This is the authors version published as:

Pribadi, K.S., Soekirno, P., dan Pangeran, M.H. (2006). Stochastic Dominance Approach in Evaluating Concession Modality of Public Private Scheme Investment in Water Supply, Proceedings of the Civil Engineering Conference, Surabaya, pp. 257-264.

International Civil Engineering Conference "Towards Sustainable Civil Engineering Practice" Surabaya, August 25-26, 2006

STOCHASTIC DOMINANCE APPROACH IN EVALUATING CONCESSION MODALITY OF PUBLIC-PRIVATE SCHEME INVESTMENT IN WATER SUPPLY

Krishna S. PRIBADI1, Purnomo SOEKIRNO1, M. Husnullah PANGERAN2

ABSTRACT: A model to evaluate various concession modalities of investment in urban water supply provision on a public-private participation scheme is proposed. The model is based on stochastic dominance approach applied in investment cashflow simulations in uncertain condition. Water supply infrastructure is unbundled into different concession modalities, such as raw water provision, water treatment plant, transmission and distribution up to revenue collecting service, and risk profile of each modality is presented. Risk factors involved in the model include tariff uncertainty, rate of nonrevenue water, exchange rate fluctuation, water consumption and uncertainty in operational costs. A case study of a water supply concession private investment was analysed and the result shows that the stochastic dominance approach provided the decision makers with a deeper insight into the risk profile of the porto-folio, which greatly help in decision making process. KEYWORDS: water supply concession, risk analysis, stochastic dominance, cash flow, simulation, risk/return profile. 1. INTRODUCTION Involving the private sector in infrastructure provision through a public-private partnerships (PPPs) scheme has been currently become a global trend. From the PPP point of view, the water supply system forms an entity of physical and non physical components of infrastructure and services which can be realized under any possible form of partnership scheme. The contract may include different modalities, ranging from the provision of raw-water intake, water-treatment, transmission and distribution, up to revenue collecting service. The arrangement options are quite broad and involve a continuum ranging from low to high end PPP, such as service-, management-, leasing-, BOT -, and concession contracts. Divestiture under license or new entry of private sector participants through BOO arrangement are also possible options (see World Bank,1997 ; Asian Development Bank, 2000). However, despite its potential market, private investment in urban water supply sector in Indonesia has not been advancing significantly. It is understandable that private sector always looks for a profitable, secure and competitive investment, whilst investing in infrastructure is always associated with high capital outlay, long lead time, long operation, with a broad range of risks of uncertainties. Investing in water supply in Indonesia is always faced with major uncertainties, which include the trend for stagnancy in water tariff and the high non-revenue water due to various factors. Various alternative strategies to define water concession modality can be devised to reduce the risk in investing in water supply infrastructure, as it can be divided and unbundled into different parts such as
Lecturer Staff, Construction Engineering and Management Division, Faculty of Civil Engineering and Environment, Institut Teknologi Bandung 2 Graduate, Master Program in Infrastructure Engineering and Management, Faculty of Civil Engineering and Environment, Institut Teknologi Bandung
1

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raw water provision, water treatment plant, transmission and distribution, up to revenue collecting service. The paper presents the development of a model to select the best water concession modality based on a stochastic dominance approach. The model simulates the investment cashflow in uncertain condition. Traditionally, there are ways to evaluate financial viability, but most of them are based on certain project cashflow assumption, including the risk-adjusted discount rate methods (such as capital asset pricing model, arbitrage pricing theory, and the weighted average cost of capital) [1]. The output of a risk-based analysis of financial viability is not a single-value of the selected figures of merit, but a probability distribution of all possible expected returns. This is where the suitability of the stochastic dominance approach can be found. Thus the result of a stochastic risk analysis presents the decision maker with an additional aspect of the investment risk/return profile [2]. The final decision is therefore subjective and rests to a large extent on the investor's attitude towards risk. The general rule is to choose the investment with the probability distribution of return that best suits one's own personal predisposition towards risk. A more complex situation can be found where decision involving two or more mutually exclusive alternives has to be made. The model can eventually be developed as a tool to propose different water infrastructure investment schemes to the private sector. The private sector can then select most suitable concession scheme based on the proposed modalities, each of them having its own risk profile. 2. THE RULES OF STOCHASTIC DOMINANCE APPROACH The stochastic dominance is a methodology for identifying investment choices which are optimal for a given class of decision makers, as defined by their utility functions for wealth [3]. Stochastic dominance (SD) rules are used to divide the sets of all feasible uncertain prospects into efficient and inefficient sets (partial ordering). The SD rules (as well as the mean-variance rule) assume that investors agree on the available distributions of returns [4]. In the stochastic dominance approach, random returns are compared by a point-wise comparison of some performance functions constructed from their distribution functions [5]. As a risk/return performance indicator, stochastic dominance describes a decision procedure that is applicable to risk averters and does not require specification of the individual utility function [6]. If certain assumptions on the type of the decision makers utility function are fulfilled, stochastic dominance rules can be used in place of expected utility rules, thus estimating utility function can be avoided [7]. The above authors argued that first order stochastic dominance (FSD) and second order stochastic dominance (SSD) showed significant similarities in terms of risk management. FSD and SSD are the most commonly used varieties of stochastic dominance. FSD is based on the assumption that individuals or decisionmakers prefer more rather then less of a given variable (i.e. outcomes). One statistical distribution dominates another if its cumulative distribution always lies to the right of the second distribution. The cumulative probability distribution of the outcomes is more useful for decisions involving alternative investments while the non-cumulative distribution is better for indicating the mode of the distribution and for understanding concepts related to expected value. On the other hand, the SSD is more useful if the decision maker is risk averse and prefers higher outcomes rather than lower outcomes. In contrast to first-degree stochastic dominance, SSD involves the comparison of areas under the CDFs for various plans and, in general, has more discriminatory power than does FSD. For developing the model for comparing and measuring the alternative options of concession modality, the authors used both rules of FSD and SSD, as discussed above, and the following definitions and assumptions were used : Definition 1 First Order Stochastic Dominance :

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If A and B are two concession modality options, the return of A (i.e. its NPV or IRR) stochastically dominates that of B to the first order, denoted by A FSD B, if and only if :

FA (x) FB (x) for all x

(1)

Where FA(x) and FB(x) is the right (ascending order) cumulative distribution function of A and B in the interval [a,b]. Thus, if the cumulative distribution of A is equal to or below that for B for every level of wealth, then concession A is preferred to (or dominates) concession B. However, this definition can be used only if the distributions of each concession do not cross each other. On the contrary, if the two are crossing , their preference can not be compared in terms of first-order stochastic dominance [6]. In this case, to compare options with crossing CDFs, the authors used the terms of higher orders stochastic dominance as described below: Definition 2 Second Order Stochastic Dominance : A return of the concession modality option A stochastically dominates that of B to the second order, denoted by A SSD B, if and only if :

FB (x) dx

(x) dx for all x with inequality for some x

(2)

To demonstrate the first and second order stochastic dominance as discussed above, the authors use a probabilistic risk analysis latin hypercube simulation technique, based on cashflow model using @RISK commercial software to find out the probabilistic dimensions of NPV and IRR of investment in their CDFs shapes [8]. The simulation technique is an option to the more traditional Montecarlo simulation. This simulation technique had also been used to analyze financial risk of Indonesian toll road concession schemes [9]. The model and assumptions is described further below. 3. MODEL AND ASSUMPTIONS 3.1. Case Study Project A proposal of water supply full concession scheme in the Tangerang area (west of Jakarta) was offered for bid in the 2005 Indonesian Infrastructure Summit, for a proposed concession period of 25 years. Investment is estimated at Rp. 186.011 Billion (current exchange rate 1 USD = Rp 9.288 at the time of the study) and consists of provision of 620 lt/sec raw water intake, 400 lt/sec water treatment plant, transmission and distribution network. Total number of customer connections during the first year of operation is estimated at 22,318, increased by 9,299 additional connections in the second year, 8,580 additional connections in the third year and followed by constant number of connections until the end of the concession period. Operation and maintenance cost is estimated at Rp. 1,225/M3 of produced water. New connection tariff is set at Rp. 1.5 million/connection. Water sale price for consumers (household, social, industry, etc) is Rp. 3,700/M3 and Rp. 2,000/M3 for bulk supply, both in the first year of concession. Composition of funding in term of debt to equity ratio (DER) is set at 65% : 35%. Using the CAPM approach, PPITA (2005) recommended that the proposal was feasible, with a payback period of less than 5 years, NPV of Rp. 82 Billions and IRR at 22 %. However, the recommendation was based on a single value result and not showing the risk profile of the investment. It does not provide the clue for different situation, such as the case of high NRW or the failure to increase the sale price or the fluctuating exchange rate, etc.

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3.2. Modelling Cashflow based on Concession Modality Three options were proposed for the concession modality, i.e. (A) concession for provision of raw water from intake up to water treatment plant, (B) concession for transmission and distribution system up to revenue collecting service, and (C) full concession for overall system. Table 1 summarizes the financial cashflow of all concession modalities. Several assumptions were used, i.e. straight line depreciation method, equity denomination in local curreny (Rupiah), debt in US Dollar. A 30 % tax rate, based on the Indonesian current rate for corporate income > Rp 100 Millions, was used.
Table 1. Summary of financial data for three concession scenarios Cash Components Investment **) In Billion Rupiah Operation : Rp./M3 Financing : Debt to Equity Ratio (DER) Debt drawing (in year-) Revenue : Water price for bulk suply (Rp/M3) Water price for consumer (Rp/M3) New connection fee (Rp/Connection)
Note :

Concession Modality B 156,218 3,603 ** 65:35:00 3x (1;2;3) 3,700 1,500,000

C 186,011 1,225 65:35:00 4x (1;2;3;7) 2,000 3,700 1,500,000

Remarks

43,757 948 65:35:00 2x (1;2) 2,000 -

In constant price In constant price

*) Investment includes 7 % continency cost **) per M3 water distributed (A) concession for raw water intake provision up to water treatment plant, (B) concession for transmission and distribution system up to revenue collecting service, and (C) full concession for overall system.

NPV and IRR of the investment were analysed based on net cashflow (NCF) analysis, as shown in the influence diagram of risk analysis in Figure 1.
R ate of T ariff C hanges W ater Price (for consum ers) R ate of NRW T otal Operation C ost T otal R evenue Earning Before T ax & Interest T ax deductable Earning After T ax & Interest Annual N C F C oncession F ee to Local Governm ent (LG )

W ater Price (for bulk supply )

Incom e T ax

T ax R ate

R ate of C onsum ption

T otal W ater C onsum ption

Interest R ate T otal C ustom er D ebt Paym ent D epreciation of Asset

N ew C ustom er N ote : : U ncertainties

N ew C onnection F ee

Exchange R ate D ebt D raw ing D ER

T otal Investm ent C ost

Figure 1. Influence diagram of risk analysis

Note : water sale price for consumer and new connection fee are applicable only for concession of transmission and distribution system up to revenue collecting service, and full concession for overall system.

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Risk factors involved in the model include tariff uncertainty, rate of non-revenue water, exchange rate fluctuation, rate of water consumption and uncertainty in operational costs. However, choosing the appropriate discount rate for present value analysis of a project under simulated environments remains the subject of debates. There is no substantial concensus whether the risk free rate or the opportunity cost of capital, which can also be the opportunity cost of debt or the cost of equity if dealing with source of financing, should be choosen [9]. The weighted average cost of capital (WACC) method has been used to define the discount rate in developing the NPV-at risk analysis method [1]. PPITA (2005) employed the capital asset pricing model (CAPM) to define the discount rate in analysing the feasibility of the case study project, using the beta value of the stock market listed Indonesian infrastructure corporates, such as Telkom and CMNP (Indonesian private toll road company). Currently there is no Indonesian water supply company listed in the stock market. The use of risk-free rate to avoid pre-judging the risk as simulation is already a way of understanding the risk [10]. The authors use an 18.5 % risk-free rate to discount uncertain cashflow, based on the value of the yield of the Indonesian Government Obligation Bond i.e bond yield 11% and risk premium 7.5%. 3.3. Modelling Risk Variables Probability distribution is a way of modeling the uncertainty risk variables. Subjective as well as objective method (based on historical data) are used to determine the distribution function types for the tariff uncertainty, rate of non-revenue water, exchange rate fluctuation, rate of water consumption and uncertainty in operational costs risk variables (see Table 2).
Table 2. Probability distribution of risk variables Risk variables Percentage of change in tariff rate Rate of non-revenue water Exchange rate fluctuation Uncertainty in water consumption Uncertainty in operational costs
Note :

Assumed Distribution Triangular Triangular Uniform Normal Normal Lognormal Lognormal

Parameter (0% ; 10% ; 10%) (0% ; 10% ; 27%) (0% ; 5%) (29% ; 12%) (9,288 ; 788) / = 10% / = 10%

Remark for concession A for concession B and C for concession A for concession B and C = PPITA estimation = PPITA estimation

Triangular (Min, Most Likely, Max), Uniform (Min, Max), Normal and Lognormal (;)

Exchange rate = conversion from USD to Rp

Distribution function of percentage of change in tariff rate was subjectively assumed as triangular. Its minimum value = 0% (stagnant price) and most likely value = 10 % was estimated by PPITA (2005). A maximum value of 27% was obtained from the maximum tariff increase experienced by the Jakarta Water Company for concession B and C. For concession scenario A, there is no historical data, hence a 10% maximum value was used. NRW distribution function for concession B and C is fitted from the data obtained from 112 Jawa-Bali local water supply companies (Perpamsi Directory 2000), which showed a Normal distribution (mean = 29% and standard deviation = 12%). The NRW distribution function for concession scenario A is modeled as a uniform one, with a minimum value of 0% (no losses) and maximum value of 5%, obtained from PPITA estimation for maximum plant losses. In fact, experience shows that most of NRW losses were recorded at the transmission and distribution stages, as well as during revenue collection. Exchange rate distribution function for all concession scope is fitted from the exchange rate (Rp./USD) data during the periode of January 2001July 2005. Water consumption as well as uncertainty in operational costs was subjectively assumed as lognormal distribution, where the coeficient of variation is 10%, based on PPITA estimation.

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4. SIMULATION RESULTS AND DISCUSSION A latin hypercube simulation of 10,000 iterations was applied. Table 3 contains a list of key simulation output as descriptive statististics. In general, based on the mean value of each figure of merit, all concession scheme is considered attractive. Despite the possibility of having the payback at the end of the concession period, negative NPV and IRR < risk free discount rate, there are possibilities that the figures of merit exceed the expected means.
Table 3. Key simulation output descriptive statictics Statistics Minimum Maximum Mean StDev Skewness Kurtosis Mode 5th percentile 25th percentile 50th percentile 75th percentile 95th percentile
Note :

The financial performance of investment Net present value Internal rate of return A B C A B -6,611 -111,140 -57,862 15.34 0.00 29,929 93,647 160,420 28.90 26.65 11,340 -19,970 14,764 22.62 15.92 5,077 26,471 25,625 1.71 3.28 0.07 0.31 0.48 -0.16 -0.40 2.97 3.16 3.45 3.08 3.56 10,682 -28,429 18,501 20.42 0.00 3,049 -60,781 -24,205 19.72 10.31 7,862 -38,500 -3,369 21.48 13.88 11,301 -21,435 12,832 22.66 16.09 14,771 -3,300 30,649 23.79 18.15 19,802 26,000 59,533 25.38 20.98

C 10.93 28.89 19.69 2.26 0.01 3.05 21.31 15.96 18.16 19.70 21.21 23.43

Except skewness and kurtosis values, NPVs in million rupiah, IRR in percent

In reality, the statistical information presented in Table 2 does not provide the clue to way to compare the three scenarios, except for the interpretation of the IRR, where scenario A dominates all the others. Thus, the IRR of all scenarios can be compared by the first order stochastic dominance (FSD). By using definition 1, the A scenario, based on CDF of IRR, stochastically dominates the B scenario to the first order, denoted by A FSD B, and concession C, denoted by A FSD C. Similarly, it can be derived that concession C FSD B. As shown on the right side of Figure 1, there is no intercepting CDFs.
NPV =0 1.0 0.9 0.8 0.7 0.6 0.5 0.4 0.3 0.2 0.1 0.0 -112,000
Intercept A and C Intercept A and B IRR = Risk free discount rate

1.0
: Concession A

0.9 0.8 0.7 0.6 0.5 0.4 0.3 0.2 0.1 0.0

: Concession B : Concession C

Cumulative Probability

: Concession A : Concession B : Concession C

-42,750

26,500 NPV (Rp. M illion)

95,750

165,000

Cumulative Probability

0.075

0.15 IRR

0.225

0.3

Figure 2. Cumulative distribution functions of NPV and IRR for all concession modalities

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To compare the NPVs of the scenarios based on the statistical data is less straight forward. Unlike the CDFs for the IRR, the CDFs for the NPVs are crossing each other, except those for B and C scenarios. For B and C scenarios, the stochastic dominance relationship FSD is applicable as C FSD B (see left side on Figure 2). The NPV CDFs for A scenario is crossing both those of B and C, such as the definition 2 of second order stochastic dominance (SSD) is applicable. The SSD relationship of A and B can be described as A SSD B if the area under the NPV CDF curve for the A scenario is less than or equal to the area under the one for the B scenario, in the range between NPV minimum and maximum given by both curves. As a reminder, it is worth mentioning again that SSD definition is prefered by the risk aversion investors. By taking the intercept point between the curves as the maximum value of [a,b] interval for integrating, that is Rp 11,357 billion for A and B and Rp 11,299 billion for A and C, it was found that the probability of NPV of A Rp. 11,357 billion is equal to 50,51% and similarly for B is equal to 87.84 %, hence the relation A SSD B holds. For the A and C scenarios, the probability of NPV of A Rp. 11,299 billion is equal to 49,98% and similarly for C is equal to 47.61 %, the relation A SSD C can not be held, or A is not dominating over C. On the other hand, C does not either dominate over A, hence the dominance relationship SSD between the two can not be concluded. In this case, an alternative way of defining the SSD relationship between A and C scenarios based on NPV criteria is proposed here. The new definition assumes that risk aversion type investors tend to prefer investment options offering return (in NPV) which its probability of success is higher than its probability of failure. This is based on the fact that if NPV is used as the figure of merit for decision making, investor may want to know what is the probability of having NPV < 0. The A scenario stochastically dominates the C scenario, denoted by SSD* if :

FC (x 0) dx

(x 0) dx for all x with inequality for some x below zero (3)

In application, a vertical line is put at the NPV axis equal zero, dividing the CDFs into two parts (negative side on the left and positive side on the right (see left side of Figure 2). The SSD definition is used by counting the area under the CDF within the negative interval, as the probability of having NPV < 0. For the A scenario, the probability of having NPV < 0, or PA(NPV<0), is 1.16 % , while for C scenario, PC(NPV<0) = 29,92%. Hence A scenario stochastically dominates C scenario to the second order, denoted by A SSD* C. See Table 4 for the complete stochastic dominance relationship between the three scenarios of concession based on NPV dan IRR figures of merit.
Table 4. Stochastic dominance relations for net present value and internal rate of return NPV A NPV A NPV B NPV C IRR A IRR B IRR C NPV B SSD FSD NPV C SSD* IRR A IRR B FSD FSD IRR C FSD -

5. CONCLUDING REMARKS A public and private participation scheme in infrastructure should not be separated from risk management concept implementation. Risk management should not only considered as a tool for

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informing the investors on the risk of project failure, but should be used for developing techniques for properly managing project risk. For PPP investment in water supply infrastructure, the problems of risk and uncertainty can be reduced by unbundling the service into separate concessions for different infrastructure system components. The paper has discussed the method to interpret risk analysis result of several mutually exclusive alternatives, and selecting the best option, based on first order and second order stochastic dominance approach. The approach is generally simple enough to be implemented, as it interprets the risk analysis output through the evaluation of the cumulative distribution functions of each alternatives. The decision making process is simplified as the method helps in reducing the complication due to overwhelming amount of statistical information. The model can eventually be developed further as a tool to promote various investment schemes for water supply infrastructure to the private sector. The private sector can select most suitable concession scheme(s) based on the proposed modality, which has been completed with its risk/return profile. 6. ACKNOWLEDGEMENT The authors wishes to thank the Directorate General of Higher Education, Ministry of National Education, Republic of Indonesia, and Mr. D. Aditya Sumanagara, President Director, PT. Aneka Tambang, Tbk., for providing the financial support which has made this research possible. 7. REFERENCES 1. Ye, S. and Tiong, R.L.K., NPV at risk method in infrastructure project investment evaluation. Journal of Construction Engineering and. Management, 126 (3), 2000,pp.227-233. 2. Savvides, Savvakis, Risk analysis in investment appraisal, Project Appraisal Vol 9 No. 1, March 1994, pp.3-18, Beech Tree Publishing [www.bcs.org] (10 September 2005). 3. Whitmore, G.A and Sipra, Naim., Implementing completely monotonic stochastic dominance : The Case of Mutual Fund Performance, Working Paper No. 94-07, Centre for Management and Economic Research, Lahore University of Management Sciences, Lahore, Pakistan, 1994 [www.ravi.lums.edu.pk] (21 Februari 2006). 4. Levy, Haim and Wiener, ZVI., Stochastic dominance and prospect dominance with subjective weighting functions, Journal of Risk and Uncertainty, 16:2 147163, Kluwer Academic Publishers,1998. [www.pluto.mscc.huji.ac.il] (21 Februari 2006). 5. Dentcheva, Darinka and Ruszczyski, Andrzej , Portfolio optimization with stochastic dominance constraints, 2003 [www.optimization-online.org] (21 Februari 2006). 6. Berleant, D., Dancre, M., Argaud, J.P., Sheble, G. , Electric company portfolio optimization under interval stochastic dominance constraints, Proceeding of 4th International Symposium on Imprecise Probabilities and Their Applications ; Pittsburgh, Pennsylvania, 2005. [www.sipta.org] (21 Februari 2006). 7. Nowak, Maciej, Investment projects evaluation by simulation and multiple criterian decision aiding procedure, Journal of Civil Engineering and Management. XI (3), 193-202. ,2005. [www.vgtu.lt] (21 Februari 2006). 8. Annon., @RISK : Advanced risk analysis for spreadsheet. Palisade Corporation.New York, 2002. 9. Wibowo, A. and Kochendrfer, B.,Financial risk analysis of project finance in the indonesian toll roads. Journal of Construction Engineering and. Management, 131 (9), 2005,pp.963-972 10. Brealey, R.A., and Myers, S.C., Principles of Corporate Finance. 6th. Ed., McGraw-Hill, New York., 2000. 11. M. Husnullah Pangeran. , Identifikasi dan Analisis Dampak Risiko-Risiko Dominan Terhadap Kelayakan Finansial Konsesi Infrastruktur Air Minum, Master Thesis, Department of Civil Engineering, Institut Teknologi Bandung. 2006.

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