflaive, 2021[15]). This section therefore discusses three recommendations:
1. A stable revenue stream: untangling the discussion on a nationwide, uniform water tariff Recommendations (Section 3.2.1)
2. Systematically increase tariff collection (Section 3.2.2)
3. Economic regulation to supervise tariffs and operations of service providers (Section 3.2.3)
In Indonesia, the appropriate pricing strategy for water supply services is best designed and implemented as part of a wider strategy of water demand management, which also includes charges for water abstraction from groundwater sources, pollution charges and wastewater treatments tariffs, water permits and possibly a water allocation regime. PDAMs would not be able to increase their coverage if groundwater is available for free, whilst their own water supply services are perceived as unreliable, and whilst raw water sources are too polluted to be treated at reasonable cost. This is discussed in the next Section (3.3).
3.2.1. A stable revenue stream: untangling the discussion on a nationwide, uniform water tariff
Water tariffs set by municipalities should ensure sustainable cost recovery. An appropriate tariff formula safeguards a combination of various objectives: economic (robust allocation of water and discouraging wastage), environmental (conservation of the resource), social (addressing affordability concerns) and financial (ensuring utilities’ capacity to finance the operation of the service, now and in the future) (OECD, 2022[16]).
Indonesia is considering the option of setting a nationwide, uniform water tariff. As the tariff methodology is still on the drawing table, this section presents the pros and cons of a national water tariff. But before doing so, it is important to untangle what a nationwide, uniform water tariff entails. During the Policy Seminar, organised as part of the Dialogue in January 2023, it appeared that stakeholders have different interpretations of a nationwide, uniform water tariff. Are we discussing a uniform tariff level, a uniform tariff structure, a uniform tariff-setting process, or all of the above? Does this concern bulk water only, or will tariffs also be uniform at every household connection? The points below can help untangle the discussion:
Is the discussion about a uniform tariff level? This can be interpreted in several ways. It could imply a uniform water tariff level (per m3) for every Indonesian, regardless of location and water supply service provider. Alternatively, a uniform tariff formula can still result in different tariff levels for every Indonesian, as the formula is based on technical and geographical factors that influence the cost of water supply.
Is the discussion about a uniform tariff structure? Uniformity in tariff structure entails a flat volumetric tariff for households and legal entities. The tariff has no sophisticated structures, such as increasing blocks. A uniform tariff structure may still result into divergent tariff levels, depending on the tariff formula adopted.
Is the discussion about a uniform tariff setting process? Uniformity in tariff setting process implies that tariffs are centrally set and approved, for example by the Minister of Public Works and Housing, the Ministry of Home Affairs, or the economic regulator (see Section 3.2.3).
Uniformity throughout the water supply chain, or for bulk water supply only? The tariff can be uniform throughout the country for bulk water supply distribution, but still be differentiated at distribution for drinking water supply (see the case of Korea in Box 3.1), or (theoretically) vice versa: a pluriform bulk water supply tariff, with uniform drinking water supply tariff levels.
There are several considerations to be made regarding each of the four above-mentioned aspects. In principle, a nation-wide, uniform water tariff level (i.e., every Indonesian pays the same price for a m3 of water at the tap) is not recommended as it does not deliver on ecological, economic, financial and social sustainability of water services. Tariffs ideally cover the operation, maintenance and renewal costs of infrastructure (OECD, 2021[17]). As these costs differ per PDAM, and are highly influenced by factors such as scarcity and distance from source to tap, a nation-wide uniform tariff is likely to be too high for some utilities, and too low for others. A central fund, or other mechanism, could be established to cross-subsidise utilities to ensure cost-recovery for all utilities. Another risk linked to the nation-wide uniform tariff is “cherry-picking” of low-cost utilities by private financiers, as the profit margins are relatively high when the excess tariff revenue is not properly redistributed. This puts additional pressure on public budgets to fund the less bankable utilities. Lastly, a nationwide, uniform tariff does not provide any incentive to utilities related to the management of cost levels. While a uniform tariff level is not favoured, a uniform tariff formula can be appropriate. This formula will result into a different tariff level for each utility, as the formula factors in the costs of operation, maintenance and renewal costs of infrastructure.
A uniform tariff structure, i.e. a flat volumetric tariff, can be of help to address affordability issues, particularly when coupled with targeted social subsidies. The literature has established that sophisticated tariff structures – such as increasing block tariffs – are usually socially regressive as they fail to reflect family structures and water consumption patterns. Tariffs that reflect the true cost of connection (fixed part) and consumption (variable part) are to be preferred, in combination with social measures targeting households that face affordability issues (Leflaive and Hjort, 2020[18]). This combination only works where public authorities have the administrative capacities to design and implement such targeted social support. Another advantage of a flat tariff structure is its administrative and financial feasibility, as flat tariffs require less information on water use and customer characteristics (Leflaive and Hjort, 2020[18]).
A centralised tariff-setting process, that is not subject to political interference, is appropriate. A centralised process can still result in different tariff levels per water service provider, depending on performance of the provider and the production costs of water based on technological and geographical parameters. Typically, an economic regulator sets the tariff formula and oversees that the tariff-setting process has been conducted according to the rules of the game. As an economic regulator is highly recommended in Indonesia, the details of developing such an institution are discussed in Section 3.2.3.
Lastly, experiences from Korea, Scotland and New Zealand show that a single, nationwide tariff for bulk water supply can work. It should be noted that this tariff only covers bulk water supply: the tariff for drinking water at retail level is still variable and based on the operations of the utility. A single tariff for bulk water promotes equity in water access, particularly in countries where the cost of bulk water supply highly diverges, such as due to topography. There are two requisites that apply to a single tariff for bulk water supply: 1) the tariff is redistributed among bulk water suppliers to ensure sustainable cost recovery of all utilities within the national bulk supply system, and 2) an economic regulator is in place to review and approve the bulk water tariff, as well as to evaluate the efficiency of operation of each service provider (see Section 3.2.3). Box 3.1 discusses the pros and cons of the Korean experience, where a single bulk water tariff is applied to facilitate equal economic development across the country.
In addition to tariff revenues, fiscal transfers can be justified to cover part of the cost of water services. Public authorities must pay attention to which fiscal instrument is most appropriate. For example, in touristic areas property taxes can be used to cover the additional cost of building and operating infrastructures for seasonal or peak water uses, and to capture some of the value added by reliable water supply and sanitation services (Leflaive and Hjort, 2020[18]). Portugal has experience in applying a seasonal tariff during tourism peaks. It operates a two-part water tariff structure that consists of an availability tariff (fixed component) and a usage tariff (variable component). The availability tariff aims to cover the fixed investment cost of water infrastructures. The usage tariff is to cover operation cost, manage social welfare considerations for low-income groups, and large families vulnerable to progressive increasing block tariff scheme. In addition, seasonal tariffs can be applied during tourism high seasons in areas with water scarcity, as a measure to prevent water shortages in those regions (Albuquerque, 2023[19]).
The water tariff framework in Korea consists of two parts: a single uniform tariff for bulk water supply and a differentiated and variable tariff applied at retail to households, industries and other users. The bulk water tariff is uniformly applied across the country and applies to all inter-regional waterworks providing clean bulk water. The tariff is proposed by K-Water (Korea Water Resources Corporation responsible for national water resources management and inter-regional water supply), approved by the Ministry of Environment, and monitored by the Ministry of Finance. The retail tariff is set and levied by local government and approved by the local ordinance. It reflects locally specific conditions, including scarcity and operation and maintenance cost of the local water supply network.
The bulk water revenues are redistributed across bulk water service providers, as a form of cross-subsidisation, to improve water supply capacity of rural areas for a balanced inter-regional development. In principle, bulk water tariffs could be differentiated by basin but there is a strong perception in Korea that the cost of water should be the same for everyone (principle of water equity) (OECD, 2018[20]).
The pros of a nation-wide, uniform bulk water tariff
Korea’s differentiated bulk and local water tariff framework is a legacy of its economic development strategy aimed at creating spill-over effects from wealthy and water abundant regions to underdeveloped and water scarce areas. During its fast economic development period in 1960-70s, the government heavily invested in constructing various water infrastructures such as multi-purpose dams, reservoirs, and inter-regional water pipelines to secure sufficient water supply to urban areas and industrial parks. These large-scale infrastructure developments boosted economic development.
From an equity point of view, Korea’s policy has been to set bulk water tariffs nationally so that every user has access to water under the same condition (OECD, 2018[20]). The single tariff alleviates the disparity between urban and rural and upholds the principle of universal public service. This tariff is estimated based on the total expenditure on all water infrastructure investments in the country.
And the cons of a nation-wide, uniform bulk water tariff
The current uniform tariff scheme (river water charges and the bulk water tariff) does not reflect basin features or local conditions, such as water scarcity. As a consequence, these fees do not signal any water-related risks (scarcity) and do not encourage water use efficiency, particularly when water resources are scarce (OECD, 2017[21]). Moreover, the tariffs do not reflect operational costs. The cost of bulk water supply varies considerably depending on the location of the delivery point within the bulk water supply infrastructure system. From an efficiency point of view, it is therefore not appropriate to apply a uniform bulk water tariff to all water supply service providers. Tariffs are ideally set at a level that reflects the costs of supply at the abstraction point in the bulk service provider’s system. Reflecting costs is central to securing sustainable finance for service providers (OECD, 2018[20]).
Sources: Lee (2019[22]); OECD (2017[21]); OECD (2018[20])
3.2.2. Systematically increase tariff collection
Tariff collection is a requirement to ensure sufficient revenue for PDAMs, which in its turn is a requisite to attract investments in the water sector. A basic requirement for tariff collection is to have reliable water services, and so tariff collection should go hand-in-hand with cyclical performance reviews of utilities (see Section 3.2.3). The Indonesian government has pointed out that the major barriers to the sustainable finance of water services is the low coverage of household connections due to a lack of willingness to connect and ability to pay for a connection. The four recommendations for increased revenue collection are: 1) increase the number of household connections, in particular those connections that can be realised at low marginal costs, 2) introduce revenue collection tools and instruments, 3) avoid free substitutes that are a negative externality, in particular groundwater abstraction, and 4) increase trust in tap water.
Increase the number of household connections
Increasing the number of household connections can support in revenue collection, particularly the household connections that can be realised at low marginal costs. The “last mile” connections can put pressure on sustainable cost recovery as these areas are relatively more expensive to connect, although these users should not be left behind in gaining access to safe water supply and sanitation.
High and upfront connection charges pose a significant barrier to connecting low-income households. Whilst connection costs cannot be free, direct subsidies or arrangements with low-income households could be considered through public, aid or philanthropic funding. One option can be to modify the payment conditions, such as an instalment scheme, for low-income households. For example, Manila Water Company in the Philippines extended the payment deadline for connection fees from 1 year to 2 years or even 3 years, allowing an increase in the number of low-income households’ connections. ADB advanced the connection fee to Manila Water Company through an interest free loan, which customers then repaid to Manila Water Company upon connection. Manila Water Company deposited the community’s repayments into a revolving fund6 that was used to connect other low-income areas in a similar way (Asian Development Bank, 2008[23]). Micro-credits are another option. For example, Indonesia has good experience with a 6 to12-month loan scheme to connect low-income households to the water supply grid, alongside capacity building programmes for PDAMs (BAPPENAS and UNICEF, 2022[24]).
Other options could be reviewing the existing regulation to reduce the cost of connection for low-income households. Usually, connection costs increase with the distance to the pipe network, which generally disproportionately affects low-income households. Examples implemented in other countries are: 1) requesting service providers to connect all low-income households under their area, regardless of the distance to the pipe network, 2) providing the materials to reach households up to their location (or a fixed number of meters) or, 3) defining a maximum connection fee.
Revenue collection
Once households are connected, consistent billing and revenue collection ensure a reliable revenue stream. Privatising bill collection could be an option. Strict monitoring and enforcement of revenue collection, monitored by an economic regulator, is another way. For example, in Israel every user pays its water bill, including the poor. Those who are not able to afford the water bill receive government subsidies that are distributed to the user through the national water company.
Avoid free substitutes for water
As long as groundwater is a free alternative for treated water supply, there is low incentive to purchase water from PDAMs. This would not be an issue if groundwater abstraction did not have any negative impacts. However, groundwater abstraction also contributes to land subsidence in cities such as Jakarta. Section 3.3.1 further discusses regulations and charges for groundwater abstractions.
The new law (No. 259/2022) on Standards for the implementation of Groundwater Permits is a positive development in this context. It stipulates that business entities applying for groundwater use are required to make a Certificate of Availability of Surface Water from the River Basin Organisation and PDAM. If surface water and water supply is available, the permission will be denied (Questionnaire, 2022[4]).
Increase trust in tap water
Households’ trust in service delivery and water quality is an essential requisite in any effort to increasing connections and tariff collection. Therefore, solutions to ensure water quality and service continuity should be prioritised. The economic regulator plays a key role in enforcing the good performance of utilities (see Section 3.2.3). Communication campaigns to increase trust in tap water could be implemented, such as public education, replacing aged pipelines and real-time water quality information sharing to end-users. Examples from Korea and Paris, France, are presented in Box 3.2 and Box 3.3. The 225 out of the 388 PDAMs that were assessed as "healthy" could start with such communication campaigns.
Korean citizens’ trust in tap water safety is low, despite the high quality of tap water. The direct drinking rate of tap water remains at around five percent of all customers, even though all tap water meets the stringent National Health and Water Quality Standards. This public mistrust came from experience with past incidents like the 1991 Nakdong River phenol contamination and concerns about aged distribution pipelines.
The Korean government is aware of the importance to rebuild public trust in tap water safety in order to improve the tap water direct drinking rate. It has therefore taken several measures:
Public education on tap water safety and the lower costs of tap water use compared to bottled water consumption;
Open blind tests for consumers to compare the taste of tap water and bottled mineral water;
Real-time tap water quality information sharing to end-users through a mobile application and electronic bulletin boards in towns and apartments.
Sources: OECD (2017[25]) OECD Environmental Performance Reviews: Korea; K-water (2017[26]) An In-depth Study for the Health Promotion Plan of Tap Water
Eau de Paris (literally translated as “Water from Paris”) is the drinking water company of Paris, France. Over the past ten years, Eau de Paris has launched several campaigns to increase customer’s trust in drinking tap water, and successfully so: over 76 per cent of Parisians even serve tap water to their guests.
Besides water quality and delivery standards, customer satisfaction is one of the key service indicators for Eau de Paris, as the company believes that their customers pay for the service of water delivery rather than the water itself. Customer satisfaction is monitored through annual surveys, monthly committee gatherings on client satisfaction, and direct client feedback collected by ground technicians.
Eau de Paris has launched several public campaigns promoting safe and tasty tap water:
“Product placement”, such as visibly putting a glass of tap water on the mayor’s table in public appearances;
Working with offices, restaurants, and 600 shops to make tap water easily accessible for clients;
Placing hundreds of public drinking water fountains across the city of Paris;
3.2.3. Economic regulation to supervise tariffs and operations of service providers
Economic regulation can support in setting appropriate tariffs and improving efficiencies of water service providers. Economic regulation in the water sector protects the public interest by making water service providers accountable for their performance and by establishing an independent price-setting process (OECD, 2015[8]). The regulator independently oversees the sector. It also builds public trust in the administration as an effective rule maker (OECD, 2015[8]).
Economic regulation in Indonesia may be an effective response to some of its water sector challenges, including the limitations of the tariff setting process, poor service delivery, fragmentation of roles and responsibilities in the sector and public distrust in drinking water services. Ultimately, economic regulation can increase the creditworthiness of the water sector and attract investments. Economic regulation can also improve planning and expenditure on water infrastructure, which encourages better spending of scares financial resources. For instance, by reviewing and comparing the plans and investment programmes of different utilities, a regulator can detect synergies with other sectors, opportunities for combining of investments, guide on the consolidation of utilities, or advise on more economical alternatives for the proposed investments. The regulator could support in the phasing out of unhealthy PDAMs and guide on consolidation of PDAMs if appropriate.
It is worth mentioning that an economic regulator is not just there to supervise PPP contracts. Economic regulation is equally relevant to ensure service provision by public utilities. In this context, the Portuguese regulator ERSAR is a good example, as it regulates both public and private service providers and it has different procedures for each category.
Indonesia has some experience with regulation of the water sector. The annual public performance assessment of PDAMs by the Ministry of Public Works and Public Housing and the Financial and Development Supervisory Agency is a regulatory practice. Moreover, an independent regulatory body was established for the DKI Jakarta service area (Ministry of Public Works and Housing, 2021[3]; Badan Regulator, 2023[9]). Economic regulation at national level would be a valuable addition to the current practice. The following section discusses how Indonesia’s water regulation could mature towards a framework of economic regulation.
Functions of economic regulation
The key functions of economic regulation are to (see Table 3.2 for a more extensive list):
Set performance standards of water service providers, including metrics such as leakages, bursts, pollution incidents, and unplanned outages. The Portuguese regulator ERSAR assesses the following metrics for water supply: service interruptions, mains failures, water losses, customer complaints, and an affordability metric (OECD, 2022[16]). For wastewater, it assesses flooding incidents, sewer collapses, compliance with discharge permits, customer complaints, and an affordability metric. Note that these standards are in addition to performance standards set by health and environmental authorities, regulating water safety.
Collect, analyse, and communicate data on actual performance of service providers. Performance of service providers is compared and can be benchmarked against, for example, the most efficient operator. Comparative performance data is commonly made public as an incentive for improvement. If Indonesia is considering a nationwide, uniform tariff for bulk water or retail water, performance reviews are especially important to provide incentives for good service delivery.
Set rules for tariff-setting and charges. This concerns the methodology, design, and the eventual tariff for each service provider. Regulators have a particular role in shielding the tariff from political interference, for example by providing a binding opinion on the tariff proposal by the municipality or operator. When the opinion of the regulator is non-binding, the municipality or utility should justify any deviations from the regulator’s recommendation.
Review expenditure programmes of service providers. The regulator can be involved in assessing the investment opportunities and expenditure programmes developed by local authorities and service providers (OECD, 2022[16])
Provide incentives for consolidation if appropriate. If there are opportunities to reach economies of scale through consolidation, the regulator can provide guidance on this process, e.g., by conducting public consultations, assessments and providing opinions. This is particularly relevant to Indonesia as the consolidation of some PDAMs could provide substantial efficiency gains for operation and investment in the long term. Consolidation of PDAMs could take several forms and merger on a geographical basis is only one of them. Other options are the mutualisation of functions that can build trust across PDAMs and lead to more coordination or coordinated development and investment. Based on other countries’ experience, consolidation can contribute to addressing challenges, and help to make better (efficient) investment decisions which lead to economies of scale, decrease operation costs, and improve water supply efficiency and decrease leakage (OECD, 2022[27]). USAID has conducted a detailed study on the consolidation of PDAMs, therefore this issue is not discussed in this report.
Institutional embedding of a regulator
Different types of regulatory models exist. Aside from self-regulation, major regulatory models include: regulation by government; regulation by contract, which specifies the regulatory regimes in legal instruments (the French model); independent regulation (Anglo-American model); and the outsourcing of regulatory functions to third parties, which makes use of external contractors to perform activities such as tariff reviews, benchmarking and dispute resolution (OECD, 2015[8]).
The third model, “independent regulation”, involves the establishment of a dedicated regulatory body for water services. Over the past two decades, independent regulation has accompanied the reform of the water industry in many countries, in particular in the corporatisation of water operators and the consolidation of water service provision.
While a regulatory function is always independent from local and national authorities, it does not need to be a stand-alone institution. Economic regulation for water services can be bundled with a regulator covering other sectors, such as sanitation, energy supply, or a competition authority. For example, the Portuguese water regulator ERSAR regulates both wastewater and water supply services. The regulatory body can also be hosted as a unit within a Ministry, provided it is shielded from interference by that same Ministry. Indonesia currently does not have a regulatory body for the energy sector. ADB (2020[28]) has written a resourceful report on ‘How better regulation can shape the future of Indonesia’s electricity sector’, which includes recommendations that are relevant for the water sector too.
A regulator requires specific expertise. The institution should be able to perform economic analyses to set appropriate levels of ambition in terms of operational efficiency and cost effectiveness; to review the appropriate tariff process and level; to review investment plans and financing strategies; to review operational performance; to set incentives, rewards and sanctions based on actual performance; to engage with service providers and users.
Economic regulators for water services interact with a broad range of institutions, at national or subnational level. This framework typically involves line ministries in charge of water policies, the Health Department in charge of water quality standards and Ministries of Environment in charge of effluents. It also involves Treasuries and Ministries of Finance (as regards tariff setting, expenditure programmes, and allocation of revenues) and Ministries of the Economy (in relation to competition policy). Various public agencies, e.g. environmental protection agencies, also play a role in specific issues of water regulation (OECD, 2015[8])
Water charges or taxes can help to promote efficient water use as well as pollution control and prevention. At the same time, charges can raise revenues to cover the costs of resource management, such as water treatment or reservoir management, thus saving scarce public funds. Moreover, charges that are set at the right level discourage water users from over-abstraction or discharging harmful effluents, saving on costs for water resources management such as treatment (OECD, 2017[29]). This paragraph discusses opportunities for abstraction charges and pollution charges in Indonesia.
The point of departure is that charges should at least reflect infrastructure costs, environmental costs and opportunity costs of using water (Box 3.4). Water charges should not be confused with “water sales” by the government or private entities. Water charges are a service charge for the supply and conservation of water resources. These services may include treatment, storage in reservoirs, distribution through canals or pipes, monitoring of flows, quality, and biodiversity, maintaining an environmental flow, administrative costs, etc.
Taxes can also generate public revenue. The OECD Working Paper on raising public revenue in Indonesia notes that there “is scope to broaden taxation of other environmental “bads” to simultaneously reduce harmful behaviour and raise revenue” in Indonesia (Lewis, 2019[11]). The Working Paper recommends introducing sub-national taxes for environmental externalities that are local, such as water pollution. It also recommends introducing taxes on specific products such as chemicals and pesticides, following the polluter-pays principle. It should be noted that, in many OECD countries, pollution and resource taxes play a minor role in generating environment-related tax revenues (OECD, 2022[30]) and additional revenues, such as tariffs and land value capture (Chapter 4), will strengthen the sustainable financing of water services and infrastructure.
From an economic theory point of view, water charges should reflect infrastructure and transaction costs, environmental costs, and opportunity costs; however, in practice the three costs are not always fully represented. The design of the charge scheme should, to the extent possible, consider these costs.
Infrastructure and transaction costs can include costs of irrigation and storage infrastructure, wastewater treatment plants, sewerage networks, energy, and administrative, monitoring and data analysis costs. They depend on technological choices, infrastructure design and financing, operation and maintenance, and asset management. Revenues from water charges do not usually cover the cost of investment or operation and maintenance (this is typically the role of tariffs for water-related services). However, where an asset benefits several sectors - such as a multipurpose reservoir for water supply, industry, agriculture and energy - it would be appropriate for abstraction charges to cover the operational and financing costs. Charges can also cover the administrative and technical costs of managing and regulating water resources for the benefit of all users.
Environmental costs correspond to the damage induced by water abstraction or pollution. For example, too much groundwater abstraction may cause land subsidence, saltwater intrusion in coastal aquifers, or reduced river flows. Excessive surface water abstraction may result in reduced environmental flows and ecosystem functioning. Note that the same level of pollution can generate different levels of externalities, depending on features of the receiving water body (e.g., dilution capacity, instream water quality levels) and potential uses downstream (recreational, drinking water, or other uses). Industry and public water supply can incur significant treatment costs to ensure that the abstracted water meets the quality standards.
Opportunity costs of using water represent the lost opportunities of alternative water uses. These costs are incurred when one water user affects the water availability to another (potential) user. For example, higher water withdrawals by a city might affect the quantity of water available to downstream irrigators, thus imposing costs on the irrigators. The same holds for polluters as a water user. When a user pollutes water, making it unsuitable for use, it excludes other potential users that need good water quality for their use, such as aquatic animals or drinking water. The opportunity cost of water is defined as the highest value alternative use. The lower the opportunity costs are, the more efficiently water is being used. Opportunity costs are typically higher where water is scarce and competition to access is fierce. They are also higher when water is being used for low value uses, preventing access for higher value uses. If property rights are in place and tradable, the market value of water would reflect opportunity costs.
Source: OECD (2017[29]) Water Charges in Brazil: The Ways Forward
3.3.1. Water demand management of surface water and groundwater
There are several policy instruments for water demand management, including water charges and allocation regimes.
Water abstraction charges
Abstraction and groundwater charges, combined with water abstraction permits, exist in Indonesia (Table 3.3). The 2019 Water Law limits the granting of abstraction licenses for drinking water exclusively to state/region/village-owned enterprises. (World Bank, 2021[1]). International practice shows that water abstraction charges are commonly managed at sub-national levels, as is the practice in Indonesia (OECD, 2017[29]).
However, the enforcement of water taxes and charges is low (ADB, 2022[10]). For example, groundwater abstraction taxes are calculated based on groundwater permits. However, since such permits are rarely being issued, there is no base to collect the groundwater tax (ADB, 2022[10]). Moreover, the charges are below the levels of environmental effectiveness and uniform across users. A good international practice is to differentiate the level of the water charge by water source (groundwater or surface water) and by the type of user (residential, industry, agriculture) (OECD, 2017[29]).
Introducing and enforcing abstraction charges that reflect water scarcity (i.e., environmental and resource cost, see Box 3.2) and that cover the administrative costs of managing the system can reduce over-abstractions. At the same time, these charges increase tax revenues for operations and maintenance of water systems. This paragraph suggests adjusting the water taxes based on scarcity and collecting taxes from a broad range of water users, including irrigation.
While all users should be charged in principle, start with and focus attention on the ones who have the more severe impacts on water quantity and quality. The following groups should not be overlooked:
Irrigation is currently exempted from surface and groundwater tax, though fees may be charged for the maintenance of irrigation infrastructure. Various stakeholders explained that the exemption intends to keep the business of smallholder farmers viable. Traditional systems of water allocation ensure equitable water supply to all farmers, such as the subak irrigation system in Bali. Nevertheless, water demand for irrigation continues to grow, sometimes beyond the carrying capacity of the river (World Bank, 2021[1]). Abstraction charges that reflect water scarcity may incentivise a more efficient use of water resources. While irrigators may claim that water charges would significantly affect their competitiveness and put them at risk, such claims can be challenged when underpinned by solid research. For example, in Brazil it was estimated that a water charge equal to charges for other users (irrigation, drinking water supply), would represent 2% of farmers' overall costs. When farmers would pay 5% of the normal user charge, the charge would equal 0.1% of their overall costs (OECD, 2017[29]). In other words, the affordability issue is not self-evident and is worth studying, especially in water scarce basins where the condition of “environmental preservation” clearly applies (Table 3.3). It should nevertheless be acknowledged that farms are very diverse (ranging from small subsistence farming to large-scale commercial farms), and the capacity to pay and their impact on water resources varies markedly.
Drinking water utilities, or PDAMS. Asking PDAMs to structurally pay for water abstractions may seem counter-intuitive given the financial distress of PDAMs. However, the upstream raw and bulk water supply providers are also in financial distress and in need of resources for operations and maintenance, such as through the Water Resources Management Services Fee. Strengthening upstream water infrastructure will also benefit PDAMs in the long run, as it secures a reliable water supply.
Explore household charges for groundwater abstraction. Many small users make one large user, and this is also the case for individual boreholes, particularly in densely populated areas such as cities. It would be key to focus on the large users, and account for the cumulative effects of large numbers of small users, including household groundwater consumption (see Box 3.5 and Section 3.2.2). Ideally, volumetric abstraction charges for groundwater that exceed water tariffs, should be developed. However, this recommendation may not be fully in line with Indonesia’s cultural understanding that water should not be sold. As the infrastructure for groundwater abstraction is commonly privately owned and operated by property owners, charging the cost for abstraction and treatment does not provide an incentive to lower abstractions either. It is noteworthy that groundwater abstraction charges deliver best in combination with other measures, such as volumetric permits capping abstracted volumes, or taxes on pumping equipment or energy inputs for pumping.
In France water users are exempt from paying abstraction charges below certain thresholds. These thresholds vary per water agency, the type of resource (groundwater/ surface water) and the scarcity of water. For example, in the Rhône-Méditerranée Corse River basin, water users abstracting less than 10 000 m3 per year are exempted from paying abstraction charges. The threshold is reduced to 7 000 m3 in areas facing water scarcity problems.
In England and Wales, some classes of small user have been exempted from charging, e.g., a borehole for household use only. Small volume users with a low water charge rate are viewed as a mere bureaucratic exercise, as the charge does provide any incentive to water use efficiencies. A charge should also reflect a service, and most small users will get little or no service other than knowing that their abstraction has been registered. They will not be inspected (or should not be — enforcement should be risk-based and small users will almost always be low risk).
In Portugal, the abstraction charge for surface and groundwater water is applied regardless of the purpose of the water use and public or private nature of users. However, there is a threshold related to the means of extraction. If the abstraction is done by a pumping system with a power of less than 5 HP, no payment is required, unless otherwise established in the river basin plan and justified by the special sensitivity of the affected area. This exemption essentially contemplates small farmers.
In Spain, at the central level, the competent authority (Ministry of Agriculture, Fisheries and the Environment, Central Government of Spain) may include some exemptions. River basin authorities shall issue within three months, in a mandatory way, and prior to the resolution to be adopted, a motivated report to provide the rationale for whatever exemption.
As per the new groundwater management, Peru is currently discussing a service tariff (not a use tariff) that levies those water users with a well of their own and that excludes agricultural groundwater users.
Source: Taken from OECD (2017[29]) Water Charges in Brazil: The Ways Forward
It is recommended to differentiate tariffs for groundwater and surface water based on scarcity (see for example Korea, Box 3.6). In those areas where groundwater resources are critically low, groundwater use is likely to become more expensive than the extension of piped water supply or construction of non-centralised solutions (OECD, 2019[13]). To reflect the geographical and temporal variations in water levels, water abstraction charges can be flexibly adapted across regions. For example, in France the threshold under which water users are exempt from paying abstraction charges depends on the water agency, the type of resource and the scarcity of water (OECD, 2017[29]). In another example in Portugal, a legislated scarcity coefficient for different river basins is applied to reflect different levels of water scarcity geographically and temporarily throughout the year (OECD, 2015[35]). Spatial and seasonal variation can be particularly important in agriculture. For instance, in Greece, water pricing is differentiated by region, while in Hungary, pressure multipliers are applied to raise prices in groundwater bodies facing water risks. In Indonesia, the implementation of water charges could, for instance, start in basins under pressure.
Water allocation regimes
Water allocation regimes are a combination of policies, laws and mechanisms to help determine who is able to use water resources, how, when and where. Water allocation regimes help in promoting water use efficiency, particularly important during periods of drought. Allocation regimes can exist at different scales within national contexts: some are set at national level (e.g. Costa Rica, Estonia, Luxembourg, Slovenia, Switzerland), others at province/state level (e.g. Canada, Brazil), or at river basin scale (e.g. Australia, Colombia, Spain).
Indonesia has a practice of water allocation based on annual water entitlements. In absence of a water permit system, water allocation plans are submitted by the Irrigation Commission to the Ministry of Public Works on an annual basis. The Minister makes the final decision on annual water allocation based on the compiled water demand. Note that annual entitlements do not provide any security on water availability in the medium term, and thereby deter investment in perennial crops or efficient water-use technology. The Water Evaluation and Planning (WEAP) model is used for water allocation, and the Ministry has access to relevant data and advanced technology for reservoir operations, meteorological forecasts, hydrological models, hydraulic models, and satellite imagery. Actual water uses and return flows are not factored in the annual allocation entitlement plans. A ladder of priority water uses during water scarce periods is in place. Some additional tools can be considered as an addition to Indonesia’s water allocation practice: water abstraction cap based on permits, enforcement and compliance mechanisms, local allocation practices and efficiency promoting instruments7.
Most allocation regimes impose an overall limit (“cap”) on water that can be abstracted from a resource pool; although in practice this limit may not be respected (OECD, 2015[35]). There is variation in terms of how that cap is defined. Some regimes put a limit on the volume of water that can be abstracted, some put a limit on the share of water that can be abstracted, while some others restrict who can abstract water, but without limit on how much water can be abstracted (OECD, 2015[35]). For groundwater, setting an abstraction limit requires consideration of the amount of water that should be left in the aquifer to meet non-extractive uses (e.g. flows for ecosystem needs, protection of water quality) and future uses. Examples from Denmark, Mexico, United States (Texas) and France illustrate approaches to limit the long-term abstraction of groundwater (OECD, 2017[36]). Allocation regimes commonly have an established sequence of priority uses to determine which sectors or uses will be allocated available water prior to others. In many OECD countries, domestic and human needs rank as the highest priority (e.g. Australia, Brazil, Colombia, Israel, Portugal) (OECD, 2015[35]). In some countries, water permits or water entitlements can be traded, leased or transferred. This occurs in formalised water markets such as in Australia (Murray-Darling Basin), Chile or Spain, or through an abstraction licensing system such as in the United Kingdom.
An allocation regime works best when coupled with instruments that provide incentives for efficient resource use and that remove perverse incentives for inefficient use. This can be done through appropriate abstraction charges or fees, which have been discussed earlier in this chapter.
Communities may already have allocation practices in place. Where these exist, valuing traditional knowledge through the recognition of indigenous peoples’ stewardship of land and water and customary water arrangements can potentially be an effective means to enhance sustainable development in a basin. The Balinese Subak system is an example of a local water allocation practice in Indonesia.
Compliance and enforcement of water allocation regimes can build public confidence in the management of water resources, discourage illegal activity, and drive positive action. Monitoring of water withdrawals and return flows is an important element of compliance and enforcement. Metering agricultural water withdrawals poses a challenge in some countries. In some countries metering, monitoring and reporting activities for agriculture are undertaken only in areas where significant abstractions occur. A declaration of water consumption could be an alternative way of monitoring agricultural water use. Compliance mechanisms can include sanctions for non-compliance with the rules and regulations of allocation regimes.
3.3.2. Pollution charges
The cost of water pollution is estimated at around IDR 45 billion per year (ADB 2018), yet pollution charges remain an underutilised economic instrument in Indonesia. What is more, the current level of charges is far from correcting externalities. More importantly, pollution charges can incentivise polluters to reduce dirty effluent loads, which leads to cleaner raw water sources, and ultimately to reduced treatment costs for drinking water supply.
Pollution charges are rarely a stand-alone policy. They are typically combined with regulatory instruments (effluent standards on treatment requirements for wastewater) and information instruments (on water quality and the performance of utilities and service provided) (OECD, 2021[17]). Regulatory instruments are particularly important, as these set environmental quality standards that ensure that the total pollution load does not breach ecological or human health limits (OECD, 2017[29]).
Table 3.4 presents the water pollution-related instruments in Indonesia. While policy instruments are present, implementation, monitoring and enforcement mechanisms need to be strengthened, and close coordination with environmental authorities is a critical factor for successful implementation (Lewis, 2019[11]). Local authorities have a critical role to play in collecting pollution charges and enforcing compliance with water quality standards (ADB, 2022[10]). An example of an integrated approach of stakeholder involvement, monitoring and enforcement in tackling pollution, is the Scottish Environmental Protection Agency’s strategy to manage diffuse pollution from agriculture (Box 3.6).
The Scottish Environment Protection Agency (SEPA, a non-departmental public body and environmental regulator) is responsible for enforcing the 2003 Water Environment and Water Services Act 2003. The Scottish strategy to tackle diffuse pollution builds on three key orientations: (i) the need for a meaningful engagement of stakeholders; (ii) the use of evidence and data in compliance monitoring enforcement; and (iii) the widely shared sense from the sector that shifting to sustainable farming practices is the only way to ensure farmers’ livelihood in the longer run.
A Diffuse Pollution Management Advisory Group was set up to include a wide range of interest groups. It developed a strategy to reduce diffuse pollution focusing on 14 priority catchments and focus areas.
The Scottish approach has been highly cooperative. Since 2001, the engagement with interest groups in public participation was established and maintained throughout the implementation process of the Act. During a period of two years, SEPA organised meetings with representatives of each policy sector to discuss new regulatory decisions and licenses, where stakeholders were able to bring arguments and evidence to have SEPA proposals modified. These discussions have created support for the adoption of the regulatory framework and reduced conflicts over binding measures through the development of trust between interest groups. SEPA also established a National Advisory Group engaging all key interest groups and providing a mechanism to resolve conflicts arising throughout the implementation process. In collaboration with professional organisations and farmers unions, the Scottish Government and SEPA worked with individual farmers to gain their trust and drive acceptability.
SEPA has developed interactive maps and tools to make the collected data on pressures and water quality more accessible. SEPA has used data and evidence to establish a common understanding of the status of the environment and on the level of commitment required to reduce water pollution. Scientific and photographic evidence of breaches and polluting practices has been presented to the farming sector representatives in dedicated meetings to convince the farming sector that diffuse pollution from agriculture is the main polluting source.
SEPA and the Scottish government have been clear from the outset that they would adopt a strict regulatory approach. Based on the results of the individual farmers’ audits, SEPA requires farmers and land managers to adopt measures to reduce polluting activities. Any issue of non-compliance identified during an initial visit would be addressed through subsequent revisits, followed by fixed monetary penalties if the non-compliance persisted. For the first cycle, the initial visits revealed a compliance rate of 34 per cent. At the end of several rounds of visits, 98 per cent of farmers carried out the required actions.
Source: OECD (2022[37]); De Vito, Fairbrother and Russel (2020[38])
It is recommended to increase pollution charges in Indonesia to correct externalities. Pollution charges are usually calculated based on volume and pollution content, and differentiated according to the sector, e.g., industries or agriculture (Acteon, 2010[39]). Other instruments, such as regulatory and voluntary instruments, need to support any economic instrument to effectively tackle pollution (Table 3.4).
However, examples of pollution charges for diffuse sources of pollution remain limited (OECD, 2017[12]). The heterogeneous impacts and damage costs of diffuse water pollution make their management more difficult than point source pollution. Additional reasons for the slow uptake of pollution charges in the management of diffuse water pollution may include: political resistance from polluters; limited data on the costs of environmental degradation; difficulties in measuring diffuse sources of pollution and attributing them to landowners; and the complexities of ambient pollution concentrations, which are a function of both point and diffuse pollution sources, natural background levels, watershed characteristics, fate and transport parameters, and stochastic environmental variables (OECD, 2017[12]; Shortle and Horan, 2001[40]). Because it is not economical to observe individual diffuse water pollution sources directly (i.e. fixing a water quality meter to a discharge pipe), the design of diffuse pollution charges must build upon one of three alternative management options:
Attach charges to certain land use practices and inputs as proxies to pollution. For example, intensive livestock farming, extensive non-permeable pavements, excessive fertiliser use and unsustainable tillage practices can lead to diffuse water pollution. However, such an approach can limit land use practices and innovation, and can be less effective at reducing pollution in some instances (OECD, 2010[41]).
Charge polluters collectively for their jointly determined impacts on ambient pollution levels at particular receptors. This approach transfers the burden of asymmetric information and the difficulties of the measurement of ambient diffuse pollution and predictions under certain management scenarios from regulators to individual polluters.
Attach charges to estimated diffuse emissions via modelling. Computer modelling offers an opportunity for individual land parcels to be managed as part of a wider catchment to achieve water quality objectives. Pollution charges to incentivise diffuse pollution can be set at a level directly proportional to the amount of estimated pollution generated or reduced. It allows land managers to innovate farm and land management practices within a pollution limit without being restricted by the inputs and land use practices they use. The approach relies on a robust calibrated and validated model and reliable input data.
3.3.3. Earmarking and collecting revenues from water taxes and charges
Contrary to what this chapter may imply, water taxes and charges are not primarily meant to mobilise funding for water infrastructure investment and maintenance8. Rather, the main economic rationale of water taxes and charges is to make users internalise the costs of water abstractions and pollution. Water taxes and charges are thus grounded on behavioural responses from users rather than on creating revenue from charging abstraction and pollution. However, in addition, abstraction and pollution charges do raise revenues from water users and polluters. From that perspective, they deliver best as water policy instruments if the revenues are used to cover expenditures that contribute to water management, possibly in the basin where they originate.
Public finance economists usually do not favour earmarking revenues collected from taxes (i.e. spending revenues from the taxes on specific projects related to the original purpose of the tax) for several reasons. First, they argue that public finance efficiency will be improved if the revenues from the tax are used to cut existing distortionary taxes (for instance, a wage income tax makes labour more expensive and may thus discourage work). This refers to the so-called double-dividend hypothesis: the environmental tax or charge (such as a tax per unit of pollution) addresses the environmental problem by sending signals on the damage caused (first dividend), and the revenues raised by this tax or charge can help reduce the distortions associated with existing taxes (the second dividend). Second, the revenue collected can finance any public spending not related to water management that is considered a priority, e.g. investment in infrastructure or, more generally, the provision of public goods and services such as education, national defence and security. Moreover, earmarking distorts budget allocation decisions since decision makers are not free to allocate spending on the basis of need or the value of public money, but have to accept predetermined allocation rules. Other examples of criticisms on earmarking is that scrutiny and control of governance may be weakened since spending does not have to be justified, there may be fluctuations in programme funding, and no necessary link between the earmarked tax and the provision of the good (ITIC, 2013[42]). For instance, on the one hand, a rise in revenues from earmarked taxes may lead to excessive spending; on the other hand, in case of a decrease, the earmarked taxes may only partly finance the programme; the link between the collected revenues and the cost of the programme is lost, with the effect that people may misperceive the cost of the programmes.
Nevertheless, earmarked taxes or charges can be defended based on political economy arguments. When revenues from the charge are earmarked, individuals “can make “private” choices on the basis of some reasonably accurate comparison of the costs and benefits of the specific public services, one at a time (Buchanan, 1963[43]). Moreover, other arguments in favour of earmarking include: the “benefits principle of taxation” (i.e. taxes should be borne by those who benefit from the associated expenditure); weak control and weak internal incentives in bureaucracies; mitigating erratic financing decisions of programmes; and the fact that budgeting with general fund financing (i.e. non-earmarking) may not be periodically reviewed to ensure that spending is allocated according to need and the value for money (Teja, 1988[44]).
Several measures can be adopted to compensate the drawbacks mentioned above from earmarking revenues from water charges or taxes. Typically, expenditures should be somehow related to revenues. The action plan adopted for public expenditure must be commensurate with the revenue collected. If not, stakeholders would not see the benefit from taxation either because the action plan is not implemented, or because the contribution of water charges to the plan is insignificant. It does not mean that the action plan should be strictly tied to revenues. Additional sources of funding could be considered, such as budget transfers. Moreover, the revenues and expenditures should be of the same magnitude for the water action plan to be realistic. Differences of one or more orders of magnitude undermine feasibility and credibility of the programme of action, and the legitimacy of the water charges. The rules for matching revenues to spending should be transparent and effective to improve the ‘benefit principle of taxation’. Earmarked revenues should be regularly reviewed, to ensure efficiency and relevance, with a view to phase out earmarking once the priority programme has been implemented.
Many countries opt to earmark water charges for pollution or abstraction. Charges can be earmarked for different types of environmental expenditures, and revenues can be shared across government (national, regional, local).
In Costa Rica, the water pollution levies for chemical oxygen demand and total suspended solids have been earmarked as follows:
70%: investment in sewer networks and household wastewater treatment;
15%: promotion of technology and clean production sources aimed at reducing contamination;
10%: monitoring by the entities of the Ministry of Environment and Energy;
In Poland, 100 per cent of the water effluent charges are earmarked to finance water treatment programmes. Abstraction charges for groundwater and surface water, however, are allocated as follows (with the condition that local governments may only use the revenues for environmental objectives):
Peru applies water abstraction charges (Retribuciones Económicas por el Uso del Agua, REUA), and uses the revenues for the following actions:
Formulation of water resource management plans per basin; management and administration of water resources in natural sources of water; integrated water management in less-favoured watersheds; and preservation of water resources in basin headwaters.
Control and monitoring measures to ensure the protection of water quality, an increase of water availability, conservation of sources of production and efficiency of water use.
In Turkey, the registration fee of water pollution control charge goes to the financing of municipalities.
Source: OECD (2021[45]) Pine database, https://pinedatabase.oecd.org/ (accessed 8 December 2022);
Collection of water taxes and charges
Collection of taxes and charges is a major challenge in Indonesia. Given the dire need of funding for the water sector, it may be worthwhile to introduce financial development targets for water charges and tariffs in the next Medium Term Development Plan. There are many ways of collecting charges, and different institutions can be tasked with collection simultaneously. For example, Peru applies different methods of collection of water abstraction charges, depending on the rights granted for the use of water (see Box 3.8).
In Peru, all water abstraction revenues (Retribuciones Económicas por el Uso del Agua, “REUAs”) are allocated to one budget, namely the budget of Peru’s National Water Authority (ANA). However, different actors are responsible for the collection of water abstraction taxes, depending on the rights granted for the use of water (Head Resolution No. 083-2019-ANA):
Users of surface water for agricultural purposes that receive the water supply service pay their charges to the hydraulic infrastructure operators:
Users of surface water other than farmers, users of groundwater, users of seawater and users with their own supply system pay to ANA annually, according to the volume of water used during the previous year. In case of failure of reporting, the volume used to calculate the charge is equal to the volume granted in the right of use.
Users with authorisation to discharge treated wastewater pay to ANA annually and in advance depending on the volume of the authorised discharge.
Users with water use authorisations pay to ANA annually based on the volume of water used. In case of failure to submit the reports, the volume used will be equal to the volume granted in the right of use.
Source: OECD (2021[45]) Water Governance in Peru
A favourable investment climate can channel more investments towards water infrastructure in Indonesia. As part of the National Dialogue on Water, a Focus Group Discussion was conducted to discuss the enabling environment for water investment in Indonesia (November 2022). The enabling environment can be characterised as a set of policies, regulations and institutional arrangements that facilitate investment in activities that contribute to water security. This includes sector-specific policies, regulations, and institutional arrangements as well as those relating to the regulation of the financial sector and capital markets.
The Focus Group discussed investment in water as a resource used by several sectors, such as water supply and sanitation services, agriculture, environment, disaster risk mitigation (flood protection), energy (hydropower) and industry. The Group discussed four dimensions of the enabling environment: the investment environment, channelling investment to water, projects sustainability, the water lens on investment in the wider economy (see Box 3.9).
The Focus Group agreed that the Indonesian water sector is considered as a promising investment opportunity. It has untapped business opportunities for foreign investors and commercial banks. Population is steadily growing, the economy is rapidly developing, and (treated) water demand is on the rise. Despite this bright prospect, the Indonesian water sector is still looking for foreign investment and private financiers to meet its everlasting financing demand for water infrastructure investment. Four critical priorities and strengths emerged from the focus group:
3.4.1. Limitations
Water sector regulation: Indonesian stakeholders evaluated their water sector regulation as poorly attractive for domestic and foreign investors in terms of revenue generation and operation efficiency of PDAMs. One of the main reasons is the limited opportunities for a robust business case, as the prevailing low water tariffs are insufficient to cover operations and maintenance costs of water treatment and supply. The role of a water service regulator to monitor and control the tariff setting process and operational performance is especially important to make the water sector attractive to domestic and foreign investors and private financiers. Indonesia has not established a national independent economic regulator that oversees the performance of service providers, guides on investment programmes, assesses customer service and reviews the tariffs (see Section 3.2.3). In addition, a governmental guarantee by central government agencies, such as the Indonesian Infrastructure Guarantee Fund (IIGF) is a key part of attracting private finance (ADB, 2020[46]). This poses a barrier in attracting investments in many low- and middle-income countries, as cash for de-risking is not readily available or sufficient, and risks and revenues are not always fairly allocated.
Decentralised for policies and investment decisions: Indonesia has an ambitious and well-designed Medium Term Development Plan and a Vision 2045 Toward Water Security. However, decentralised policies and investment decision making processes by local governments hinder or delay implementation of this ambitious blueprint. The lack of a clear roadmap for implementation of the National Master Plan is also indicated as an obstacle.
Data for decision making: The absence of comprehensive project data management among Ministries, public organisations, and the private sector affect the capacity to document the track record of water-related PPP, a crucial feature to attract domestic and foreign investors. Comprehensive data management, including on the performance of local PDAMs, is helpful to gain trust in the water sector from the private sector and stimulate the supply of private finance.
3.4.2. Strengths
Financing availability: Foreign investors consider Indonesia as untapped PPP market full of business opportunity. Singapore, Malaysian and Chinese companies have participated in several hydropower and drinking water supply PPP projects. The Indonesian government issued a Green Fund to facilitate infrastructure development including water projects. Furthermore, the Indonesian government launched the Green Infrastructure Bond to facilitate climate resilient infrastructure development including water infrastructure. Indonesia has a solid local financial market, able to meet financial needs for various PPP projects. The pending issue on financing availability is how to secure the repayment capability of local governments to domestic and foreign private financiers. In a nutshell, local water supply is solely administered by local governments. It means that guarantors of PPP projects on local water supply are local governments. Therefore, sound financial stability and strong commitment of local governments to pay back commercial loans are key to facilitate private financiers’ engagement in water projects.
Access to affordable finance: As a result of a business-friendly investment policy, ample PPP project opportunities, and overall national economic development, the Indonesian water service providers can access affordable finance. However, financiers are still concerned about local governments’ capacity to pay back loans or capital, which is a key barrier for financing water in Indonesia as this is largely led by local governments.
The National Development Strategy: The National Development Strategy of Indonesia stipulates that improving water security is one of its main goals and acknowledges the importance of the Water-Food-Energy Nexus. In addition, this masterplan considers the correlation between water and climate change.
1. A sound investment environment
This dimension focuses on the enabling conditions required for providing opportunities for all investors (public and private, large and small, and foreign and domestic) in the country. This dimension consists of a set of macro-economic indicators defining the national investment environment from external data sources and series of questions.
2. Channelling investment to water
This dimension focuses on the specificities required to attract investment to water sectors. A sound investment environment will attract and grow the scale of investment at a national level, however water sectors attractiveness also depends on particular elements such as sector specific policy and regulation, the business model and revenue stream elements.
3. Sustainable projects
This dimension focuses on the projects requirements to ensure the sustainable of the investment, meaning the project value, impact, and the support required, which relates to the ideation and investigation phases of the projects and its operation and monitoring.
4. An economy wide water lens
This dimension focuses on how the wider economy considers water, in particular how economic sectors manage their impact on water resources and consequently, support or undermine water security.
Source: OECD (forthcoming) Enabling environment for water investments - score card
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Notes
← 1. Improved water sources include drinking water from piped water sources and drinking water from non-piped improved water sources, e.g., boreholes or tubewells, protected dug wells, protected springs, rainwater, and packaged or delivered water. This definition was derived from the SDG 6.1.1 data portal: https://sdg6data.org/en/indicator/6.1.1 (accessed on 21 February 2023).
← 2. Drinking water from an improved water source which is located on premises, available when needed and free from faecal and priority chemical contamination, is considered as a safely managed drinking water service. This definition was derived from the SDG 6.1.1 data portal: https://sdg6data.org/en/indicator/6.1.1 (accessed on 21 February 2023).
← 3. Ministry of Home Affairs Regulation 71/2016: Guidelines for Setting Tariffs of Drinking Water
← 4. Regulation 22/2021
← 5. River Basin Authorities, as a government entity, are not allowed to incur any charges on water. This is an exclusive right of non-government entities.
← 6. A revolving fund is a financing mechanism that allows a fund to be replenished through the repayment of loans, rather than relying on external sources of funding. In the context of water utilities, revolving funds are often used to finance the provision of water and sanitation services in low-income areas. Water utilities may use revolving funds to provide loans or subsidies to low-income households or communities to help cover the costs of connecting to the water supply network or improving their sanitation facilities. As households or communities repay the loans, the funds are replenished, allowing the utility to provide assistance to additional households or communities.
← 7. The following section is based on the OECD (2021) Toolkit for Water Policies and Governance: Converging Towards the OECD Council Recommendation on Water.
← 8. This paragraph originates from the OECD (2017) report on Water Charges in Brazil: The Ways Forward.