I.    Introduction and assumptions

This article is intended to describe the legal framework and business environment of water and sanitation in Brazil. It does not comprise, therefore, specific and defined business opportunities, but rather an overall picture of selected relevant aspects of water and sanitation sector under a strictly legal and regulatory standpoint.

Brazil has approximately 5,000 municipalities and, therefore, potentially more than 5,000 incumbent authorities for water and sanitation services to the population in general. These authorities are not allowed to circumvent the main features of the general guidelines and the national framework discussed hereto, but particularities within the boundaries of the areas under their jurisdiction may arise, and they cannot be captured for this article, which intends not to reflect the local norms and practices existing throughout the country.

For ease of reference, this article is divided into the following sections: (i) Introduction and assumptions; (ii) Regulatory guidelines; and (iii) New Regulatory Framework.

II.  Regulatory guidelines

Water and sanitation services to the population in general are legally qualified as utilities (public services) in Brazil. It means that the rendering of such services is not open to competition under the free market, but rather an attribution of the government, which may delegate these services within certain boundaries set forth in the law. Brazilian law recognizes two types of governmental entities as the primary authorities over water and sanitation activities: municipalities and regions (such as metropolitan areas). They can deliver water and sanitation services for the users either directly or by means of operators, to whom the services may be delegated and consisting of state-owned companies (“SOC”) or privately held companies (“PHC”). When services are delegated, municipalities or regions reserve to themselves a role of Granting Authorities (“GA”), overseeing operators, but must engage governmental agencies of another federative entity (for example, a municipality may engage a state agency) to coordinate interests and resolve conflicts among operators, GA and users.

That is to say: water and sanitation utilities are highly regulated activities in Brazil. As it will be discussed in item III, below, this regulation has recently been positively impacted by the enactment of a new framework that establishes national standards fostering private participation in water and sanitation sector (“New Regulatory Framework”). Although New Regulatory Framework is not aimed at deregulating water and sanitation in Brazil, it improves the standards for GA, regulatory agencies and SOC to perform their roles in water and sanitation sector, bringing more transparency, rule of law and long-term policies that result in the enhancement of the business environment in the water and sanitation sector. For details on this enhancement, please refer to section III below.

• (a) Models of regulation
  

Brazilian governmental agencies implement regulation on water and sanitation utilities under two different models: the discretionary regulation, usually applicable to agreements executed by SOC, and the contractual regulation, which must be carried out in compliance with the formal agreements entered with PHC, as predefined in the bid notice. This difference originates predominantly from the proceeding adopted for delegation of services for each type of operator.

• (b) Programme Contracts

As a general rule, service agreements entered with SOC do not come from a competitive procurement procedure, but rather from a former statutory authorization, now removed by the New Regulatory Framework, whereby SOC, based only on their state-owned status, could negotiate directly with GA the tariffs, tenor extensions from time to time and other terms and conditions for rendering services to the users. Such service agreements entered by and between SOC and GA (and not preceded by a public bidding) are called “Programme Contracts”.

• (c) Concessions

In turn, service agreements granted for PHC are necessarily preceded by a competitive bidding procedure, initiated with the publication of a bid notice by a certain GA, containing a binding draft of the services agreement that will be entered into with the winning bidder. The criteria for choosing the winning bidder may vary from the lowest tariff/payments value up to the highest concession fee (signing bonus) offered by the bidders, under the conditions set forth by the bid notice and the attached services agreement. Service agreements derived from such competitive procurement procedure may have different legal regimes, such as common concessions and public-private partnerships (“PPP”). Most of such agreements are common concessions and will be referred hereto as “Concessions” or “Concession Agreements”, as opposed to the Programme Contracts.

In other words, while discretionary regulation applies to Programme Agreements, contractual regulation governs Concessions.

• (d) Tariff review under Programme Contracts

Overall, because they rely on a discretionary regulation, Programme Contracts executed between municipalities (or regions) and SOC do not provide for investments, key performance indicators (“KPI”) and/or goals for universalizing the access to water and sanitation services applicable to the whole timeframe of the agreement. Indeed, the terms of the obligations incumbent on SOC are determined from time to time by the governmental agency in charge of regulating the services delivered in a certain local or region. For such purpose, agencies periodically calculate tariff values valid for the next operation cycle (with a horizon of up to five years) by implementing specific methodologies for projecting values of WACC, CAPEX and OPEX applicable to that operation cycle. Few governmental agencies have detailed methodologies set forth in advance for water and sanitation services.

• (e) Tariff review, KPIs, universalization goals and investments under Concessions

On the other hand, Concessions go at the opposite direction: tariffs, obligations (including KPIs and universalization goals) and risk allocation between PHC and GA are predefined in the bid documents, resulting in the initial economic and financial balance of the agreement and, therefore, supporting the offer submitted by the winning bidder. By statutory definition, whenever such initial economic financial balance is affected (and to the extent that such risk has not been allocated to the PHC), the PHC has the right to rebalance the agreement aiming at the maintaining of that initial balance.

In addition, modifications agreed upon between PHC and GA during the Concession (as additional investments to include new neighborhoods as supervening obligations of PHC) may result in amendments that must also assure to PHC appropriate compensation to preserve the initial economic and financial balance of the agreement. Rules for rebalancing the Concession are laid down in detail by the agreement. Governmental agencies coordinate the procedure to rebalance Concessions and have the final word in the administrative level on the amounts and mechanisms for compensating PHC, in accordance with the terms and conditions established by the agreements. When the rebalancing claim is accepted by a governmental agency, the agreement is amended to reflect the compensation mechanism that settle the dispute, which is in most of the cases either a tenor extension of the Concession or an increase in the tariff value.

Economic and financial rebalances are also set forth in Programme Agreements. What makes the rebalancing procedure different for SOC and PHC is the fact that Concessions are not governed by a regulatory WACC. While the cost of capital under the discretionary regulation is arbitrated periodically for SOC, such cost is a market variable for PHC, which undertake interest rates as a risk usually fully allocated to private party under Concessions. Notwithstanding such risk allocation under Concessions, the financial data necessary to carry out rebalance procedures are predefined as a fix value in the bidding procedures.

Alongside the economic and financial rebalance of the Concession, the agreement provides for inflation protection mechanisms structured as an annual price readjustment. Either national indexes of prices, such as IPCA or IGPM, or methods specifically defined by the agreement, with parametric components that reflect price changes from time to time (“fómula paramétrica”), underlie such mechanisms.

• (f) Efficiency gains

One difference between discretionary and contractual regulation that warrants attention relates to the appropriation of efficiency gains by SOC and PHC. From one side, under Programme Contracts, tariff review procedures applicable to SOC arbitrate OPEX to calculate the tariff valid for the next cycle as being the OPEX value effectively incurred by SOC in the last cycle. This approach has the practical effect of reducing tariff value for the new cycle, in relation to OPEX, in the total amount of operational efficiency gains that SOC may have achieved during the previous cycle. In other words, SOC are not allowed to appropriate efficiency gains from reducing OPEX from time to time.

On the other side, Concessions go to the opposite direction. Differently from Programme Contracts, Concessions, as a rule, allow PHC not to share with users nor GA the reduction of estimated expenses. Specifically with regards to OPEX value, PHC are expected to have uncapped returns, since tariff review procedures applicable to Concessions do not capture potential efficiency gains that PHC might have achieved.

The difference on the approach to the efficiency gains under tariff review procedures between Programme Agreements and Concessions leads to potential opposite incentives to SOC and PHC to run their OPEX. Since for SOC efficiency will be fully captured for the reduction of the tariff (modicidade tarifária) and become the ceiling for the OPEX in the next operational cycle, such companies are expected to have in comparative terms less incentives as PHC have to carry on OPEX in the most efficient manner.

• (g) Intermediary Conclusion

All things considered, one may conclude under Brazilian law and regulatory practices that contractual regulation has relevant upsides when comparing it with the discretionary regulation:

1. under the discretionary regime, tariff review tends to be much less predictable. While the New Regulatory Framework may enhance the current scenario, since it assigned to Water National Agency (“ANA”) responsibilities on professionalizing and unifying water and sanitation regulation in Brazil, the actual enactment of such uniform rules applicable nationwide will still take time. On the other hand, contractual regulation does not offer so much leeway to agencies for tariff review purposes, considering that such rules are expressed in the agreements, thus bringing more stability for decision making in investing in the water and sanitation sector;

2. as anticipated, discretionary regulation offers less incentives for efficiency gains, which is the essence for the private participation in the sector. Concessions, in turn, usually allow the appropriation of efficiency gains by PHC. This circumstance fosters attraction to projects modelled under contractual regulation guidelines;

3. contractual regulation is more consistent with the legal regime of public procurement procedures in Brazil, whereby bidders must be granted with accurate and complete information to enable them to make their best offers.

For the ease of reference, please refer to the table below:

 III.       New Regulatory Framework

In July, 2020, the Federal Government enacted Law 14026, which modified Law 11445 of 2007 (known as Statute of National Policy on Basic Sanitation, comprising water and sanitation) among other statutory provisions by stablishing a new legal and regulatory framework on water and sanitation services. New Regulatory Framework results from the necessity of attracting private capital to accelerate the universalization access to water and sanitation services in Brazil.

Nowadays, 100 million people in Brazil (almost 40% of the total population) do not have sewage services and 30 million are deprived from drinking water in their homes. The policy makers behind New Regulatory Framework decided to overcome this scenario until 2033 (with some exceptions up until 2040) when it is expected that Brazilians become duly served with drinking water (99% of the population) and with collection and treatment of sewage (90% of the population). This timeframe brings financial constraints to SOC, which is why PHC are welcome to expand their participation in the sector. In this sense, New Regulatory Framework is essentially a private participation program. Its main features are listed below.

• (a) Compliance of SOC with universalization goals

Under New Regulatory Framework, all the agreements in force on the date of the enactment of the new law must be amended up until March 31st, 2022, to set forth explicit universalization goals. Most of Programme Contracts, because of their incompleteness typical of the discretionary regulation, were silent with respect to such goals. For embracing such goals on serious and viable terms, SOC have two basic alternatives to comply with New Regulatory Framework: either by their own financial means or privatization.

• (a.1) Evidence of funding capacity^[1]

For complying with New Regulatory Framework by their own financial means, SOC must evidence their funding capacity to meet the universalization goals through appropriating equity or debt funding. Decree regulating New Regulatory Framework determined December 31st, 2021 as a deadline for SOC to demonstrate before the governmental agency in charge of regulation of each Programme Agreement economic and financial means for enabling them to perform the obligations set forth in the new law. Governmental agencies have, on their turn, up until March 31st 2022 to review that information and make a decision. The agencies shall review the financial statements of SOC, feasibility studies and a funding plan. Under the funding plan, SOC must appoint relevant banks providing financing and present the respective engagement letters (not necessarily binding though), evidencing the SOC ability to raise sufficient funds up until December 31st, 2026.

Only the agreements deemed as being feasible under New Regulatory Framework and Decree requirements may be amended for providing the universalization goals in compliance with the new law. The agreements declared not feasible may be early terminated by decision of the respective GA or even judicially.

• (a.2) Incentives for privatization 
  

The other alternative for SOC to comply with New Regulatory Framework goals is privatization^[2].

New Regulatory Framework fosters privatization in two ways:

1. According to the New Regulatory Framework, privatization will no longer result in the early termination of the Programme Agreements held by the SOC being privatized, subject to certain conditions. Before the enactment of New Regulatory Framework, the change of control of a SOC would implicate the automatic forfeiture of Programme Contracts, rendering privatization of SOC unfeasible under the old legislation;

2. New Regulatory Framework allowed the extension of Programme Agreements if done as a step towards privatization, by converting them into Concessions. In these situations, consent of relevant GA is still mandatory, because of the extension of the agreement.

New Regulatory Framework does not exclude other private participation arrangements already regulated by previous regulation, such as PPP or even common concessions when combined with the redefinition of SOC role. For example, GA may commission SOC to commercialize treated water to PHC granted with a Concession Agreement, in such a way that SOC becomes solely an upstream operator while PHC is granted with all the other services, including all the relationship with end users.

• (b) Prohibition of new Programme Contracts

Aiming at the competitiveness and equal treatment among SOC and PHC, New Regulatory Framework prohibits the execution of new Programme Contracts and even the extension of Programme Contracts (other than as a step towards privatization). SOC may participate in auctions and other bidding procedures on the same terms as any other interested company, with no privileges or distinctions.

• (c) ANA: new assignments

Brazil has 27 states and over 5,000 municipalities. As above mentioned, municipalities alongside with regions, which are created by the states, are the incumbent authorities for water and sanitation services under Brazilian law, thus retaining the powers to delegate and regulate services.

Such federative organization on water and sanitation sector led Brazil to have dozens of governmental agencies in charge of regulating either Programme Contracts or Concessions. There are no uniformity and consistency among regulations enacted by each of those governmental agencies. In spite of the fact that each agreement has only one governmental agency in charge for its respective regulation, this multitude of authorities dealing with rules increases transactional costs and hampers the doing business.

Considering this scenario, New Regulatory Framework assigned to ANA roles for consolidating and harmonizing regulation and best practices in the sector by means of the enactment of national reference standards. Such standards do not directly bind the municipal and state regulatory agencies, but these subnational agencies have a strong incentive to adhere to them: when local and regional regulation is not conformed to the national standards, the respective operators and projects are prevented from receiving federal financial aids or even facility loans granted by banks controlled by the federal government, such as BNDES and CEF.

On water and sanitation, ANA has enacted only one national standard up until now, which regulates the applicable amendments to Programme Contracts and Concessions for conforming them to New Regulatory Framework.

• (d) Regionalization

Regionalization, under the New Legal Framework, consists of joining a number of different municipalities to act as a single block in delegating the services to a concessionaire in charge of providing water and sanitation services to the whole region. Such public policy aims at:

1. Sustaining water and sanitation services in municipalities with low populational density, in which water and sanitation services might not be economically viable by themselves, by combining their operational revenues with larger, more profitable municipalities;

2. Increasing state influence and attributions in the water and sanitation sector, since states tend to be more sophisticated and technically prepared to regulate these services;

3. Fostering private participation in the sector, since operators benefit from larger scale in the context of regionalization of water and sanitation services (as opposed to providing services to a single municipality).

The main tools set forth by the New Regulatory Framework that contribute to the regionalization of water and sanitation services are:

1. Creation, by the states, of metropolitan areas, urban agglomerations and micro regions, embracing a cluster of municipalities which must share with the state the granting authority on water and sanitation services to the relevant region, to the extent that the municipalities also need to share among themselves or with the state the infrastructure related to these public utilities. Under these regionalized structures and conditions, municipalities are automatically burdened with the obligation to share among themselves and the state where they are located the grating authority on water and sanitation services;

2. Besides creating metropolitan areas, urban agglomerations and micro regions, states may create regional unities for water and sanitation services. The adhesion of the municipalities to the regional units is not mandatory;

3. In the event that a particular state does not create the referred regions, federal government is entitled to set interfederative clusters for implementing the regionalization of these services (reference blocks) and adhesion of the municipalities to the reference blocks is not mandatory;

4. Municipalities may implement another alternatives for regionalizing water and sanitation services, such as by means of public consortia or mutual interest agreements entered into with other municipalities and/or the state where they are located;

In the absence of metropolitan region, urban agglomeration or micro region, with the characteristics summarized in number 1, above, municipalities are incentivized to adhere to/implement a non mandatory regionalized structure, since they are not automatically burdened with the obligation to share the grating authority on water and sanitation services under regional units, reference blocks, public consortia or mutual interest agreement (as opposed to metropolitan areas, urban agglomerations and micro regions, which are mandatory). The main incentive municipalities have by doing so is the access to federal funding for water and sanitation services. Municipalities non-compliant with regionalization requirements are prevented to benefit from federal financial resources otherwise available to water and sanitation.

As a general rule, after Federal Decree 11030/2023, most of municipalities that do not participate of a metropolitan area, urban agglomeration, micro regions, regional units, reference blocks, public consortia or mutual interest agreement have until March 31st, 2023, to adhere to/implement a regionalized structure for providing water and sanitation services. From this date, municipalities that are not regionalized will be prevented to access financial resources provided by Federal Government as explained above.

Prior to the enactment of New Regulatory Framework, the determination of the incumbent authority on water and sanitation services among the federative entities could be debatable. Interpreting our Federal Constitution, most scholars and court precedents deemed municipalities as the natural authorities (treating water and sanitation as local services), but there were doubts with regards to municipalities located in metropolitan areas. Brazilian Supreme Court (“STF”) had three relevant precedents prior to the New Regulatory Framework. Under these precedents, the creation of metropolitan areas, which is a decision reserved to the states only, results in the necessary sharing of powers among the municipalities comprised in the region and additionally with the respective state.

As presented above, New Regulatory Framework consolidated such case law and deepened the general understanding on the matter. According to New Regulatory Framework, all the regions created by states lead to such mandatory sharing^[3].. Accordingly, regions became authentic GA of water and sanitation services carried out in their territory. Moreover, considering the governance among the state and the municipalities comprised in the region, as far as region structures are adopted, state government tends to fulfill a predominant role among all the federative entities involved in the coordination and delegation of water and sanitation services.

That leadership of the state government is an upside for private participation in the sector. From a base case standpoint, it is easier for PHC to deal with only one government responsible for a whole region comprising dozens of municipalities. Additionally, as above mentioned, states tend to be a more sophisticated interlocutor for water and sanitation projects when comparing their administrative structure with those of municipalities.

• (e) Final Conclusion

Brazil faces an undeniable improvement in its business environment in the water and sanitation sector. The experience on contractual regulation as an alternative more friendly to private investment has been solidified for the last two decades. On the top of that, bidding procedures follow increasingly best practices for auctions and competitiveness, in terms of transparency, anti-corruption rules and equal treatment among national and foreign players. BNDES, since 2016, has been structuring bidding procedures for an increasing number of water and sanitation projects: aside from engaging highly skilled consultants for modelling bid notices and agreements, the bank capitalizes on its structure and reputation to materialize larger and challenging projects, as it was the recent case in Alagoas and Rio de Janeiro.

In parallel, New Regulatory Framework brings relevant keystones for doing water and sanitation business, promoting opportunities without threatening legal stability. Judicialization of certain projects and agreements may take place, although it is worth mentioning that STF, in a recent precedent which discussed the constitutionality of New Regulatory Framework, recognized that the new law is entirely conformed with the Brazilian legal system.

Considering the short-term needs for universalizing the access to water and sanitation services in favor of millions of Brazilians, it is expected a dynamic and legally robust pipeline of projects in the next few years.

^[1] To be updated in attention to the recent enactment of a new decree.

^[2] This provision does not prevent that specific laws at the state level must be enacted for authorizing the divestiture of the stockholding control. Since state governments are the controlling shareholders of SOC, New Regulatory Framework, as a federal legislation, could not have the effect of authorizing such a transaction on the benefit of another federative entity.

^[3] There are few exceptions in which municipalities may withdraw from sharing water and sanitation utilities assigment in regions. For example, when one municipality does not share any infrastructure of water and sanitation with another entity, the former may preserve its exclusive powers on the matter.