WHAT ECONOMISTS NEVER TOLD US:
THE ELUSIVE SOLUTION TO
HIGH PUBLIC SERVICE RATES
All of my writings, all of my recommendations, all government reforms that have to be undertaken towards reduction of our unduly high public service rates, have to culminate in what I wrap up in this paper. If there is a “magic formula” towards reasonable power, water, telecom, toll-road, and other service rates in captive markets attended to by public interest, this is it.
THE CASE FOR REGULATION
OF CAPTIVE MARKETS CLOTHED
WITH PUBLIC INTEREST
OBSERVE THAT ALL OF OUR HIGH POWER,
WATER, TELECOM, AND TOLL-ROAD RATES
ARE ROOTED FROM A COMMON DENOMINATOR:
LACK OF ENFORCED SAFETY NET AGAINST
OVERPRICING: RATE-OF-RETURN LIMIT
THE SOLUTION THEN TO OUR UNDULY HIGH
PUBLIC SERVICE RATES IS ENFORCEMENT
OF REASONABLE RATE-OF-RETURN CEILING
TO BEGIN WITH,
THE BASIC PREMISE OF DEMOCRATIC GOVERNANCE:
THE GREATEST GOOD FOR THE GREATEST NUMBER
Under Article II of the Constitution: “The Philippines is a democratic and republican state. Sovereignty resides in the people and all government authority emanates from them…. The prime duty of government is to serve and protect the people.”
In effect, our Constitution and laws have adopted the majority rule as normal basis of decision making, with simple majority of one or two-thirds majority as winning vote on crucial issues. In essence, majority rule translates to the greatest good for the greatest number under democratic governance.
Free-market Economists have Ignored
the Greatest Good for the Greatest Number
in the Privatization of—or Awarding of Franchises
in—Captive Markets Clothed with Public Interest,
Thereby Resulting in Unduly High Public Service Rates
Our very high public service rates, which stick out like a sore thumb in Asia, is an economic problem that has victimized not only big and small businesses but also generally poor consumers and commuters nationwide. We have abnormally high power, water, telecom, and toll-road rates in the region. We also have very high medicine and agro-chemical prices. For example, our second highest power rates in Asia (next only to those in Japan) have for so long served as heavy burden to business and stumbling block to our rapid industrialization and faster economic growth.
THE ROOT AND COMMON DENOMINATOR
OF OUR VERY HIGH PUBLIC SERVICE RATES:
LACK OF ENFORCED RATE-OF-RETURN CEILING
ON ALL—REPEAT ALL—PUBLIC SERVICE PROVIDERS!
HOW THIS CAME ABOUT IS UNFLATTERING TO
THE PHILIPPINE ECONOMICS “PROFESSION”
There is a common denominator or cause of our unwarrantedly high public service rates in the power, water, telecom, toll-road, and probably other public service industries that cater to mass consumers and commuters—lack of properly enforced rate-of-return limit on government authorized public service providers. Obviously, if there is an effectively implemented profit-rate ceiling, EVEN IF THERE IS NO COMPETITION, public service rates cannot go beyond reasonable levels—this is basic and plain common sense.
Conversely, even if there are competing oligopolistic public service providers, if there is no prescribed profit-rate limit, cartelized operation or regulatory capture can easily nullify the price-lowering effect of competition.
Root of Lack of Enforced Rate-of-Return Limit:
Products of Local and Foreign Top Universities—
Dominant Free-Market Economists Unskilled in the Fine
Points of Properly Managing the Two Types of Market:
(1) the Really Free Market for Thousands of Ordinary Goods
and Services, and (2) the Captive Markets for Relatively Few
Basic Necessities Clothed with Public Interest, to Which
the Power, Water, Telecom, and Toll-Road Markets Belong
From management audit standpoint, the Philippine economics “profession” has failed to help the government shape national economic policies and practices that spur economic development, promote equality and inclusive growth, maintain a fair balance between the conflicting interests of business and consumers, and bridge the gap between the poor and the rich.
Our abnormally high power rates, for example, have long served as obstacle to our industrialization and fast economic growth, yet our economists in and out of government have not offered the readily available solution that will definitely bring down our country’s second highest power rates in the region to reasonable level—strict enforcement of the Supreme-Court-ruled 12% rate-of-return limit, to be calculated based on net income before income tax (ERB vs. Meralco, G.R. No. 141314, November 15, 2002).
As explained further later, Meralco’s return on equity (ROE) as of 2015 stood at 31% before income tax and 24% after income tax, in violation of the Supreme Court ruling either way we look at it. Under the situation, if Meralco’s rate of return is adjusted downward to 12% as required by jurisprudence, its rates will definitely go down, so why is the Philippine economics “profession” deafeningly silent on it, despite my repeated emails to key members of it in the past?
Thus, our high public service rates are caused by lack of properly enforced rate-of-return ceiling, rooted in turn from the failure of the academe in the Philippines and abroad to produce Filipino economists who can distinguish between—and treat differently—the two types of market: the really free market for ordinary goods and services and captive market for basic necessities clothed with public interest. This problem stems from the dominance of free-market economists in the academe. They do not teach the fine points and applicability to crucial captive markets of regulation—probably because they are biased against it, they themselves were not taught about it in their student days in business schools, they are inexperienced on it, and they are simply not experts on it.
The past oil industry regulation was conceptualized by one of my former immediate bosses, then Bureau of Energy Utilization Director Orlando L. Galang, a chemical engineer—not an economist—and alumnus of Texas A & M University, Under it, oil prices were limited to those that will yield rock bottom peso profit per liter of petroleum products sold. From it, I learned to appreciate the need for regulation in captive markets affected with public interest. I improved on what I saw in the past by espousing not peso-per-unit profit limit but percent rate-of-return ceiling. To my recollection, the oil industry—or at least Petron Corporation where I served as Controller before changing career to become a modest entrepreneur—was then earning way less than 8% return on equity. Now, under deregulation, we do not even know what rate of return the oil industry is earning, or whether it engages in overpricing or not—definitely not the proper way to manage the economy.
What Competition as Price-Lowering Economic Tool
Has Failed to Do Indirectly in Deregulated WESM under
Fallacious EPIRA (RA 9136)—Bring Down High Power Rates—
Regulation with Proper Enforcement of Rate-of-Return Limit
Will Do Directly in the Power Generation Industry, and Such
Regulation Applies to Other Crucial Captive Markets as Well
“Economists firmly believe that voluntary transactions in free markets tend to work toward the common good. But they also believe that nearly every participant in the market place would love to rig the system in his or her own favor.” [Sean Masaki Flynn, Economics for Dummies (NJ: Wiley Publishing, Inc., 2005) p. 334]
Therefore, instituting free-market COMPETITION under DEREGULATION does not always mean low prices, because profit-maximizing market players will instinctively work for more profits for as long as they can, as in the case especially of our ultra high medicine prices before the passage of the Cheaper Medicine Act in 2008 (RA 9502).
As part of human nature and rapacious greed, despite presence of numerous suppliers, free market can yield high prices to the extent the MARKET CAN BEAR—without regard to actual low cost of goods sold by the competing market players, an advantage that they keep to themselves and do not share as price reduction to consumers—for as long as there is opportunity for “every participant in the market place... to rig the system in his or her own favor.”
The government should be proactive, not reactive. It should plug vulnerabilities to, or opportunity for, market rigging. It should promptly institute the safety net against already existing—not just impending—unreasonable rates in the power, water, telecom, and probably other crucial captive markets: reasonable cap in rate of return.
Why Regulation of Captive Markets
Will Not be Unfair to Public Service Providers:
They Will Not be Forced Against their Will to Serve,
They Will Serve the Captive Markets, With Sure Demand
From Mass Consumers, Under Regulation Rules Set by
the Government Because it is Still More Profitable
for them to Do So Compared to Available Alternatives
In affirming its landmark decision that disallowed deduction from net income of corporate income tax in the reckoning of Meralco’s entitlement to 12% reasonable return (ERB vs. Meralco, G.R. No. 141314, November 15, 2002), upon Meralco’s appeal, the Supreme Court ruled further, as follows:
“The business and operations of a public utility are imbued with public interest. In a very real sense, a public utility is engaged in public service—providing basic commodities and services indispensable to the interest of the general public. For this reason, a public utility submits to the regulation of government authorities and surrenders certain business prerogatives, including the amount of rates that may be charged by it.” (Republic of the Philippines, represented by Energy Regulatory Board vs. Manila Electric Company, G.R. No. 141314, April, 9, 2003).
Therefore, in the privatization of government public-utility operations and awarding of franchises to public service companies, like those in the power, water, telecom, and toll-road industries, the government should set franchise or concession conditions protective of consumers and commuters, such as 12% or lower rate-of-return ceiling.
For as long as there are takers—which means that the government franchise or concession conditions are still more advantageous to private investors compared to their opportunity cost, the government should stick to those conditions. Only if there are no takers should the government sweeten the pot to attract investors.
THE FUNDAMENTAL SOLUTION
TO OUR UNDULY HIGH PUBLIC SERVICE RATES
THAT HAS ELUDED FOR SO LONG OUR HIGHLY
EDUCATED ECONOMISTS AND FINANCE EXPERTS
IN AND OUT OF GOVERNMENT AND ACADEME:
PROPER ENFORCEMENT OF RATE-OF-RETURN
CEILING TO PUBLIC SERVICE PROVIDERS—
THE SAFETY NET AGAINST OVERPRICING
There is a basic and common-sense solution that has been lacking and has seemingly eluded even our reputable economic and finance experts—proper enforcement of reasonable rate-of-return ceiling, which currently stands at 12% for public utility monopolies, as ruled by the Supreme Court in 1966 and reiterated in 2002 (ERB vs. Meralco, G.R. No. 141314, November 15, 2002). The lack of enforced rate-of-return ceiling stems from the following:
1. Lack of proper regulation of oligopolies in captive markets affected with public interest, such as those in the telecom industry, followed by those in the power generation industry which have been deregulated under the Electric Power Industry Reform Act (EPIRA) of 2001 (RA 9136).
2. Lack of proper regulation of even the monopolies already subject to regulation pursuant to Section 19, Article XII of the Constitution—those operating in captive markets for public services clothed with public interest, such as in the power, water, and toll-road industries.
Following are the key performance indicators of lack of proper regulation of monopolies Meralco and Maynilad Water: their excessively high rates of return on equity (ROE) based on their annual financial reports to stockholders and Securities and Exchange Commission (SEC):
Meralco ROE: Maynilad ROE:
2011: 20% 2008: 247%
2012: 25% 2009: 147%
2013: 23% 2010: 82%
2014: 23% 2011: 59%
2015: 24% 2012: 44%
The foregoing rates of ROE were calculated based on the conventional method of reckoning profit: net income AFTER income tax. In the case of Meralco, if the rate of return is determined based on the Supreme Court ruling that disallowed INCOME TAX deduction in the reckoning of 12% reasonable rate of return, Meralco’s ROE based on net income BEFORE income tax is a whopping 31% in 2015! Is the Supreme Court ruling a joke that ERC and Meralco can make a mockery of it and violate it with impunity?
HOW TO INSTITUTE PROPER
REGULATION OF CAPTIVE MARKETS
IMBUED WITH PUBLIC INTEREST
HOW TO ENFORCE RATE-OF-RETURN LIMIT
UNDER PROPER REGULATION OF MONOPOLIES
AND OLIGOPOLIES IN CAPTIVE MARKETS FOR BASIC
NECESSITIES AFFECTED WITH PUBLIC INTEREST
Under a system of fair and justifiable regulation, reasonable rate-of-return limit can—and should—be applied to all monopolistic and oligopolistic public service providers in captive markets clothed with public interest, including the power-generator oligopoly deregulated under EPIRA (RA 9136).
As Change for the Better
Under Privatization, Private Power Generators
Should be Subject to 12% Reasonable Return Limit
Allowed to Monopolies, or Preferably Lower; Allowing
them Higher Rate of Return Will Make Privatization
a Change from Bad to Worse, Not Change for the Better
If regulated monopolies like public utilities are entitled to 12% maximum return on investment (ROI) under a 1966 Supreme Court ruling on Meralco, reiterated in its landmark decision on Meralco corporate income tax (ERB vs, Meralco, G.R. NO. 141314, November 15, 2002), then as change for the better under EPIRA-mandated privatization, competing deregulated private generators should be entitled to less than 12% ROI, or at most equal to it, otherwise the change will be from bad to worse.
Privatization in the power generation industry is a shift from regulated government monopoly without competition—the power-generator National Power Corporation (NAPOCOR)—to deregulated private oligopoly with supposed competition. It is intended to be a change for the better, from a monopoly without competitors to oligopoly with price-lowering competition.
If so, as key performance indicator (KPI) of the change for the better, as regulated monopolies NAPOCOR and Meralco, as well as other public utility monopolies, are entitled to maximum 12% return on investment as ruled by the Supreme Court (ERB vs. Meralco, G.R. No. 141314, November 15, 2002), then—as proof of change for the better—the private oligopoly with competition should be entitled to return on investment lower than, or at most equal to, the 12% rate-of-return ceiling for the cited monopolies without competition—otherwise what is privatization with competition for?
Unfortunately, this safety net against overpricing has not been injected into the government’s management of the power industry—resulting in the rise, rather than reduction, of our power rates that have earned the notorious distinction of being highest in the region except Japan. It will not be surprising if this way of ensuring change for the better may have never even occurred to our government planning, economic, and financial experts who, if asked, may not know even if deregulated oligopolistic power generation companies are already exploiting unfettered free market—through overpricing, as may be betrayed by excessively high actual rates of return on their investments. This utter lack of consumer protection against overpricing under fallacious privatization is an example of why we cannot leave everything to economists.
To Attain its Elusive Goal,
REGULATION Should Start Right from
Public Bidding of Privatized Public Services,
and the Bidding Should Zero In On the Two
Determinants of Reasonable Return to Private
Investors and Reasonable Rates to Consumers:
COST and PROFIT Components of Service Rates
The elusive goal of REGULATION is to provide reasonable return to private investors that equates to reasonable rates to the paying public. The reasonable return to public service companies has to be determined first, then whatever are the rates that will yield reasonable return to them will be deemed the reasonable rates to consumers.
Following are the proper objects of competitive public bidding on the two components of service rates—COST and PROFIT:
1. Competition on LOWEST PROJECT CONSTRUCTION COST, in order to keep as low as practicable the project investment cost that the winning bidder has to recover through service rates from the paying public. This is precisely the main objective of public bidding on procurement of government infrastructures under the Procurement Law (RA 9184), whether or not the projects will be charged to the using public.
2. Competition on LOWEST percent RETURN on EQUITY (ROE), which the winning bidder will earn as part of regulated service rates during the concession period, aimed at lowest profit-generation charge to consumers. However, the lowest ROE should not exceed 12%, the rule of thumb on rate-of-return ceiling under Supreme Court ruling (ERB vs. Meralco, G.R. No. 141314, November 15, 2002), Section 12 of the MWSS Charter (RA 6234), and Section 2 (o) of the Build-Operate-Transfer (BOT) Law (RA 6957 as amended by RA 7718). This ceiling applies to monopolies in captive markets characterized with public interest, like public utilities, telecom, and toll-road industries.
If the winning bidder on lowest project construction cost is different from the bidder which offered the lowest rate of return on completed project operation and maintenance, then there should be two winning bidders—one for infrastructure construction and another for project operation and maintenance during the concession period. This scheme will rein in within reasonable range the annual rate of return of the service providers through the indispensable tool of rate regulation—return on equity (ROE) ceiling acceptable to both the government and private investors. This includes disallowance in rate setting of constitutionally prohibited irregular, unnecessary, extravagant, excessive, and unconscionable capital and operating expenditures.
In the case of corporations, the term investment in the Supreme-Court ruled 12% reasonable return on investment (ROI) should logically refer to corporate stockholders’ invested capital, called equity in the corporations’ books of accounts and Balance Sheet. Hence, the needed rate-of-return ceiling should be properly expressed as return on equity (ROE), not return on rate base (RORB) as currently provided in the MWSS Charter, (RA 6234), as well as in Section 9.1, Article 9 of the MWSS concession contracts with Maynilad and Manila Water. Why RORB is a wrong profit-rate limit is illustrated in ANNEX A.
3. Separate Competition on PROJECT DESIGN where applicable, in order to tap the expertise of competent and creative design professionals who are not necessarily working with the potential winner in competitive bidding on lowest project construction cost.
Roads and bridges have more or less standard design, which can be customized depending on the required load-bearing capacity and other specifications of each particular project, therefore the proponent government agency itself can prepare the project design, to serve as common basis of bidding competition on lowest project construction cost and ROE ceiling.
However, where the project lends itself to varying creative designs—like an international airport—where the best and most suitable design may be submitted by a losing bidder on lowest construction cost, there will be a problem in using the submitted best design by the sulking losing bidder, which may not allow its use. In this case, there should be a separate prior public bidding for the infrastructure design, where the government will offer a fee for the winning design. Thereafter, the winning design will be the one subjected to competitive bidding on lowest project construction cost, as well as lowest ROE ceiling on completed project operation and maintenance.
MODEL PRICE REGULATION:
How to Implement the 12% ROE Ceiling
as MAXIMUM Rate but NOT as GUARANTEED Rate
- Institution of Safety Net Against Overpricing Through Setting Profit-Rate Ceiling, With Service Rate Limited to the Level that Yields the Allowable Maximum Profit Rate
With the help of PLANNING experts, government regulators should properly enforce the 12% ROE ceiling on public service companies, Based on actual and projected industry data, they should set the regulated service rates, designed to yield 12% ROE, under normal operating capacity of each regulated industry, as shown below:
Prepare projected annualized industry Income Statement at present cost levels and under normal industry operating capacity:
a. Indicate the estimated annual costs and expenses at current levels using normal industry “production/sales” volume.
b. Calculate the net income that will yield 12% ROE to the industry based on the present industry Stockholders’ Equity.
c. Add the total costs & expenses and net income to derive the needed revenue or sales at 12% ROE.
d. Divide the revenue by the annual “sales” volume to arrive at the regulated rate at 12% ROE ceiling.
- Institution of Safety Net Against Bloated Expenses, which Serve to Reduce Net Income and Consequently Raise Service Rates to Attain Targeted Net Income at Rate-of-Return Ceiling
In calculating service providers’ Net Income for rate-of-return determination, irregular, unnecessary, excessive, extravagant, or unconscionable expenditures should not be allowed as deduction from their Revenue. These types of anomalous expenditures are not allowed as government disbursements under Section 2 (2), Article IX-D of the Constitution. The paying public under government protection should not be made to shoulder such anomalous disbursements as part of public service rates.
To guard against bloated expenses, ERC should require Meralco (as well as other similarly situated power marketers) to submit annual special-purpose financial statements that show the calculation of Meralco’s actual rate of return. The financial statements should be audited by an ERC-accredited independent auditing firm of CPAs. ERC should issue guidelines on how to calculate Meralco’s rate of return. The guidelines should provide that income tax, as well as other expenditures that are irregular, unnecessary, excessive, extravagant, or unconscionable should be disallowed as deductible expenses in net income and rate-of-return determination. On a test basis, government regulators should review the findings of the independent CPAs—which can be done, such as through looking at their working papers, particularly their analyses of crucial accounts. This provision should be made as pre-condition to ERC’s accreditation of the independent CPAs.
ERC should likewise require Meralco to conduct competitive bidding in the procurement of high-value equipment and services, like transformers, infrastructures, contract works, etc.. It should explicitly prohibit procurement of equipment and services through negotiated contracts from subsidiaries, sister companies, affiliated companies, and companies with which it has interlocking directorate.
- Economic solutions or measures should be condition oriented; the government should apply separate treatments for distinctly different power generation costs of power generators.
For refinement, accuracy, and fairness, separate calculation and setting of regulated rates should be done for each type of power-generation plants with separate and distinct normal generation cost per kWh. This means that a separate regulated rate will be set for each of hydro, geothermal, coal-fired, bunker-oil-fired, diesel-fired, natural-gas-fired, wind, solar, and other types of power plants and facilities.
This way, while consumers will be constrained to pay high rates for electricity from high-cost generating plants (which cannot be avoided because these plants are needed in meeting total power demand), they can enjoy low rates for power from low-cost plants—an improvement over the present situation, especially in WESM, where the unavoidable high rates set for high-cost power plants also apply to low-cost plants.
The suggested scheme is fair to consumers. It is also fair—or clearly not unfair—to power generators because all of them are entitled to the same 12% reasonable return ceiling, the absolute amounts of which are dependent on the varying amounts of their respective capital investments.
Once government regulators have set industry service rates at 12% ROE ceiling under normal operating capacity, any industry member that will operate below its capacity owing to shutdowns, force majeure, or inefficiency shall understandably earn a rate of return lower than the 12% ROE ceiling.
Thus, the 12% ceiling is the maximum allowable ROE but it should not be a guaranteed profit rate. To attain it, regulated companies have to work hard and achieve performance targets, like fixed schedule of annual reduction in unbilled volumes from distribution losses.
With the regulated rates under normal operating capacity already designed to yield investors the 12% ROE ceiling—or whatever is the agreed upon lower ROE ceiling—any further rate increase allowable by government regulators should be for cost-increase recovery only, otherwise any cost over recovery will result in higher net income and ROE that will breach the ROE ceiling. This means that contrary to the existing practice, shutdowns of some power plants that cause shortfall in power supply will not be a ground for rate increase in WESM by remaining operating plants.
* * *
To reiterate, if there is a "magic formula" toward reasonable power, water, telecom, toll-road, and other service rates in captive markets affected with public interest, this is it. There seems no alternative to it. Can members of the Philippine economics "profession" find a substitute to it? If they can, let them come up with it—in service of the people, the government, and their own families victimized by unduly high public service rates.
MARCELO L. TECSON
A CPA and Concerned Citizen
Former Controller, Petron Corporation
Former Head of Planning Group, PNOC Energy Companies
Former Head of Planning Group and Internal Audit & Systems
in the then local subsidiary of a US multinational oil company
Former Chief Accountant and later Financial and Management
Service Chief of what is now the Department of Energy (DOE),
where he gained insights on how to fight corruption in government
Former insider in oil industry regulation; directly responsible for
preparation of implementing rules, calculation, and processing
of multi-billion-peso reimbursements from the then subsidy-free
Oil Price Stabilization Fund (OPSF), done without any Commission
on Audit (COA) disallowances
San Miguel, Bulacan
Cc through separate letters/emails:
Select executive and legislative government officials
Select members of media, academe, and economic society
Select civil society groups and concerned citizens, etc.
ILLUSTRATIVE EXAMPLE OF MONUMENTAL ERROR IN USING
RETURN ON RATE BASE (RORB) AS RATE-OF-RETURN CEILING
FOR PUBLIC SERVICE COMPANIES THAT USE BORROWED FUNDS
Let us assume the following financial data (in Philippine pesos):
Assets in operation (99 funded by loans and 1 by equity) …...… 100
Liabilities (Loans) ............................................................................. 99
Equity (Capital) ………………………………………………………….. 1
Interest on loans (loan balances constant during the year) .….… 11.88
Net income for the year….................................................................. 12
The respective returns to creditors and stockholders are as follows:
Rate of return to creditors:
Interest payments to creditors, 11.88 over 99 loans ……………. 12%
Rates of return to stockholders:
RORB: 12 net income over 99 + 1 or 100 assets in operation ..... 12%
ROE: 12 net income over 1 Equity ..……………..…….…....... 1,200%
Analysis of Financial Statistics
a. Return to Creditors: The creditors’ return on loans used to acquire P99 worth of assets consists of the P11.88 or 12% interest on loans incurred by the company as interest expense, thereby resulting in reduced net income already net of creditors’ return on the assets financed by them.
b. Return to Stockholders: For their 12% maximum RORB, with assets used in operation as rate base, corporate stockholders are entitled to P12 net income or 12% return on P100 total assets used in operation. The P12 net income is broken down as follows: (1) P11.88 or 12% return on the P99 assets financed by creditors, and (2) P0.12 or 12% return on the P1 asset acquired out of stockholders’ capital investment or equity.
Clearly, under fallacious RORB, there is double reckoning of return on the P99 creditor-financed assets—first, to creditors as P11.88 interest on loans, and second, to stockholders as P11.88 net income even if they were not the ones who funded the acquisition of the P99 assets. The result is pure and simple DOUBLE BILLING to consumers.
In the example, the stockholders will recover within one year 12 times their invested capital or equity, yet they will still NOT EXCEED the prescribed 12% RORB ceiling, exactly the reason why, in the case of Maynilad, despite its unconscionably high rates of return on equity (ROE) of as much as 247% in 2008 and 147% in 2009 based on its annual reports to stockholders, it did not exceed the 12% RORB ceiling imposed by Section 12 of RA 6234 (MWSS Charter) as well as by Article 9, Section 9.1 of the MWSS concession agreement that adopted the 12% RORB limit set by the MWSS Charter.