Strengthening Economic Regulation of Water and Sanitation Services in the Philippines

Annex A. Tariff setting in theory and practice

Determining the preferred methodology to set tariffs for regulated services – such as water and sanitation or electricity – is no copy-paste exercise. Rather, it should result from a reflection on what regulation is expected to achieve in each context and an understanding of existing challenges. This section looks at the theoretical underpinnings of tariff setting and examples from international practice.

A theoretical perspective

In considering what the appropriate tariff methodology for water and sanitation services in the Philippines should be, three concepts matter (Figure A A.1):

• Regulatory objectives – the goals that regulation is expected to achieve

• Tariff principles – the desired characteristics of a tariff model

• Enablers and constraints – the broader context in which economic regulation takes place

Figure A A.1. The relationship between objectives, principles and the tariff methodology

Regulatory objectives

Regulatory objectives define the goals that regulation is expected to achieve and as such set a direction and clarify the purpose of regulatory intervention. Regulatory objectives differ across sectors and countries, based on the existing challenges and policy priorities in the sector. While policy objectives define the wider objectives a government aims to achieve in a sector or market, regulatory objectives define the objectives for a given regulator or regulatory framework. Governments may use other policy instruments, for example public investment or subsidies, to achieve their objectives. Responsibilities for the achievement of policy objectives may also be shared or divided between different public actors. Regardless, regulatory and policy objectives should remain consistent and aligned to support effective delivery.

At times, regulatory objectives may be at odds with each other. This is the case when actions to achieve a certain objective may undermine or reduce the chance of meeting another objective, or the extent to which it is achieved. For example, achieving financial viability of water service providers through increased tariffs can potentially conflict with objectives to ensure access to affordable services, although this does not always need to be the case (OECD, 2022[1]).1

The likelihood of potential conflicts between regulatory objectives should be considered in decisions by policymakers on the set of regulatory objectives to assign to a regulator, considering also the roles of other policy instruments and public actors. In particular, decision-makers must be aware of and address potential risk-risk trade-offs that may arise when pursuing multiple objectives. These efforts can support the overall predictability of regulatory decision-making.

Tariff principles

To support the achievement of regulatory objectives, economic regulators need to consider what desired characteristics their tariff regulation model should have. Tariff principles serve as the foundation for designing appropriate tariff methodologies. They also influence how tariffs are structured and adjusted over time. While these principles may vary in emphasis depending on the specific goals of different regulators, there is often a significant degree of alignment across countries and sectors.

A scan across European water and energy regulators2 highlights the following potential tariff principles that could be considered in the design of tariff methodologies:

• Affordability – safeguarding equitable access to water and the provision of water services to all, regardless of their ability to pay

• Cost-recovery – allowing regulated entities to recover (efficiently) incurred costs

• Cost-reflectivity – ensuring tariffs reflect the costs imposed by users on the system

• Non-discrimination – preventing undue discrimination between users

• Performance incentives – promoting efficiency and/or the achievement of targets by regulated entities

• “Polluter Pays” – ensuring polluters, or those that cause the identified harm, bear the expenses of prevention and control measures to protect the environment

• Predictability – allowing regulated entities and users to reasonably anticipate tariff outcomes

• Proportionality – tailoring the complexity of tariff models according to the type and capacity of regulated entities

• Simplicity – making tariff methodologies as easy to understand and implement as possible

• Transparency – ensuring methodologies are clear, transparent and accessible

Regulators will balance between the various principles based on the objectives they aim for, the data and information they hold and other practical considerations.

Tariff design

A wide variety of tariff regulation models exists across countries. While there are many differences and nuances, two main aspects on which tariff regulation models tend to differ are the way in which costs are calculated and the degree of incentives provided to operators to improve their performance, or to users to alter their behaviour.

Tariffs are usually determined based on the costs of providing the service, with few exceptions.3 However, the way in which service costs are determined can differ:

• Costs can be based on the cash flows of operators (i.e. their actual expenses), which guarantees liquidity and helps maintain the financial viability of operators. Costs can be otherwise based on accounting costs (including OPEX, depreciation and a return on investment), which can support tariff stability.4 A tariff model based on accounting costs is more typical for water and energy regulators in Europe (WAREG, 2024[2]), while water supply and sanitation tariffs in the Philippines are usually cashflow-based.

• Other aspects that lead to varying costs (and tariffs) are the level of allowed return and the asset valuation method (e.g. based on book values or historical costs). A survey of water regulators in Europe shows that most regulators calculate the allowed return based on financial market data (WAREG, 2024[2]), while in the Philippines allowed returns have consistently been capped at the level of 12% for decades without reference or adjustment for changing market conditions.

Another key difference between tariff setting methodologies is the extent to which incentives to improve efficiency or performance are integrated into the tariff methodology:

• Traditionally, cost-based regulatory approaches have been used by many regulators to set tariffs, which do not provide much incentive but simply remunerate operators’ costs. They include rate-of-return (predefined return on asset base) and cost-plus approaches (predefined profit margin added to the costs).

• Given the need to raise service quality and efficiency, as well as support innovation, regulators are increasingly turning to performance-based approaches that integrate incentives into the tariff design. Incentive regulation can take different forms – such as price caps, revenue caps, yardstick competition, profit sharing and many hybrid modes – but are essentially characterised by a system of rewards and penalties to motivate regulated entities to achieve preset goals.

• While many approaches focus on incentives to improve cost efficiency, incentive regulation can also target other goals such as network expansion or quality. Tariffs can incorporate various types of incentives targeting both users and utilities, in support of key policy objectives (Box A A.1). The use of incentive regulation is not universal, where surveys among European regulators found that most energy regulators use some form of incentive regulation but only roughly half of water regulators (WAREG, 2024[2]; CEER, 2025[3]).

Finally, tariff setting models differ in how allowed revenues of regulated entities are allocated to tariff groups. This concerns both the sharing of costs across different tariff groups (incl. cross-subsidisation of lower income groups) and the types of tariffs used (flat fee vs. fixed and volumetric charge, etc.). The allocation of costs to tariff models may be influenced by regulatory objectives and tariff principles as well as practical considerations such as the availability of water meters.

Box A A.1. Tariff-setting practices: incentive design

Tariffs can incorporate incentives targeting both users and utilities to support key policy objectives such as efficiency, equity, service quality and environmental sustainability. Various incentives may be combined into a single tariff structure or regulatory approach:

• For users, incentives can encourage water conservation (e.g., through volumetric or increasing block tariffs [IBTs]), promote timely payment (e.g., discounts or penalties) and reduce pollution (e.g., effluent-based charges). Further measures may support affordability and access (e.g. lifeline tariffs or embedded subsidies).

• For utilities, tariff structures can incentivise cost efficiency (e.g., via price caps or benchmarking), improved service delivery (e.g., performance-based tariffs), investment (e.g., return on capital), equity (e.g. output-based tariffs based on coverage targets) and environmental sustainability (e.g., pollution charges).

These incentives can be adjusted through various mechanisms. Automatic adjustments include for example yearly indexation to inflation or input costs or other automatic recalibrations. Performance-linked adjustments adjust tariffs based on verified service outputs or efficiency gains. Regulatory reviews and reopener clauses more generally allow for periodic or exceptional adjustments to reflect evolving conditions and ensure continued alignment with policy goals.

Table A A.1. Examples of tariff-based incentives in the water supply and sanitation sector

Incentive Type	Target Group	Tariff Tools (examples)	Adjustment Mechanisms
Water conservation	Users	IBTs, seasonal pricing	Block threshold reviews
Efficiency	Utilities	Price caps, benchmarking	Indexation, performance audit, regulatory review
Service quality	Utilities	Performance-linked tariffs	Output or performance verification
Investment	Utilities	Return-on-investment structures	Multi-year tariff reviews
Pollution control	Users, utilities	Effluent-based pricing	Regulatory review or review of overarching standards

Source: Developed by authors based on case study and gap analysis, OECD work and literature review.

Table A A.2 provides an overview of the main tariff design options and relevant advantages and disadvantages.

Table A A.2. Overview of tariff design options and parameters

Option	Key variations	Advantages	Disadvantages
Cost-based	Rate-of-return Cost-plus	Predictability Simplicity Transparency Supports financial sustainability	Weak/absent efficiency incentives Higher costs passed on to users Tariffs do not reflect service quality
Value-based	Performance-based incentives (cost efficiency or quality) Output-based (service outputs such as expansion)	Focus on service quality and outcomes Efficiency incentives Supports willingness to pay Incentivises innovation	Difficult to assess/measure value or performance Risk of under-recovery Complexity
Market-based	Benchmark or yardstick competition Negotiated or contract-based	Efficiency incentives via competition Performance focus (contracts can specify outcomes or benchmarks can be based on outcomes) Incentivises innovation	Not always feasible due to lack of comparable companies or competition Lack of transparency of negotiated tariffs Complexity
Politically administered	Politically determined Social tariffs Solidarity-based	Simple and fast to implement Affordability protections Political acceptance	Risk of under-pricing Low financial sustainability Limited investment in quality Weak incentives Regulatory capture or politicisation (and lowered trust)
Hybrid	Blended models Progressive transition between models (over time)	Balance of objectives Tailored design for sector context and maturity Compatibility with incentives	Complexity Requiring high regulatory capacity Potentially higher regulatory burden (negotiation, monitoring, stakeholder engagement)

Source: Developed by authors based on case study and gap analysis, OECD work and literature review.

Regardless of which tariff design approach or variation is pursued, various operational parameters will need to be considered and calibrated to allow for the effective delivery and management of the tariff framework in practice (Box A A.2).

Box A A.2. Operational parameters for tariff design

This box presents a selection of operational parameters, to illustrate the range and potential complexity of the decisions to be made on parameter specification. The various categories and types of parameters that should be considered are included in the table below.

Table A A.3. Overview of relevant parameters for tariff design, by category

	Cost-related parameters	Performance mechanisms	User targeting, affordability and social safeguards	Market-related parameters	Governance / oversight tools
Relevance	Relate to cost recovery, economic efficiency and how tariffs reflect underlying costs.	Encourage performance improvements, conservation and optimal utility behaviour	Distinguish users and/or address user ability to pay and distributional fairness	Focus on value perception, willingness to pay and comparative pricing.	Support sound regulatory processes and oversight capacity.
Parameters	Cost definitions and boundaries Regulatory Asset Base (RAB) definition Rate of return Depreciation method Allocation rules Utility compensation Tariff period Component weighting	Efficiency benchmarks Performance measurement KPIs & value indicators Performance-linked incentives Incentive structures Treatment of non-revenue water and inefficiencies (pass-on) Risk-balancing mechanisms	Affordability thresholds Affordability controls Cross-subsidy design Public interest safeguards User segmentation	Definition of value (willingness to pay, marginal value, perceived benefits, …) Price discovery method Reference market	Transparency and comparability Regulatory backstop Decision-making criteria Adjustment mechanisms Risk allocation Tariff review period Planning framework Interface rules (reconciling components in adjustments)

Source: Developed by authors based on case study and gap analysis, OECD work and literature review.

International practice

Many countries and regulators are increasing efforts to harmonise and improve tariff methodologies, de-politicise tariff decisions, improve data and transparency and support utility consolidation, among other actions. International experience highlights a focus on benchmarking, designing targeted subsidies, promoting inter-municipal co-operation and stakeholder engagement, as well as strengthening the role of economic regulators and addressing regulatory governance and performance gaps (OECD, 2015[4]; OECD, 2022[5]; OECD, 2022[1]; OECD, 2022[6]; OECD, 2023[7]).

Countries show diverging approaches in terms of the tariff arrangements and methodologies that are put in place. Table A A.4 illustrates the diversity of approaches seen within a sample of countries (OECD, 2015[4]).

Table A A.4. Sample of international approaches to tariff design in the water supply and sanitation sector

Country	Methodology	Design principles	Incentives	Regulator(s)
Australia	Hybrid – “Building block” approach (Weighted Average Cost of Capital + Operation & Maintenance + depreciation) with price caps over 4-5 year periods.	Combines cost reflectivity and efficiency incentives. Sets allowed revenues based on ex-ante efficiency review, Regulatory Asset Base (RAB) management (capex added to RAB if efficient and prudent).	Price cap regulation creates incentive to improve productivity and reduce waste. Financial penalties and rewards based on customer service performance.	IPART (NSW), Essential Services Commission (Victoria)
Chile	Model company benchmarking approach using long-term total cost (investment, replacement, maintenance).	Tariffs based on model company – hypothetical efficient utility. Simulated efficient costs. Investment plans are assessed to ensure consistency with regulatory standards and needs.	Financial incentives – utilities can keep the difference if performing better than the model. Transparent, law-based methodology incentivising private investment and efficiency.	SISS
Peru	Optimised planning with performance-based tariffs	Aligns tariff setting with long-term planning (30-year optimised master plan, OMP) and efficiency goals. 5-year updates. Utilities propose tariffs based on the OMP which Sunass reviews.	Tariffs are linked to service improvement goals (coverage expansion, non-revenue water reduction, quality compliance). Risk allocation means utilities bear risk for failed targets.	Sunass
Portugal	Hybrid – cost reflective with performance oversight. (Cost-plus for bulk operators, transitioning to revenue cap) Regulatory scrutiny and approval of investment plans.	Promotes cost recovery of all “justified” costs. Not a simple pass-through model, instead, anchored on benchmarks (performance scorecards) and evaluated based on predefined efficiency metrics. Not full price-cap or performance-based model due to provider capacity and political sensitivities.	Relies on regulator’s enforcement of compliance at municipal level – utility performance links to access to finance, while incentives for private operators are embedded in long-term contracts monitored by ERSAR.	ERSAR
Hungary	Tailored cost-plus model	Cost-plus with tight controls (scrutiny of eligible costs) and national oversight (focus on regional consolidation of service provision).	Implicit efficiency incentives, via tariff freezes, efficiency targets.	MEKH
Latvia	Tailored cost-plus model	Cost-plus with profit cap and service standards. Tariffs are approved based on service level indicators.	Periodic reviews to challenge costs and adjust forecasts. Capped return on equity (7%) to avoid excessive rent-seeking.	PUC
England and Wales	Hybrid – incentive-based, multi-year price control, reviewed every 5 years	Encourages cost efficiency, innovation and service improvement, as well as customer protection and affordability tools. The approach incorporates competitive benchmarking, price cap regulation and is based on TOTEX5.	Financial rewards and penalties for performance versus customer-facing targets. Competitive benchmarking creates reputational risks. Cost of capital – utilities can beat the return by outperforming cost and service targets.	OFWAT
France	Decentralised tariff autonomy with national norms and incentives	Tariff setting by local authorities (prioritising accountability) in line with national cost recovery and non-profit rule principles.	Management contracts include performance targets, financial incentives and revision mechanisms. Performance database creates reputational incentives. Investment subsidies targets based on outcomes.	No national regulator – tariffs set by municipal councils. Shaped by EU WFD. OFB, via SISPEA6, role in promoting transparency and benchmarking.

Source: (OECD, 2015[4])

Note: Please note data and description of regulatory practices is current as of 2015 report publication date.

References

[13] ACER (2025), Getting the signals right: Electricity network tariff methodologies in Europe.

[12] ACM (2024), Principles for tariff structure electricity [Uitgangspunten voor de tariefstructuur elektriciteit].

[3] CEER (2025), Regulatory Frameworks for European Energy Networks 2024, https://www.ceer.eu/wp-content/uploads/2025/02/GA191_05_2_IRB-Regulatory-Frameworks-Report-2024-Main-report-1-1.pdf (accessed on 12 May 2025).

[10] CEER (2017), Electricity Distribution Network Tariffs - CEER Guidelines of Good Practice.

[7] OECD (2023), Implementing Water Economics in the EU Water Framework Directive, OECD Studies on Water, OECD Publishing, Paris, https://doi.org/10.1787/d6abda81-en.

[6] OECD (2022), Financing a Water Secure Future, OECD Studies on Water, OECD Publishing, Paris, https://doi.org/10.1787/a2ecb261-en.

[1] OECD (2022), Reform of Water Supply and Wastewater Treatment in Lithuania: Practical Options to Foster Consolidation of Utilities, OECD Studies on Water, OECD Publishing, Paris, https://doi.org/10.1787/f966a980-en.

[5] OECD (2022), Towards Sustainable Water Services in Estonia: Analyses and Action Plan, OECD Studies on Water, OECD Publishing, Paris, https://doi.org/10.1787/b82d71c6-en.

[4] OECD (2015), The Governance of Water Regulators, OECD Studies on Water, OECD Publishing, Paris, https://doi.org/10.1787/9789264231092-en.

[8] OECD (2010), Pricing Water Resources and Water and Sanitation Services, OECD Studies on Water, OECD Publishing, Paris, https://doi.org/10.1787/9789264083608-en.

[11] Scottish Government (2020), General statement of policy - Principles of Charging for water and sewerage services 2021-27.

[2] WAREG (2024), Tariff Regulatory Frameworks in WAREG Member Countries, https://www.wareg.org/documents/water-tariffs-frameworks-in-europe/ (accessed on 12 May 2025).

[9] WAREG (2023), 3 - Water Priciping Principles in the EU.

Notes

← 1.  Countries may prevent potential conflicts between objectives of improving financial sustainability and ensuring access to affordable services through the use of other instruments such as cross-subsidisation between users, taxes or transfers (OECD, 2010[8]).

← 2.  The list of tariff principles has been developed by the authors, based on documentation by the European Water Regulators (WAREG), the Council of European Energy Regulators (CEER), the European Agency for the Co-operation of Energy Regulators (ACER), the Scottish government and the Netherlands Authority for Consumers and Markets (ACM) (CEER, 2017[10]; Scottish Government, 2020[11]; WAREG, 2023[9]; ACM, 2024[12]; ACER, 2025[13]).

← 3.  One exception can be found in systems where tariffs are based on affordability or other political considerations. This model often results in tariff levels below cost recovery, thereby harming the financial viability of operators and their ability to invest in long-term sector sustainability and the quality of service.

← 4.  For example, an investment can generate an immediate and significant negative cashflow in one year, while under the accounting cost approach the investment sum will be spread out as depreciation costs over the lifetime of the asset.

← 5.  TOTEX stands for Total Expenditure. In the context of utility regulation – including water supply and sanitation – it refers to the combined total of capital expenditures (CAPEX) and operating expenditures (OPEX).

← 6.  Système d’Information sur les Services Publics d’Eau et d’Assainissement (Information System on Public Water Supply and Sanitation Services). SISPEA is a national database and reporting system managed by the Office Français de la Biodiversité (OFB) (formerly under ONEMA), created under the French Water Law of 2006.