UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549

FORM 20‑F

o    REGISTRATION STATEMENT PURSUANT TO SECTION 12(b) OR (g) OF THE SECURITIES EXCHANGE ACT OF 1934

OR

þ    ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE FISCAL YEAR ENDED DECEMBER 31, 2012

OR

o    TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the transition period from ________________ to _______________________

OR

o    SHELL COMPANY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

Date of event requiring this shell company report__________________________

Commission file number 001‑31317

Companhia de Saneamento Básico do Estado de São Paulo–SABESP
(Exact name of Registrant as specified in its charter)

Basic Sanitation Company of the State of São Paulo‑SABESP
(Translation of the Registrant’s name into English)

Federative Republic of Brazil
(Jurisdiction of incorporation or organization)

Rua Costa Carvalho, 300
05429‑900 São Paulo, SP, Brazil
(Address of principal executive offices)

Rui de Britto Álvares Affonso
raffonso@sabesp.com.br
(+55 11 3388 8247)
Rua Costa Carvalho, 300 05429‑900 São Paulo, SP, Brazil

Securities registered or to be registered pursuant to Section 12(b) of the Act:

Securities registered or to be registered pursuant to Section 12(g) of the Act:  None

Securities for which there is a reporting obligation pursuant to Section 15(d) of the Act:  None

Indicate the number of outstanding shares of each of the issuer’s classes of capital or common stock as of the close of the period covered by the annual report.

683,509,869 Shares of Common Stock

Indicate by check mark if the registrant is a well‑known seasoned issuer, as defined in Rule 405 of the Securities Act.

Yes þ No o 

If this report is an annual or transition report, indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934.

Yes o No þ 

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports) and (2) has been subject to such filing requirements for the past 90 days.

Yes þ No o 

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S‑T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).

Yes þ No o 

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non‑accelerated filer.  See definition of “accelerated filer and large accelerated filer” in Rule 12b‑2 of the Exchange Act.  (Check one):

Large accelerated filer þ Accelerated filer o Non‑accelerated filer o 

Indicate by check mark which basis of accounting the registrant has used to prepare the financial statements included in this filing:

U.S. GAAP o International Financial Reporting Standards as issued by the International Accounting Standards Board þ Other o 

If “Other” has been checked in response to the previous question, indicate by check mark which financial statement item the registrant has elected to follow

Item 17 o Item 18 o 

If this is an annual report, indicate by check mark whether the registrant is a shell company (as defined in Rule 12b‑2 of the Exchange Act).

Yes o No þ 

TABLE OF CONTENTS

i

PRESENTATION OF FINANCIAL AND OTHER INFORMATION

General

We maintain our books and records in reais.  We prepare our consolidated financial statements in accordance with International Financial Reporting Standards, or IFRS, as issued by the International Accounting Standards Board, or the IASB.  Our consolidated financial statements as of December 31, 2012 and 2011 and for the three years ended December 31, 2012 have been audited, as stated in the report appearing herein, and are included in this annual report on Form 20-F.

We also prepare individual financial statements in accordance with accounting practices adopted in Brazil, or Brazilian GAAP, which include the pronouncements issued by the CPC, for certain purposes, including for the calculation of dividends.

Convenience Translations

We have translated some of the real amounts contained in this annual report into U.S. dollars.  The rate used to translate such amounts in respect of the year ended December 31, 2012 was R$2.0435 to US$1.00, which was the commercial rate for the purchase of U.S. dollars in effect on December 31, 2012, as reported by the Central Bank.  The U.S. dollar equivalent information presented in this annual report is provided solely for the convenience of the reader and should not be construed as implying that the real amounts represent, or could have been or could be converted into, U.S. dollars at the above rate.  See “Item 3.A. Selected Financial Data—Exchange Rates” for more detailed information regarding the Brazilian foreign exchange system and historical data on the exchange rate of the real against the U.S. dollar.

Rounding

Some percentages and numbers included in this annual report have been subject to rounding adjustments.  Accordingly, figures shown as totals in certain tables may not be an arithmetic aggregation of the figures that precede them.

Other Information

In this annual report, unless the context otherwise requires, references to “we,” “us,” “our,” “Company,” or “SABESP” refer to Companhia de Saneamento Básico do Estado de São Paulo – SABESP.

In addition, references to:

·         “real,” “reais” or “R$” are to the Brazilian real, the official currency of Brazil;

·         “U.S. dollars” or “US$” are to the United States dollar, the official currency of the United States;

·         “Brazil” are to the Federative Republic of Brazil;

·         “State” are to the State of São Paulo, which is also our controlling shareholder;

·         “federal government” and “Brazilian government” are to the federal government of the Federative Republic of Brazil and “state government” are to the state government of the State of São Paulo;

·         “São Paulo metropolitan region,” with respect to our operations, are to the area where the Metropolitan executive office operates, comprising 38 municipalities, including the city of São Paulo;

·         “Regional systems” are to the area where the Regional systems executive office operates, comprising 325 municipalities in the interior and coastline regions of the State of São Paulo;

·         “water coverage ratio” are to the ratio between the number of residences connected to the water supply network, divided by the number of urban residences in a certain area; and

·         “sewage coverage ratio” are to the ratio between the number of residences connected to the sewage collection network, divided by the number of urban residences in a certain area.

Information in this annual report related to liters, water and sewage volumes, number of employees, kilometers, water and sewage connections, population served, operating productivity, water production rate, sewage lines (in kilometers), savings achieved and investment in improvement programs has not been audited.

Market Information

We make statements in this annual report about our market share and other information relating to Brazil and the industry in which we operate.  We have made these statements on the basis of information from third‑party sources and publicly available information that we believe is reliable, such as information and reports from the Brazilian Institute of Geography and Statistics (Instituto Brasileiro de Geografia e Estatística), or IBGE, and the State Data Analysis System Foundation (Fundação Sistema Estadual de Análise de Dados) or SEADE, among others.  We have no reason to believe any of this information is inaccurate in any material respect.

References to urban and total population in this annual report are estimated based on a research prepared by SEADE:  “Projections for the State of São Paulo – Population and Residences until 2025” (Projeções para o Estado de São Paulo – População e Domicílios até 2025). 

CAUTIONARY STATEMENTS ABOUT FORWARD‑LOOKING STATEMENTS

This annual report includes forward‑looking statements, mainly in Items 3 through 5.  We have based these forward‑looking statements largely on our current expectations and projections about future events and financial trends affecting our business.  These forward‑looking statements are subject to risks, uncertainties and assumptions, including, among other factors:

·         general economic, political, demographical and other conditions in Brazil and in other emerging market countries;

·         changes in applicable laws and regulations, as well as the enactment of new laws and regulations, including those relating to environmental, tax and employment matters in Brazil;

·         fluctuations in inflation, interest rates and exchange rates in Brazil;

·         the interests of our controlling shareholder;

·         our ability to collect amounts owed to us by our controlling shareholder and by municipalities;

·         our ability to continue to use certain reservoirs under current terms and conditions;

·         our capital expenditure program and other liquidity and capital resources requirements;

·         droughts, water shortages, intensive rain and other climatic events;

·         power shortages, rationing of energy supply or significant changes in energy tariffs;

·         the effects of the agreement for provision of water and sewage services in the City of São Paulo, which we executed with the State and the City of São Paulo;

·         the lack of formal agreements between our company and certain municipalities to which we provide water and sewage services, including cities comprising metropolitan regions, and the fact that the State and municipal governments share competency regarding these services;

·         the municipalities’ ability to terminate our existing concession agreements prior to their expiration date and our ability to renew such agreements;

·         our ability to provide water and sewage services in additional municipalities and to maintain the right to provide the services for which we currently have contracts;

·         the size and growth of our customer base;

·         our ability to comply with the requirements regarding water and sewage service levels included in our agreements with municipalities;

·         our level of debt and limitations on our ability to incur additional debt;

·         our ability to access financing with favorable terms in the future;

·         the costs we incur in complying with environmental laws and any penalties for failure to comply with these laws;

·         our exposure to probable increases in the frequency of extreme weather conditions;

·         the outcome of our pending or future legal proceedings;

·         our management’s expectations and estimates relating to our future financial performance;

·         the regulations issued by the São Paulo State Sanitation and Energy Regulatory Agency, or ARSESP, regarding several aspects of our business, including limitations on our ability to set and adjust our tariffs; and

·         other risk factors as set forth under “Item 3.D. Risk Factors.”

The words “believe,” “may,” “estimate,” “continue,” “anticipate,” “plan,” “intend,” “expect” and similar words are intended to identify forward‑looking statements.  In light of these risks and uncertainties, the forward‑looking events and circumstances discussed in this annual report might not occur.  Our actual results could differ substantially from those anticipated in our forward‑looking statements.  Forward‑looking statements speak only as of the date they were made and we do not undertake any obligation to update or revise any forward‑looking statements, whether as a result of new information, future events or otherwise, unless required by law.  Any such forward‑looking statements are not an indication of future performance and involve risks.

PART I

ITEM 1.            IDENTITY OF DIRECTORS, SENIOR MANAGEMENT AND ADVISERS

Not applicable.

ITEM 2.            OFFER STATISTICS AND EXPECTED TIMETABLE

Not applicable.

ITEM 3.            KEY INFORMATION

A.         Selected Financial Data

The following selected financial data should be read in conjunction with our consolidated financial statements (including the notes thereto), “Item 5.  Operating and Financial Review and Prospects” and “Presentation of Financial and Other Information.”

The selected financial data as of December 31, 2012 and 2011 and for the years ended December 31, 2012, 2011 and 2010 have been derived from our consolidated financial statements, prepared in accordance with IFRS, and included in this annual report.  The selected financial data as of December 31, 2010, 2009 and 2008 and for the years ended December 31, 2009 and 2008 have been derived from our consolidated financial statements, prepared in accordance with IFRS, which is not included in this annual report.

We have included information with respect to the dividends and/or interest attributable to shareholders’ equity paid to holders of our common shares since January 1, 2008 in reais and in U.S. dollars translated from reais at the commercial market selling rate in effect as of the payment date under the caption “Item 8. Financial Information—Dividends and Dividend Policy—Payment of Dividends.”  We prepare individual financial statements in accordance with Brazilian GAAP for certain purposes, including for the calculation of dividends.

The following tables present our selected financial data as of and for each of the periods indicated.

______________

(1)   American Depositary Shares, or ADSs.

(*)   On January 10, 2013, our board of directors approved a change in the ratio of American Depositary Receipts (“ADRs”), to common shares on the New York Stock Exchange (“NYSE”), from 1:2 to 1:1.  We have calculated the earnings per ADS and dividends and interest on shareholders’ equity per ADS for the 2012, 2011, 2010, 2009 and 2008, according to a ratio of 1:1 for comparison purposes.

______________

(2)   On April 22, 2013, our shareholders approved a stock split, following which each common share represented three new common shares. Therefore, the per share information in the selected financial data has been revised to give effect to the stock split retrospectively to all periods presented.

(3)   Treated sewage as a percentage of collected sewage.

(4)   Includes both physical and non‑physical water loss.  Water loss percentage represents the quotient of (i) the difference between (a) the total amount of water produced by us less (b) the total amount of water invoiced by us to customers minus (c) the volume of water set out below that we exclude from our calculation of water loss, divided by (ii) the total amount of water produced. 

        We exclude the following from our calculation of water loss:  (i) water discharged for periodic maintenance of water mains and water storage tanks; (ii) water supplied for municipal uses such as firefighting; (iii) water we consume in our facilities; and (iv) estimated water loss related to the supply of water to favelas (shantytowns).  

(5)   Measured in liters/connection per day, according to the method by which we measure water loss, based on worldwide market practice for the sector.  See “Item 4.B. Business Overview—Description of Our Activities—Water Operations—Water Loss.”

Exchange Rates

In the past, the Brazilian National Monetary Council (Conselho Monetário Nacional), or the CMN, has introduced changes to the Brazilian foreign exchange regime, such as unifying the Commercial and Floating Markets and easing the rules governing the ability of Brazilian residents to acquire foreign currency, among others.  On March 24, 2010, the CMN and the Central Bank approved Resolution No. 3,844, which led to a series of measures to consolidate and simplify Brazilian foreign exchange market regulations.

The Brazilian foreign exchange system allows any person or legal entity to purchase or sell foreign currency and make international transfers of reais, regardless of the amount, subject to certain regulatory procedures.

The Brazilian currency has experienced frequent and substantial variations in relation to the U.S. dollar and other foreign currencies in recent decades.  Between 2003 and mid‑2008, the real appreciated significantly against the U.S. dollar with the exchange rate reaching R$1.634 in August 2008.  Primarily as a result of the global financial crisis, the real depreciated 32.0% against the U.S. dollar during 2008 and closed the year at R$2.337 per US$1.00.  The real  strengthened again by 25.5% in 2009 and 4.3% in 2010, but depreciated against the U.S. dollar by 12.6% in 2011 and 8.94% in 2012.  On December 31, 2012, 2011 and 2010, the real/U.S. dollar exchange rate was R$2.043, R$1.876 and R$1.666 per US$1.00, respectively.

The Central Bank sometimes intervenes in the market to combat instability in foreign exchange rates.  We cannot predict whether the Central Bank or the Brazilian government will continue to let the real float freely or will intervene in the exchange rate through a currency band system or other proceedure.  The real may fluctuate against the U.S. dollar substantially in the future.  For further information on this risk, see “Item 3.D. Risk Factors—Risks Relating to Brazil—Exchange rate instability may adversely affect us and the market price of our common shares or ADSs.”

Exchange rate fluctuations will affect the U.S. dollar equivalent of the real price of our common shares on the São Paulo Stock Exchange (BM&FBOVESPA S.A. ‑ Bolsa de Valores, Mercadorias e Futuros), or the BM&FBOVESPA, as well as the U.S. dollar equivalent of any distributions we make in reais with respect to our common shares.

The following tables set forth the selling rate, expressed in reais per U.S. dollar (R$/US$), for the periods indicated.

The following tables set forth the selling rate, expressed in reais  per Japanese Yen (R$/¥1.00):

______________

9

·         the regulatory environment related to our business operations and concession agreements;

·         interest rates;

·         exchange rates and exchange controls and restrictions on remittances abroad;

·         currency fluctuations;

·         inflation; 

·         liquidity of the Brazilian capital and lending markets;

·         tax and regulatory policies and laws;

·         economic and social instability; and

·         other political, diplomatic, social and economic developments in or affecting Brazil.

For example, the Brazilian government may change its tax policy, such as changing tax rates or imposing temporary taxes.  If overall taxes are increased, we may be unable to immediately recover the difference from our consumers, which may have an adverse effect on our financial condition and results of operations.

Uncertainty over whether the Brazilian government will implement changes in policies or regulations affecting these factors or others may contribute to economic uncertainty in Brazil and to heightened volatility in the Brazilian securities market and in securities issued abroad by Brazilian issuers, which could have a material adverse effect on us and on our common shares and ADSs.

Inflation and the Brazilian government’s measures to combat inflation may contribute to economic uncertainty in Brazil, adversely affecting us and the market price of our common shares or ADSs.

Brazil has experienced extremely high rates of inflation in the past.  Inflation and the Brazilian government’s measures to combat inflation have had significant negative effects on the Brazilian economy, contributing to economic uncertainty and heightened volatility in the Brazilian securities market.  The Brazilian government’s measures to control inflation have often included maintaining a tight monetary policy with high interest rates, thereby restricting the availability of credit and reducing economic growth.  The Special Clearing and Settlement System (Sistema Especial de Liquidação e Custódia), or SELIC, the official overnight interest rate in Brazil, equaled 7.14%, 10.91% and 10.66% at the end of 2012, 2011 and 2010, respectively, in line with the target rate set by the Brazilian Committee on Monetary Policy (Comitê de Política Monetária).   

The annual rate of inflation, as measured by the General Market Price Index (Índice Geral de Preços—Mercado), or IGP‑M index, fell from 9.95% in 2000 to 3.83% in 2006, increased to 7.75% in 2007 and further increased to 9.81% in 2008.  According to the IGP‑M index, Brazil underwent deflation of 1.71% in 2009, followed by inflation of 7.81%, 5.1% and 11.32% in 2012, 2011 and 2010, respectively.  Brazilian governmental actions, including interest rate decreases, intervention in the foreign exchange market and actions to adjust or fix the value of the real, may trigger increases in inflation.  If Brazil experiences high inflation again, our costs and expenses may rise, we may be unable to increase our tariffs to counter the effects of inflation, and our overall financial performance may be adversely affected.  In addition, a substantial increase in inflation may weaken investors’ confidence in Brazil, causing a decrease in the market price of our common shares or ADSs.

Additionally, in the event of an increase in inflation, the Brazilian government may choose to raise official interest rates.  Increases in interest rates would not only affect our cost of funding, but could also have a material adverse effect on us and may also adversely affect the market price of our common shares or ADSs.

Exchange rate instability may adversely affect us and the market price of our common shares or ADSs.

The Brazilian currency experienced frequent and substantial devaluations in relation to the U.S. dollar and other foreign currencies during the decades leading up to the mid-1990s.  Throughout this period, the Brazilian government implemented various economic plans and exchange rate policies, including sudden devaluations, periodic mini‑devaluations (during which the frequency of adjustments ranged from daily to monthly), floating exchange rate systems, exchange controls and dual exchange rate markets.  From time to time since that period, there have continued to be significant fluctuations in the exchange rate between the Brazilian real and the U.S. dollar and other currencies.  For example, the real appreciated 13.8%, 9.5% and 20.7% against the U.S. dollar in 2005, 2006 and 2007, respectively.  In 2008, primarily as a result of the global financial crisis, the real depreciated 32.0% against the U.S. dollar and closed the year at R$2.337 per US$1.00.  The real  strengthened again by 25.5% in 2009 and 4.3% in 2010, but depreciated against the U.S. dollar by 12.6% in 2011 and 8.94% in 2012.  On December 31, 2012, 2011 and 2010, the real/U.S. dollar exchange rate was R$2.043, R$1.876 and R$1.666 per US$1.00, respectively.  There can be no assurance that the real will not depreciate further against the U.S. dollar.  As of April 23, 2013, the commercial selling rate as reported by the Central Bank was R$2.0435 per US$1.00.

Depreciation of the real against the U.S. dollar could create inflationary pressures in Brazil and cause increases in interest rates, which could negatively affect the growth of the Brazilian economy as a whole and harm our financial condition and results of operations, curtail our access to financial markets and prompt government intervention, including recessionary governmental policies.  Depreciation of the real against the U.S. dollar could also lead to decreased consumer spending, deflationary pressures and reduced growth of the economy as whole.

In the event of a significant devaluation of the real in relation to the U.S. dollar or other currencies, our ability to meet our foreign currency denominated obligations could be adversely affected because our tariff revenue and other sources of income are denominated solely in reais.  In addition, because we have debt denominated in foreign currencies, any significant devaluation of the real will increase our financial expenses as a result of foreign exchange losses that we must record.  We had a total foreign currency denominated debt of R$3,215.8 million as of December 31, 2012 and we anticipate that we may incur substantial additional amounts of foreign currency denominated debt in the future.  In 2012, our results of operations were negatively affected by the 8.94% depreciation of the real against the U.S. dollar, and an appreciation of the real against the yen by 2.43% which led to a R$50.5 million negative impact on our foreign exchange result, net.  We do not currently have any derivative instruments in place to protect us against a devaluation of the real  in relation to any foreign currency.  A devaluation of the real may adversely affect us and the market price of our common shares or ADSs.

Developments and the perception of risk in other countries, especially in the United States and in emerging market countries, may adversely affect the market price of Brazilian securities, including our common shares and ADSs.

The market price of securities of Brazilian companies is affected to varying degrees by economic and market conditions in other countries, including the United States and other Latin American and emerging market countries.  Although economic conditions in these countries may differ significantly from economic conditions in Brazil, investors’ reactions to developments in these other countries may have an adverse effect on the market price of securities of Brazilian issuers.  Crises in other emerging market countries or economic policies of other countries may diminish investor interest in securities of Brazilian issuers, including ours.  This could adversely affect the market price of our common shares or ADSs, and could also make it more difficult for us to access the capital markets and finance our operations in the future, on acceptable terms or at all.

The global financial crisis has caused significant consequences, including in Brazil, such as stock and credit market volatility, unavailability of credit, higher interest rates, a general slowdown of the world economy, volatile exchange rates, and inflationary pressure, among others, which have and may continue to, directly or indirectly, materially and adversely affect us and the price of securities issued by Brazilian companies, including our common shares and ADSs. 

Risks Relating to Our Control by the State of São Paulo

We are controlled by the State of São Paulo, whose interests may differ from the interests of non-controlling, including holders of ADSs.

As it owns the majority of our common shares, the State of São Paulo is able to determine our operating policies and strategy, control the election of a majority of the members of our board of directors and appoint our senior management.  As of April 23, 2013, the State owned 50.3% of our outstanding common shares.

Both through its control of our board of directors as well as by enacting State decrees, the State has in the past directed our company to engage in business activities and make expenditures that promoted political, economic or social goals but that did not necessarily enhance our business and results of operations.  The State may direct our company to act in this manner again in the future.  These decisions by the State may not be in the interests of our non-controlling, including holders of ADSs.  See “Item 5.A. Operating and Financial Review and Prospects—Certain Transactions with Controlling Shareholder.”

Following the elections for State governor in 2010, the new governor appointed Ms. Dilma Seli Pena as our chief executive officer in 2011, and Mr. Edson de Oliveira Giriboni, the Secretary of State for the State Secretariat for Sanitation and Water Resources (Secretaria de Saneamento e Recursos Hídricos do Estado de São Paulo), was elected as chairman of our board of directors.  Future changes in policy by State government may cause changes in all or some of the members of our management, which may have a material adverse effect on our business and results of operations.

The State and some State entities owe us substantial unpaid debts.  We cannot assure you as to when or whether the State will pay us.

Historically, the State and some State entities have delayed payment of substantial amounts owed to us related to water and sewage services. Aditionally, the State also owes us substantial amounts related to reimbursements of State‑mandated special retirement and pension payments that we make to some of our former employees for which the State is required to reimburse us.  As of December 31, 2012, the State owed us R$65.5 million for water and sewage services.  With respect to payment of pensions on behalf of the State, we had a non-contested reimbursement in the amount of R$196.9 million as of December 31, 2012 for actuarial liability, and a contested amount of R$1,351.2 million  as of the same date.  We do not record this contested amount as a reimbursement for actuarial liability due to the uncertainty of payment by the State.  In addition, as of December 31, 2012, we had a provision for an actuarial liability in the amount of R$1,547.2 million in respect of future supplemental pension payments the State does not accept responsibility for paying.  The amounts owed to us by the State for water and sewage services and reimbursements for pensions paid may increase in the future.

We have entered into agreements with the State to settle the overdue amounts that relate to water and sewage services.  For a detailed discussion of these agreements, see “Item 7.B. Related Party Transactions, Agreements with the State of São Paulo” and Note 8 of our consolidated financial statements.  Under these agreements, the State agreed that the amounts due with respect to water and sewage services through December 2007 could be settled through the application of dividends payable by us to the State.  In December 2007, the State agreed to pay us the outstanding balance as of November 30, 2007 of R$133.7 million in 60 consecutive monthly installments, beginning on January 2, 2008, and an amount of R$236.1 million relating to a portion of the unpaid invoices from March 2004 through October 2007 for water and sewage services.  We agreed to pay the State, in the period from January through March 2008, the outstanding balance of dividends owed to it in respect of interest on shareholders’ equity in our company from March 2004 through December 2006, in the amount of R$400.8 million.

In March 2008, we entered into a commitment agreement with the State to settle the outstanding debt related to the reimbursement of the pension benefits we paid on the State’s behalf.  For a detailed discussion of this commitment agreement, see “Item 7.B. Related Party Transactions―Agreements with the State of São Paulo.”  Under this commitment agreement, we and the State agreed that the amounts owed to us with respect to the pensions we paid on behalf of the State could be partially settled through the transfer of certain reservoirs to us that we use in the Alto Tietê System, which are owned by the State.  Following this commitment agreement, in November 2008 we and the State entered into a formal agreement relating to the pension benefits we paid on the State’s behalf.  Under this agreement, the State acknowledged that it owed us a total of R$915.3 million in this regard as of September 30, 2008, and we provisionally accepted the reservoirs in the Alto Tietê System as partial payment (R$696.3 million) subject to the transfer of the property rights in the reservoirs to us.  In November 2008, the State began to pay us the remaining balance of R$219.0 million in 114 monthly installments through to early 2018.  However, on October 29, 2003 the Public Prosecutor’s Office of the State of São Paulo (Ministério Público do Estado de São Paulo) commenced legal proceedings alleging that the transfer of ownership of the Alto Tietê System reservoirs to us would be illegal, on the basis that there is no specific legislative authorization for the transfer. We are unable to predict, however, whether and when these reservoirs will be transferred to us and therefore whether and when we will receive payment or assets equivalent to the R$696.3 million owed.  See “Item 8.A. Financial Information—Consolidated Statements and Other Financial Information—Legal Proceedings—Other Legal Proceedings.”

In addition to the R$915.3 million that the State acknowledged that it owed us under the November 2008 agreement, we are also negotiating with the State in respect to the further amount that the State does not accept that it owes us.  We are not able to assure you that we will be successful in these negotiations.  Accordingly, as of December 31, 2012, we have not recorded R$1,351.2 million related to the reimbursement that we believe is due to us for the pension benefits we paid on the State’s behalf, but we have recorded R$1.547.2 million in pension obligations.

We cannot assure you when or if the State will pay the remaining overdue amounts it owes us.  Due to the State’s history of not paying us in a timely manner for water and sewage services, and not reimbursing us in a timely manner for the pension benefits we paid on its behalf, we cannot assure you that the amount of account receivables owed to us by the State and some State entities will not significantly increase in the future.

In addition, certain municipalities and other government entities also owe us money.  See “—We may face difficulties in collecting overdue amounts owed to us by municipalities to which we provide water on a wholesale basis and municipal government entities.”  

A state controlled company that has a concession to produce energy in the Guarapiranga and Billings reservoirs may require us to pay damages for the use of water from these reservoirs.

Empresa Metropolitana de Águas e Energia S.A., or EMAE, may require us to financially compensate them for our use of water from the Guarapiranga and Billings reservoirs, which they view as a loss of electricity that could otherwise be generated and sold. Additionally, payments to EMAE, which we were supposed to have made by a specific deadline, were not made. As such, EMAE has requested compensation from us. In the event water from these reservoirs was no longer made available to us, we would have to bring water in from locations further away, which would increase the risk of not being able to provide adequate service in the region, as well as an increase in water transportation costs.

The majority shareholder of both EMAE and us, the state of São Paulo, may force a resolution regarding the dispute of water use from the Guarapiranga and Billings reservoirs, which may have an adverse affect on our business.

Additionally, in the event we are required to make  payments and compensation, our cash position and overall liquidity may be adversely affected.

We may be required to pay substantial charges for the use of reservoirs that are not our property.

We use the Billings and Guarapiranga reservoirs in order to provide water services.  We are entitled to withdraw water from these reservoirs under a grant from the State Department of Water and Energy (Departamento de Águas e Energia Elétrica do Estado de São Paulo), or DAEE. We are not currently charged for the use of these reservoirs and are uncertain as to whether we will continue to be able to use the reservoirs without paying charges, or what the likely fee scale would be if one were imposed.  We may also be required to pay additional maintenance and operational costs for our use of these reservoirs.  If we were required to pay substantial charges to the owner or additional maintenance or operational costs for our use of these reservoirs, we could be materially and adversely affected.

Risks Relating to Our Business

The Brazilian Basic Sanitation Law is still in the process of implementation and interpretation, and doubts remain as to its full impact on the industry.  ARSESP, the regulator, has the function to implement regulations under the Basic Sanitation Law within the State of São Paulo, and is in the process of reviewing, implementing and proposing changes to São Paulo State water and sewage regulations, including potentially significant changes to the tariff methodology and structure applicable to our business.  The current regulatory uncertainty, and any of the changes that are currently proposed, may have an adverse effect on our business.

Although Law No. 11,445, or the Basic Sanitation Law, has been in effect since early 2007, the full implementation of a number of its provisions remains subject to regulations that have not yet been published.  Federal Decree No. 7,217, which was enacted on June 21, 2010, and Law 11,445 implemented a first series of new principles under the Basic Sanitation Law, including the following:

·         for public‑public partnership contracts (or program contracts), public hearings must be held with respect to bid announcements, and technical and economic viability studies must be carried out;

·         the rights and obligations of customers and service providers, including penalties, are determined by the owner of the public service, not by the regulatory agency;

·         the technical and financial viability of the provision of water and sewage services should be determined based on (i) capital contributions necessary to offer the services and (ii) expected revenues from the provision of the service; and

·         when a regulated service is to be provided by different service providers, those providers must execute an agreement regulating their respective activities. 

We cannot currently anticipate all the effects that the Basic Sanitation Law and the decree will have on our business and operations, if any.

The Basic Sanitation Law requires states to establish independent regulators with the responsibility of monitoring basic sanitation services and regulating tariffs.  Federal law No. 11,445/07 and São Paulo State Law No. 1,025/07 established the ARSESP, which regulates and supervises the basic sanitation services that we provide in municipalities that have agreed to come under ARSESP’s jurisdiction.  For the municipalities that have not yet agreed to come under ARSESP’s jurisdiction for which we currently provide basic sanitation services, we determine tariffs based on State Decree 41,446/96. ARSESP has proposed or enacted a number of regulatory changes, including the following:

·         In 2008, the tariff adjustment formula was reviewed. In 2009, ARSESP opened the methodology for tariff revisions for public discussion and hearings. In 2010, ARSESP published Resolution No. 156.  This resolution established the methodology and general criteria for the valuation of our regulatory asset base to be used for purposes of tariff review processes and auditing. During 2011 and 2012 ARSESP held further public consultations regarding the methodology for tariff revisions, which was finally specified and disclosed in April 2012.  In November 2012, ARSESP published a preliminary technical note for public consultation, proposing a preliminary initial maximum average tariff (P0) and efficiency gains factor (X), based on a preliminary evaluation of assets held by us.  Following further public consultations, in March 2013 ARSESP published two resolutions, Resolution No. 406 and Resolution No. 407.

·         Resolution No. 406 sets out the following:  (i) an initial maximum average tariff (P0) and a preliminary asset base value to apply until the conclusion of an external audit of our asset base, resulting in a tariff revision of 2.3509%; (ii) authorizes the repayment to consumers of the regulation and supervision rate of 0.5% immediately after the conclusion of the operational adjustments necessary for the inclusion of this rate in the bills in the municipalities where it will be charged; (iii) ARSESP also establishes an annual tariff adjustment formula, to be implemented during the second tariff cycle, consisting of the IPCA variation (a consumer price index) for the period, adjusted by an efficiency factor designed to transfer a portion of our productivity gains to consumers, and further adjusted to reflect changes in service quality to be defined and applied as of the third year of the second tariff cycle.  According to ARSESP’s timetable the final maximum average tariff (P0) will be announced in August 2013 after the asset base value presented by us is audited.

·         A tariff revision of to a rate of 2.3509% was implemented in April 2013 pursuant to Resolution No. 406. Additionally, we will pass an inspection fee of 0.5% to consumers immediately after the conclusion of the operational adjustments necessary for the inclusion of this rate in the bills to municipalities where it will be charged.

·         Resolution No. 407 authorizes us to pass on to the service bill legal charges defined by municipal legislation, which under the Program Contracts and the Sewage and Water Supply Service Contracts must be considered in the tariff revision.

In April 2013, ARSESP passed Resolution No. 413, which effectively suspended Resolution No. 407, thereby postponing the authorization for the passing on of a municipal tax to consumers’ bills, which, prior to this Resolution, had been established in Resolution No. 407. The final decision regarding Resolution No. 407 has been postponed until August 2013.

In August 2012, ARSESP published Resolution No. 346, which established the principle that users should be compensated for any interruptions in water supply.  Implementation of this regulation has been suspended pending further technical discussions.

In 2011, ARSESP altered the standard contract that we are required to use in our relationships with retail customers, requiring that invoices be sent to the consumer of the service rather than the owner of the property.  We estimate that this change will affect ongoing legal disputes, particularly those regarding collection procedures, as well as business discussions in general.  Since this change is still being implemented, we are not currently able to predict its impact on our business.

In 2009 ARSESP enacted rules regarding the following:

·         general terms and conditions for water and sewage services;

·         procedures for communication regarding any failure in our services;

·         penalties for deficiencies in the provision of basic sanitation services; and

·         procedures for confidential treatment of our customers’ private information.

We are currently evaluating the enforceability and legality of some of these rules.  Implementation of these rules started during 2011, is currently ongoing, and is expected to continue for the next few years.  The implementation of the above mentioned rules will impact our commercial and operations processes, and may adversely affect us in ways we cannot currently predict.

The Basic Sanitation Law also allows municipalities to create their own regulatory agencies rather than being subjected to overview by ARSESP, and a number of municipalities have therefore created their own regulatory agencies.  For example:

·         The municipality of Lins, which had decided in 2007 to create its own regulatory authority, revisited this decision in 2010 and transferred the regulation of water activities in Lins, including the setting of tariffs, to ARSESP.  Lins has retained, however, the power to ultimately approve the tariff set by ARSESP.

·         The municipalities in which the hydrographic basins of the Piracicaba, Capivari and Jundiaí rivers are located created a consortium for the regulation and supervision of our activities in that area in 2011.  We are currently involved in legal proceedings in which this consortium is claiming that it has jurisdiction over our activities in the municipality of Piracaia and that ARSESP has no right to regulate our activities or set tariffs in the municipality.  We cannot predict the outcome of this case or how it may impact our business.

If other municipalities create new agencies or retain regulatory powers, we will be subject to regulation and supervision by them and to any limitations on our services that they may set.  We cannot foresee any changes that any such new agency may implement regarding our business.  If any such changes are unfavorable, they could materially and adversely affect us.

For more information on ARSESP regulations, see “Information on the Company—Business Overview—Government Regulation——”Tariff Regulation in the State of São Paulo” and “Consumer Relations in the State of São Paulo.”

New joint entities will be set up to oversee basic sanitation services in metropolitan regions, including the São Paulo Metropolitan Region.  We cannot predict how the shared management of these operations will be carried out in the São Paulo Metropolitan Region and other metropolitan regions we operate or what effect this may have on our business, financial condition or results of operations.

There are some pending cases before the Brazilian Supreme Court regarding whether the right to execute concession and program agreements in metropolitan regions belongs to the State or the municipal government.  On February 28, 2013 the Brazilian Supreme Court decided a pending case on this matter related to the State of Rio de Janeiro.  A majority of the court held that the State of Rio de Janeiro and municipal governments must set up new joint entities to oversee the planning, regulation and auditing of basic sanitation services in metropolitan regions.  On March 6, 2013, the court ruled that this decision would come into effect after a 24-month period over the State of Rio de Janeiro.  Such decision may be considered a relevant precedent on this matter and therefore similar decisions may be taken on other pending cases as well as on new cases that can be initiated.  The São Paulo metropolitan region (including the municipalities to which we provide water on a wholesale basis), one of which new decisions on such pending or new cases may apply, accounted for 74.1% of our gross revenue from services in 2012 (excluding revenues relating to the construction of concession infrastructure).  We cannot predict how the shared management of these operations could be carried out in the São Paulo Metropolitan Region and other municipalities we operate or what effect it may have on our business, financial condition or results of operation.

The terms of our agreement to provide water and sewage services in the City of São Paulo could have a material adverse effect on us.

The provision of water and sewage services in the City of São Paulo accounted for 54.7% of our gross operating revenues (excluding revenues relating to the construction of concession infrastructure) in the year ended December 31, 2012.

On June 23, 2010, the State and the City of São Paulo executed an agreement in the form of a convênio, to which we and ARSESP consented, under which they agreed to manage the planning and investment for the basic sanitation system of the City of São Paulo on a joint basis.  The principal terms of this convênio  were as follows:

·         The State and the City of São Paulo would execute a separate agreement with us, granting us exclusive rights to provide water and sewage services in the City of São Paulo.

·         ARSESP would regulate and oversee our activities regarding water and sewage services in the City of São Paulo, including tariffs.

·         A management committee (Comitê Gestor) would be responsible for planning water and sewage services for the City and for reviewing our investment plans.  The management committee consists of six members appointed for two-year terms.  The State and the City of São Paulo have the right to appoint three members each.  We may participate in management committee meetings but may not vote.

In application of the convênio, we executed a separate contract with the State and the City of São Paulo, also dated June 23, 2010, to regulate the provision of these services for the following 30 years.  The principal terms of this contract are as follows:

·         The total investment stated in the contract must be equal to 13% of gross revenues from the provision of services to the City of São Paulo, net of the taxes on revenues, which total approximately R$500 million per year.

·         We must transfer 7.5% of the gross revenues we derive under the convênio, and subtract (i) COFINS and PASEP taxes, and (ii) unpaid bills of publicly owned properties in the city of São Paulo, to the Municipal Fund for Environmental Sanitation and Infrastructure (Fundo Municipal de Saneamento Ambiental e Infraestrutura),  established by Municipal Law No. 14,934/2009.

·         Our investment plan must be compatible with the sanitation plans of the State, the City of São Paulo and, if necessary, the Metropolitan region.

·         ARSESP will ensure that the tariffs will adequately compensate us for the services we provide and that tariffs may be adjusted in order to restore the original balance between each party’s obligations and economic gain (equilíbrio econômico‑financeiro).  

We currently have an investment plan in place that reflects these obligations and addresses their compatibility with the sanitation plans for 363 in which we operate, that includes the City of São Paulo and the Metropolitan region.  The investment plan is not irrevocable and will be reviewed by our management committee every four years, particularly with respect to the investments to be executed in the subsequent period.

Because we were not previously required to invest 13% of our gross revenues or transfer 7.5% of our gross revenues to the São Paulo Municipal Sanitation and Infrastructure Fund as described above, our existing tariff and adjustment formula do not account for these requirements.  Although ARSESP is required to ensure that the tariffs will adequately compensate us for the services we provide, and ARSESP has published Resolution No. 407 authorizing us to pass on specified charges to the municipalities and include these charges in our tariff revisions, Resolution No. 407 has not yet been implemented and the final decision concerning this has been postponed until August 2013.  If we cannot pass on these charges to our customers, our financial condition and results of operations could be materially adversely affected.  For further information see “Risk Factors – Risks Relating to Our Business – The Brazilian Basic Sanitation Law is still in the process of implementation and interpretation, and doubts remain as to its full impact on the industry.  ARSESP, the regulator, has the function to implement regulations under the Basic Sanitation Law within the State of São Paulo, and is in the process of reviewing, implementing and proposing changes to São Paulo State water and sewage regulations, including potentially significant changes to the tariff methodology and structure applicable to our business.  The current regulatory uncertainty, and any of the changes that are currently proposed, may have an adverse effect on our business.” 

We currently lack formal agreements or concessions with 67 of the municipalities to which we provide service, and 38 of our existing concession agreements will expire between 2013 and 2034.  We may face difficulties in continuing to provide water and sewage services in return for payment in these and other municipalities, and we cannot assure you that they will continue to purchase services from us on the same terms or at all.

As of December 31, 2012, we provided service to 363 municipalities, of which we held formal 30‑year agreements with 258 municipalities (including the City of São Paulo).  We executed 33 of these agreements during 2012.  The 258 municipalities with which we had formal agreements at year-end accounted for 69.9 % of our total revenues for the year ended December 31, 2012 and 63.5% of our intangible assets as of December 31, 2012.  Of the 67 served municipalities for which we lacked formal agreements at year-end, we were in the process of actively renegotiating with all municipalities, including the municipality of Santos.  Together, these 67 municipalities accounted for 18.6% of our total revenues for the year ended December 31, 2012 and 26.7% of our intangible assets as of that same date.  Between 2013 and 2034, 38 of our existing concession agreements will expire.  These 38 concession agreements accounted for 9.4% of our total revenues for the year ended December 31, 2012 and 8.1% of our intangible assets as of that same date.

We may not be able to continue providing service on current terms, or at all, in the municipalities for which we do not have formal agreements, including the 67 for which we are renegotiating expired agreements.  In particular, the lack of formal concessions or contractual rights in these municipalities means that we may not be able to enforce our right to continue to provide services and we may face difficulties in being paid on a timely basis, or at all, for the services that we provide.  If we are successful in renegotiating the expired agreements, or executing formal agreements with the municipalities for which we have never had agreements, those agreements may not contain terms that are as favorable as those under which we currently operate.  We cannot make any such assumption because the Basic Sanitation Law prevents us from planning, regulating and monitoring our services and it requires more stringent control by the municipalities or by ARSESP.  The municipalities for which we do not have formal agreements may choose to start providing water and sewage services directly themselves, or may run public tenders to select another provider.  They may set eligibility requirements for which we do not qualify and, if we do qualify and participate in these tenders, we may not win.  In addition, our ability to continue operating without formal agreements may be modified or cancelled by federal, state or municipal governments, court decisions or other factors.

Any of these events could have a material adverse effect on our business, results of operations and financial condition.  See “Item 4.B. Business Overview—Our Operations” and “Item 4.B. Business Overview—Government Regulation—Concessions—Public Consortia and Cooperation Agreement Law for Joint Management.”

In the municipalities with which we did not have formal agreements by December 31, 2012, we continued operating with municipal approval or with judicial support.

The municipalities may terminate our concessions before they expire in certain circumstances.  The indemnification payments we receive in such cases may be less than the value of the investments we made.

The municipalities have the right to terminate our concessions if we fail to comply with our contractual or legal obligations, or if the municipality determines in expropriation proceedings that early termination of the concession is in the public interest.  If a municipality terminates our concession, we are entitled to be indemnified for the unamortized portion of our investments. 

The Basic Sanitation Law provides that on early termination of a concession, the entity that provides sanitation services should carry out a valuation of the assets that relate to the services we provide, in order to calculate the unamortized portion of our investments.  This valuation uses the criteria defined in the service contract or, in the absence of a contract, is based on customary practice with respect to the services for the preceding 20 years.  The resulting indemnification payment may be less than the remaining value of the investments we made. 

In addition, the São Paulo State constitution permits the municipalities to pay us this compensation in installments over 25 years.  Receiving compensation over this extended period after termination of a significant concession would have a material adverse effect on our financial condition.  The Brazilian Supreme Court suspended this deferred payment mechanism in a 1997 decision, but we cannot assure you that the mechanism will not be reinstated.  This case is still awaiting a final decision, but on March 15, 2004 the Attorney General issued an opinion that this payment method is unconstitutional.  The Basic Sanitation Law reduced the maximum time period for payment of indemnification in such cases to four years.  This provision applies to concession agreements entered into prior to the enactment of the Basic Sanitation Law only to the extent that the concession agreement does not contain a contractual indemnification provision, or we have not otherwise entered into an agreement with the municipality with regard to such early termination.  These provisions have not yet been tested by the courts and we are therefore unable to predict the effect of the Basic Sanitation Law on our rights to indemnification for the early termination of any particular concession.

In 1997, the municipality of Santos enacted a law in order to repossess our water and sewage systems in Santos.  We have adopted the necessary judicial measures to contest this and continue to operate our services in Santos as of December 31, 2012.

In 1995, the municipality of Diadema terminated its concession agreement with us.  We commenced legal proceedings against the municipality, which were settled in 1996, but the municipality did not comply with the terms of the settlement.  In December 2008, we entered into a memorandum of understanding with the State of São Paulo, the municipality of Diadema and the State Secretariat for Sanitation and Water Resources, previously known as the State Secretariat for Sanitation and Energy (Secretaria de Saneamento e Energia do Estado de São Paulo).  Under this memorandum of understanding the parties agreed to conclude negotiations and settle all outstanding amounts, and we agreed to stay the collection proceedings we had filed against the municipality.  In 2011 we and the municipality of Diadema agreed to develop shared infrastructure for water and sewage services through a mixed capital company to be called Companhia de Agua e Esgoto de Diadema, or CAED.  According to the agreement, the amount owed to us by Diadema would be repaid through the issuance of shares in CAED.  However, CAED has not yet been established, and we cannot predict whether or when it will be created or begin operations.  Feasibility studies have been completed and indicate that CAED would have a viable business, but the Diadema municipal authorities have started new negotiations to amend the legislation that provided for the setting up of CAED.  We can give no assurance that we will recover the amount owed to us by Diadema, whether through an investment in CAED or otherwise.

For further information on these proceedings, see “Item 8.A. Financial Information—Consolidated Statements and Other Financial Information—Legal Proceedings.”

Other municipalities may seek to terminate their concession agreements before the contractual expiration date.  If this occurs and we do not receive adequate indemnification for our investments, or the indemnification is paid over an extended period, we may suffer material harm to our financial position.

We may face difficulties in collecting overdue amounts owed to us by municipalities to which we provide water on a wholesale basis and municipal government entities.

As of December 31, 2012, our total accounts receivable was R$4,098.0 million.  Of this amount, certain municipalities to which we provide water on a wholesale basis owed us R$1,677.7 million, and certain municipal government entities owed us R$792.1 million.  Of the total amount owed by municipalities, R$174.3 million was overdue by between 30 and 360 days and R$1,453.3 million was overdue by over 360 days.

The Brazilian courts are entitled to obligate us to continue to supply water to these municipalities, even when we have not received payments due to us.  We have no way of ensuring that negotiations with these municipalities or legal action taken against the municipalities will result in payments being made.  Some entities associated with municipal governments for which we provide services also do not make regular payments.  We cannot guarantee if or when these entities will make payments on a regular basis or pay the amounts owed to us.  If the municipalities and related entities do not pay the amounts owed to us, we may suffer material harm to our financial position. 

Any failure to obtain new financing may adversely affect our ability to continue our capital expenditure program.

Our capital expenditure program will require resources of approximately R$9.9 billion in the period from 2013 through 2016.  In 2012 we recorded R$2.5 billion in capital expenditures.

We have funded these capital expenditures with cash generated by our operations as well as borrowings in Brazilian reais  and foreign currencies, and we intend to continue to fund our capital expenditures from these sources.  A significant portion of our financing needs has been provided by the Brazilian federal public government banks.  We have obtained long‑term financing at attractive interest rates from multilateral agencies and domestic and international governmental development banks.  If the Brazilian government changes its policies regarding the financing of water and sewage services, or if we fail to obtain long‑term financing at attractive interest rates from domestic and international multilateral agencies and development banks in the future, we may not be able to meet our obligations or finance our capital expenditure program, which could have a material adverse effect on our business and financial condition.

Governmental agencies, institutional lenders and multilateral agencies constitute our main sources of financing in addition to cash generated by our operations and issuances of debt securities in the domestic and international capital markets.  Brazilian financial institutions are legally limited up to a certain percentage of their shareholder’s equity to provide loans to public sector entities, such as us.  These limitations could adversely affect our ability to continue our capital expenditure program.

Our debt includes financial covenants that impose indebtedness limits on us, which could have a material adverse effect on us.  For further information on these covenants, see “Item 5.B. Liquidity and Capital Resources—Capital Sources—Indebtedness Financing—Financial Covenants.”  Our failure to comply with these covenants could seriously impair our ability to finance our capital expenditure program, which could have a material adverse effect on us.

Compliance with environmental laws and environmental liability payments could have a material adverse effect on us.

We are subject to extensive Brazilian federal, state and municipal laws and regulations relating to the protection of human health and the environment.  These laws and regulations set water potability standards and limit or prohibit the discharge or spillage of effluent produced in our operations, particularly raw sewage.  We occasionally suffer accidents such as leakages or breaks in pipes that could lead to liability for damages under environmental law.  We could be subject to various types of criminal, administrative and civil proceedings for non‑compliance with environmental laws and regulations, which could expose us to penalties and criminal sanctions, such as fines, closure orders and significant indemnification obligations.  The scope and enforcement of environmental laws in Brazil are becoming more stringent, and our capital expenditures and environmental compliance costs may increase substantially as a result.  These expenses may lead us to reduce expenditure on strategic investments, which could harm our business.  In addition, Brazilian courts are enforcing environmental laws more stringently than in the past, which may result in fines or liability for damages that are significantly higher than those we currently anticipate.  We are party to various environmental proceedings that could have a material adverse impact on us, including civil processes and investigations relating to the release of untreated sewage into waterways and the disposal of sludge generated by treatment plants.  Any unfavorable judgment in relation to these proceedings, or any material unforeseen environmental liabilities, may have a material adverse effect on us.  For further information on these proceedings, see “Item 8.A. Financial Information-Consolidated Statements and Other Financial Information-Legal Proceedings.”  For further information on investments in environmental programs, see “Item 4.A - Main Projects of our Capital Expenditure Program,” “Item 4.B – Busniess Overview – Sewage Treatment and Disposal ,” “Item 4.B – Business Overview - Environmental Matters” and “Item 4.B – Business Overview - Environmental Regulation.”

New laws and regulations relating to climate change and changes in existing regulation, as well as the physical effects of climate change, may result in increased liabilities and increased capital expenditures, which could have a material adverse effect on us.

Current federal, state and municipal laws and regulations on climate change establish global goals, which we intend to meet  concerning greenhouse gas emissions and this may require us to increase our investments in order to comply with these laws. Currently, however, if we increase our capital expenditures for this purpose, we may be required to reduce expenditures on other strategic investments.

In addition, climate change may lead to increases in extreme weather events such as droughts or torrential rain, which may affect our ability to deliver our services and require us to take action such as:

·         investing in seeking new water sources located further from major consumer centers;

·         investing in new technologies;

·         adopting water conservation practices and implementing alternative demand management systems such as economic mechanisms or educational programs; and

·         increasing our reserve capacity.

We have not attempted to evaluate the investments that may be necessary as a result of climate change.  It may require us to increase expenditures, whether for compliance with changes in environmental regulations or for preventing or remedying the physical effects of climate change.  We may be required to adopt new standards aimed at improving energy efficiency and minimizing emissions of greenhouse gases when we renew our operating systems licenses or seek to obtain licenses for new ventures.  See “Item 4.B. Business Overview—Environmental Matters—Climate Change Regulations:  Reduction of Greenhouse Gases (GHG).”

An increase in sea levels could cause additional intrusion of salt water in the river estuaries where we collect water for treatment, which could generate problems in our treatment, water supply and sanitation systems in coastal areas, including physical damage to facilities and networks.  Additionally, increases in air temperature could affect demand for water.  Climate change may also reduce water levels in the reservoirs that power hydroelectric plants in Brazil, which may cause energy shortages and increase electricity prices, which may adversely affect our costs and operations.

We cannot predict all of the effects of climate change.  We have not provisioned any funds for climate change events as current technology and  contrasting scientific understandings of climate change make it difficult to predict potential expenses and liabilities.  We may need to make substantial new expenditures, either to comply with new environmental regulations linked to climate change or to prevent or correct the physical effects of climate change, any of which could have a material adverse effect on our results of operations. 

We are exposed to risks associated with the provision of water and sewage services.

Our industry is affected by the following additional risks relating to the provision of water and sewage services:

·         The state and federal government agencies that manage water resources impose substantial charges for the abstraction of water from bodies of water and the discharge of sewage.  We may not be able to pass these charges on to our customers.  See “Item 4.B. Business Overview—Government Regulation—Water Usage.”

·         The degradation of watershed areas may affect the quantity and quality of water available to meet demand from our customers.  See “Item 4.A. History and Development of the Company—Capital Expenditure Program” and “—Main Projects of Our Capital Expenditure Program.”

·         In addition to the risks discussed under “—The terms of our new agreement to provide water and sewage services in the City of São Paulo could have a material adverse effect on us,” we may not be able to increase our tariffs on a timely basis, or at all, in order to pass on increases in inflation or operating expenses, including taxes, to our customers.  These constraints may have an adverse effect on our ability to fund our capital expenditure program and financing activities, and to meet our debt service requirements.  See “Item 5.A.  Operating and Financial Review and Prospects—Factors Affecting Our Results of Operations—Effects of Tariff Increases.”

·         In addition to the risks discussed under “— New laws and regulations relating to climate change and changes in existing regulation, as well as the physical effects of climate change, may result in increased liabilities and increased capital expenditures, which could have a material adverse effect on us,” we are exposed to various weather-related risks, since our financial performance is closely linked to climate patterns.  The expected increase in the frequency of extreme weather conditions in the future may adversely affect both the quality and quantity of waters available for abstraction, treatment, and supply.  Droughts could adversely affect the water supply systems, resulting in a decrease in the volume of water distributed and billed as well as in the revenue derived from water supply services.  An increase in heavy rainfall could impact water quality and the regular operation of water sources, including abstraction of waters from our dams, due to increased soil erosion, silting, pollution and eutrophication of aquatic ecosystems.  See “Item 5.A. Operating and Financial Review and Prospects—Factors Affecting Our Results of Operations—Effects of Climate Change (Drought and Intense Rainfalls).”

·         We are dependent upon energy supplies to conduct our business.  Any shortages or rationing of energy may prevent us from providing water and sewage services, and may also cause material damage to our water and sewage systems when we resume operations.  Also, we may not be able to pass on any significant increases in energy tariffs to our customers.  See “Item 4.A. History and Development of the Company‑Energy Consumption.”

Any of the above may have a material adverse effect on us.

Any substantial monetary judgment against us in legal proceedings may have a material adverse effect on us.

We are party to a number of legal proceedings involving significant monetary claims.  These legal proceedings include, among others, civil, environmental, tax, labor, criminal and other proceedings.  As of December 31, 2012, the total value of all outstanding claims against us was R$36,866.9 million (net of R$330.2 million in court deposits).  A substantial monetary judgment against us in one or more of these legal proceedings may have a material adverse effect on our financial condition.  We have provisioned a total aggregate amount of R$1,189.2 million (net of court deposits) as of December 31, 2012 to cover probable losses related to legal proceedings.  This provision does not cover all legal proceedings involving monetary claims filed against us and it may be insufficient to cover our liabilities related to these claims.  Any unfavorable judgment in relation to these proceedings may have a material adverse effect on us.  For more information, see “Item 8.A. Financial Information—Consolidated Statements and Other Financial Information—Legal Proceedings.”

Risks Relating to Our Common Shares and ADSs

We may not always be in a position to pay dividends or interest on shareholders’ equity and ADSs.

Depending on our future results, our shareholders may not receive dividends or interest on own capital if we do not generate a profit.  Despite the requirement to distribute a minimum of 25% of our annual net income to shareholders, our future financial position may not permit us to distribute dividends or pay interest on own capital.

The relative volatility and illiquidity of the Brazilian securities markets may substantially limit your ability to sell our common shares underlying the ADSs at the price and time you desire.

Investing in securities from emerging markets such as Brazil involves greater risk than investing in securities of issuers in major securities markets, and these investments are often considered to be more speculative in nature.  The Brazilian securities market is substantially smaller, less liquid, more concentrated and can be more volatile than major securities markets.  Accordingly, although you are entitled to withdraw the common shares underlying the ADSs from the depositary at any time, your ability to sell the common shares underlying the ADSs at a price and time at which you wish to do so may be substantially limited.  There is also significantly greater concentration in the Brazilian securities market than in major securities markets.  The ten largest companies in terms of market capitalization represented approximately 51.8% of the aggregate market capitalization of the BM&FBOVESPA as of December 31, 2012.  The top ten stocks in terms of trading volume accounted for approximately 43.0%, 47.2% and 48.8% of all shares traded on the BM&FBOVESPA in 2012, 2011 and 2010, respectively.

Investors who exchange ADSs for common shares may lose their ability to remit foreign currency abroad and obtain Brazilian tax advantages.

The Brazilian custodian for the common shares underlying our ADSs must obtain a certificate of registration from the Central Bank in order to be entitled to remit U.S. dollars abroad for payments of dividends and other distributions relating to our common shares or upon sales of our common shares.  If an ADR holder decides to exchange ADSs for the underlying common shares, the holder will be entitled to continue to rely on the custodian’s certificate of registration for five business days from the date of exchange.  After that period, the holder may not be able to obtain and remit U.S. dollars abroad upon sale of our common shares, or distributions relating to our common shares, unless he or she obtains his or her own certificate of registration or registers under Resolution No. 2,689, dated January 26, 2000, of the CMN, which entitles registered foreign investors to buy and sell on a Brazilian stock exchange.  If the holder does not obtain a certificate of registration or register under Resolution No. 2,689, the holder will generally be subject to less favorable tax treatment on gains with respect to our common shares.

If a holder attempts to obtain his or her own certificate of registration, the holder may incur expenses or suffer delays in the application process, which could delay his or her ability to receive dividends or distributions relating to our common shares or the return of his or her capital in a timely manner.  The custodian’s certificate of registration or any foreign capital registration obtained by a holder may be affected by future legislative changes, and additional restrictions applicable to the holder, the disposition of the underlying common shares or the repatriation of the proceeds of disposition may be imposed in the future.

A holder of common shares or ADSs may face difficulties in protecting his or her interests as a shareholder because we are a Brazilian mixed capital company.

We are a mixed capital company (sociedade de economia mista) organized under the laws of Brazil, and all of our directors and officers and our controlling shareholder reside in Brazil.  All of our assets and those of these other persons are located in Brazil.  As a result, it may not be possible for a holder to effect service of process upon us or these other persons within the United States or other jurisdictions outside Brazil or to enforce against us or these other persons judgments obtained in the United States or other jurisdictions outside Brazil.  Because judgments of U.S. courts for civil liabilities based upon the U.S. federal securities laws may only be enforced in Brazil if certain requirements are met, a holder may face more difficulty in protecting his or her interests in the case of actions by our directors, officers or our controlling shareholder than would shareholders of a corporation incorporated in a state or other jurisdiction of the United States.  In addition, under Brazilian law, none of our assets which are essential to our ability to render public services are subject to seizure or attachment.  Furthermore, the execution of a judgment against our controlling shareholder may be delayed, since the State may only be able to pay a judgment if it is provided for in its budget in a subsequent fiscal year.  None of the public property of our controlling shareholder is available for seizure or attachment, either prior to or after judgment.

Mandatory arbitration provisions in our bylaws may limit the ability of a holder of our ADSs to enforce liability under U.S. securities laws.

Under our bylaws, any disputes among us, our shareholders and our management with respect to the Novo Mercado rules, Brazilian Corporate Law and Brazilian capital markets regulations will be resolved by arbitration conducted pursuant to the BM&FBOVESPA Arbitration Rules in the Market Arbitration Chamber.  Any disputes among shareholders, including ADR holders, and any disputes between us and our shareholders, including ADR holders, will also be submitted to arbitration.  As a result, a court in the United States might require that a claim brought by an ADR holder predicated upon the U.S. securities laws be submitted to arbitration in accordance with our bylaws.  In that event, a purchaser of ADSs would be effectively precluded from pursuing remedies under the U.S. securities laws in the U.S. courts.

A holder of our common shares and ADSs might be unable to exercise preemptive rights and tag‑along rights with respect to the common shares.

U.S. holders of common shares and ADSs may not be able to exercise the preemptive rights and tag‑along rights relating to common shares unless a registration statement under the U.S. Securities Act of 1933, as amended, or the Securities Act, is effective with respect to those rights or an exemption from the registration requirements of the Securities Act is available.  We are not obligated to file a registration statement with respect to our common shares relating to these rights, and we cannot assure you that we will file any such registration statement.  Unless we file a registration statement or an exemption from registration is available, an ADR holder may receive only the net proceeds from the sale of his or her preemptive rights and tag‑along rights or, if these rights cannot be sold, they will lapse and the ADR holder will receive no value for them.

A holder of our ADSs may find it more difficult than a holder of our common shares to exercise his or her voting rights at our shareholders’ meetings.

Holders may exercise voting rights with respect to the common shares represented by our ADRs only in accordance with the deposit agreement relating to our ADRs.  Neither Brazilian law nor our bylaws limit the ability of ADR holders to exercise their voting rights with respect to the underlying common shares through the depositary.  However, the additional procedural steps involved in communicating with ADR holders impose practical limitations on the exercise of voting rights.  For example, our common shareholders will receive notice of shareholders’ meetings through publication of a notice in an official government publication in Brazil and will be able to exercise their voting rights by either attending the meeting in person or voting by proxy.  ADR holders, by comparison, will not receive notice directly from us; instead, in accordance with the deposit agreement, we will provide the notice to the depositary, which in turn will mail the notice of the meeting to ADR holders as soon as practicable after publication, along with a statement as to the manner in which holders may give voting instructions, but only if we request the depositary to do so.  To exercise their voting rights, ADR holders must then give instructions to the depositary.  Due to these procedural steps, the process for exercising voting rights may take longer for ADR holders than for holders of common shares.  The deposit agreement provides that if the depositary does not receive any instructions from a holder of ADRs, the ADR holder may be deemed to have given a discretionary proxy to a person designated by our company and the underlying shares may be voted by such person.  However, we chose not to designate any person to exercise these deemed proxy rights with respect to the annual general meeting held to approve our financial statements for 2012, and ADSs for which no specific voting instructions were received by the Depositary were therefore not voted at that meeting.

A.      History and Development of the Company

Overview

Companhia de Saneamento Básico do Estado de São Paulo – SABESP is a mixed capital company (sociedade de economia mista) with limited liability.  We were incorporated on September 6, 1973 under the laws of the Federative Republic of Brazil.  We are registered with the Commercial Registry of the State of São Paulo (Junta Comercial do Estado de São Paulo) under registration number NIRE 35300016831.  Our principal executive offices are located at Rua Costa Carvalho, 300, 05429‑900 São Paulo, SP, Brazil.  Our telephone number is +55 11 3388‑8000.  Our agent for service of process in the United States is CT Corporation System, with offices at 818 West Seventh Street – Team 1, Los Angeles, CA 90017.  We are allowed to operate, in a subsidiary form, in other Brazilian locations and abroad.  See “Item 4.B. Business Overview—Government Regulation—Concessions—Public Consortia and Cooperation Agreement Law for Joint Management.”

We believe we are one of the largest water and sewage service providers in the world (based on the number of customers in 2012, according to the 14^th edition of the Pinsent Masons Water Yearbook 2012-2013).  We operate water and sewage systems in the State of São Paulo, which includes the city of São Paulo, Brazil’s largest city.  According to the IBGE, the State of São Paulo is Brazil’s most populous state and the state with the highest gross domestic product, or GDP, in Brazil.  For the year ended December 31, 2012, we generated consolidated net revenue of R$10,754.4 and consolidated net income of R$1,911.9.  Our total consolidated assets amounted to R$26,675.8 and our total shareholders’ equity amounted to R$11,715.6 as of December 31, 2012.

As of December 31, 2012, we provided water and sewage services to a broad range of residential, commercial, industrial and governmental customers in 363 of the 645 municipalities in the State of São Paulo, including the city of São Paulo.  Substantially all of our concessions or program agreements have 30‑year terms.  At year-end 2012 we lacked formal agreements for 67 of the municipalities we serve, each of which we are in the process of actively renegotiating, including in the municipality of Santos.  From January 1, 2013 through 2034, 38 further concessions will expire, and we will seek to replace them with program agreements.

We also supply water on a wholesale basis to six municipalities in the São Paulo metropolitan region in which we do not operate water distribution systems (together covering a total estimated urban population of approximately 3.5 million).  Five of these municipalities also utilize our sewage treatment services.  For the year ended December 31, 2012, the São Paulo metropolitan region (including the municipalities to which we provide water on a wholesale basis) accounted for 74.1% of our gross operating revenue (excluding revenues relating to the construction of concession infrastructure), while the Regional Systems accounted for 25.9%.

As of December 31, 2012, we provided water services through 7.7 million water connections to approximately 24.2 million people, representing approximately 59% of the urban population of the State of São Paulo, and had a water coverage ratio of approximately 99% in respect of all regions.  As of that date, we provided sewage services through 6.1 million sewage connections to approximately 21.0 million people and had an effective sewage coverage ratio of 83%.  As of December 31, 2012, we operated using 67,647 kilometers of water pipes and mains and 45,778 kilometers of sewer lines.

We also provide water and/or sewage services to four other municipalities through special purpose companies.  In addition, we provide consulting services regarding the rational use of water and commercial and operational management in Panama and Honduras through a partnership with Latin Consult.  In addition we recently set up two new activities in partnership with other companies:  Aquapolo Ambiental S.A., a joint venture with a private sanitation services operator, which commenced operations in the second half of 2012 and operates the largest water recycling facility in the southern hemisphere, supplying up to 1,000 liters per second to industries in the Capuava petrochemical cluster in the São Paulo metropolitan region; and Attend Ambiental, a joint venture with Estre Ambiental S.A., which is constructing a pre-treatment and processing plant for non-domestic effluent in the São Paulo metropolitan region that is expected to commence operations in the second half of 2013.

The State of São Paulo, our controlling shareholder, is required by law to own at least 50% plus one of our common shares.  As of May 8, 2013, the State owned 50.3% of our outstanding common shares.  As a mixed capital company, we are an integral part of the State governmental structure.  Our strategy and major policy decisions are formulated in conjunction with the State Secretariat for Sanitation and Water Resources as part of the State’s overall strategic planning.  The majority of the members of our board of directors and our board of executive officers are nominated by the State government.

In addition, our capital expenditure budget is subject to approval by the State legislature and is approved in conjunction with the budget of the State Secretariat for Sanitation and Water Resources as a whole.  Our consolidated financial statements and accounting records are subject to review by the State Accounts Tribunal (Tribunal de Contas), as are all accounts of the State.

Our Strengths

We believe that our strong business position and future prospects derive from the following strengths:

Well‑established business with significant size, scale and know‑how to operate in complex urban settings.  We believe we are one of the largest water and sewage service providers in the world.  We provide water services directly to approximately 24.2 million people and supply water on a wholesale basis to an additional urban population of approximately 3.5 million people.  As of December 31, 2012, we had an effective water coverage ratio of approximately 99% in respect of all regions in which we operate.  We also provide sewage services directly to approximately 21.0 million people, achieving an effective sewage coverage ratio of 83% in respect of all regions in which we operate as of December 31, 2012.  During the year ended December 31, 2012, our net operating revenues (including revenues relating to the construction of concession infrastructure) increased by 8.2% as compared to 2011.  Our significant size and scale have required us to operate in complex urban settings such as favelas (shantytowns) and environments without urban planning, which has enabled us to develop skill in operating in adverse conditions, well‑trained personnel and a specialized structure that we believe our competitors lack.

Operations in Brazil’s most populous and wealthy state.  The State of São Paulo, which is located in the most developed and economically active region of Brazil, is the most populous state in Brazil, with an estimated total population of 43.9 million as of December 31, 2012.  The city of São Paulo had an estimated total population of 11.0 million as of the same date, while the São Paulo metropolitan region had a total population of 20.8 million.  Based on its GDP, the State of São Paulo is the wealthiest state and largest economy in Brazil.  The GDP of the State of São Paulo was approximately R$1.2 trillion in 2010, representing approximately 33% of Brazil’s total GDP.  The State of São Paulo generates more revenue from water and sewage services than any other Brazilian state.

Strong Base of Contracted Business.  Of the 363 municipalities we serve, we have executed 30‑year agreements with 258 of the municipalities in the last six years, including the agreement with the City of São Paulo, which we executed in June 2010.  For the year ended December 31, 2012, the income from the 258 municipalities with which we have formal long‑term contracts accounted for 69.9% of our gross operating revenues (including revenues relating to the construction of concession infrastructure).

Access to low‑cost and diverse sources of financing.  Our strong cash flow generation from operations and our role as an essential public service provider places us in a privileged position in our industry to obtain low cost, long‑term financing from Brazilian public banks, and domestic and international multilateral agencies and development banks.  We do not depend on a limited number of sources of financing, but instead have access to various funding alternatives in the Brazilian and international markets to fund our working capital needs and our capital expenditure programs.

Strong corporate governance practices.  In 2002, we joined the Novo Mercado segment of the BM&FBOVESPA, which is the listing segment in Brazil with the highest corporate governance requirements.  As a result, we are committed to certain corporate governance standards that are not otherwise required by Brazilian law, which provides heightened protection to our shareholders and enhances the quality of information we disclose to the market.  On December 1, 2007, we became part of the BM&FBOVESPA Corporate Sustainability Index, or ISE, which reflects our high degree of commitment to sustainable environmental and social practices.  Commencing February 2013, our shares have also been included in the Dow Jones Sustainability™ Emerging Markets Index.

High quality operations.  We believe that we adhere to high standards of service and employ the best available technology in the sanitation business to control the quality of the water we abstract, process and distribute.  All of our water quality control laboratories operate in accordance with the ABNT NBR ISO 9001 standard, the highest international water quality standard.  In addition to our central laboratory, 12 of our regional laboratories are accredited by the National Institute of Metrology, Standardization and Industrial Quality, or INMETRO, and comply with the ABNT NBR ISO IEC 17025 standard, thereby assuring the quality and accuracy of our test results.  Moreover, our laboratories and field teams use the latest equipment to detect substances controlled by regulations and have highly trained teams to handle contingencies and customer complaints.  We believe our technology enhances the efficiency and quality of our operations.

Our Strategy

Our mission is to provide water and sewage services, contributing to improvements in quality of life and the environment.  To this end, our strategic objectives are based upon the guiding principles of growth, quality, universalization of sanitation services and social, economic and environmental sustainability, while focusing on reaching excellence in customer service.  Our strategic objectives also focus on our political and institutional relationships as well as on our commitment to the market to increase shareholder value.  We seek to implement these guiding principles through the following strategies:

Continue to seek growth while improving our financial results by reducing operating costs, increasing productivity and profitability and prudently managing our levels of indebtedness.  We aim to apply our principles of financial growth and sustainability to each business unit, assigning goals and setting clear responsibilities to each unit so as to strengthen our financial results.  To achieve this goal, we intend to use our best efforts to reduce operating costs and increase productivity and profitability.  We plan to improve the management of our assets, as well as to continue to reduce our total operating expenses by automating some of our facilities, streamlining operational processes, implementing integrated planning and further investing in internal technological research and development.  We also plan to continue our efforts to improve our collection of overdue accounts receivable from municipalities to which we provide services, from the State and from other governmental entities, including by exploring opportunities to offset these outstanding debts against certain possessory or property rights over utilities relating to water and sewage systems.  We intend to continue to fund our working capital needs and estimated capital expenditure programs with diversified sources of financing, such as domestic and international development banks and multilateral agencies.  We will continue to seek market opportunities for low‑cost financing and restructuring of our indebtedness if and when advantageous and appropriate.

Improve operating efficiency and reduce water loss.  We seek to reduce both physical water loss, which results mainly from leakage; non‑physical water loss, which results primarily from inaccurate water meters installed at customers’ premises and at our water treatment facilities; and clandestine and illegal water use.  In order to achieve more consistent long‑term results, we have developed a comprehensive 12 year program to reduce our water loss rate.  The first four years of the program from 2009 to 2012 were funded by BNDES.  From 2013 to 2016 the program will be funded by a loan granted by the government of Japan through the Japan International Cooperation Agency, or JICA.  The program focuses on renewing our water distribution infrastructure and improving maintenance and control services as a means of reducing physical water loss.  We are also seeking to reduce physical water loss by creating smaller water supply districts through the construction of district metering areas, which reduce system pressure and pipe bursts, and allow leaks to be detected and repaired more efficiently.  The program also seeks to reduce non‑physical water loss by upgrading and replacing inaccurate water meters and through inspections of non‑authorized water consumption in water service connections.

Ensure the quality and availability of our services in our existing service area.  Our goal is to maintain an effective water coverage ratio of around 100%, coupled with a high standard of quality and availability, and meet the expected population growth by adding 1.3 million water connections between 2013 and 2020.  We also intend to increase our sewage coverage ratio to 95% by 2020 by adding 1.9 million sewage connections.  In addition, we are also developing short, medium and long‑term marketing strategies, such as client segmentation and tailor‑made solutions for different types of clients, which we believe will help us increase our customer base.  We also seek to improve our customer support strategies by modernizing our telephone and internet‑based customer support and to continuously measure the level of satisfaction of our clients.

Maintain and continue to expand our existing service areas.  We intend to maintain and expand our operating base by executing new agreements.  To this end, we are actively seeking to develop closer relationships with the municipal governments that we currently serve in order to increase customer loyalty and thereby renew all or substantially all our concession agreements as they expire.  In June 2010, we entered into a 30‑year agreement with the State and city of São Paulo for the provision of water and sewage services in the city of São Paulo, which in the year ended December 31, 2012 accounted for 54.7% of our gross operating revenues (excluding revenues relating to the construction of concession infrastructure).  Between January 1, 2007 and December 31, 2012, we entered into 258 30‑year agreements with municipalities (including our services agreement with the city of São Paulo), of which 33 were entered into in 2012.  These 33 municipalities accounted for 4.3% of our total revenues for the year ended December 31, 2012 and 4.2% of our intangible assets as of the same date.  As of December 31, 2012, 67 of our concessions had expired and are currently being renegotiated.  These 67 municipalities accounted for 18.6% of our total revenues for the year ended December 31, 2012 and 26.7% of our intangible assets as of the same date.  From January 1, 2013 through 2034, 38 concession agreements, accounting for 9.4% of our revenues for the year ended December 31, 2012 and 8.1% of our intangible assets as of the same date, will expire.

We have also developed a platform to offer specialized services in the field of sustainability, environmental preservation and water resource management to our large industrial, commercial and residential customers in order to encourage these customers to continue to use our water services.  We also intend to continue to expand our sewage services.  A significant portion of our capital expenditure program, representing approximately R$9.9 billion between 2013 and 2016, is designed to achieve this goal.  We also regularly explore the possibility of executing agreements for the provision of water and sewage services in municipalities in the State of São Paulo in which we currently have no operations or to which we currently supply water and provide sewage treatment solely on a wholesale basis, which together represent a total population of approximately 17 million.  We evaluate possible expansion opportunities in terms of proximity to our existing service areas to maximize return on investment and improve our financial performance.  We also intend to study and take advantage of opportunities in other Brazilian states and in other countries to expand our services and increase our market share.

Expand our water and sewage services.  We had an effective sewage coverage ratio of 83% as of December 31, 2012 and plan to increase this ratio to 95% by 2020 by adding over 1.9 million sewage connections.  In addition, there are municipalities in the State of São Paulo representing a total population of approximately 17 million to which we currently do not provide water or sewage services, or to which we currently supply water solely on a wholesale basis.  Our strong presence in the State and experience in providing water and sewage services places us in a privileged position to expand our sewage services to these additional municipalities in the State of São Paulo, as well as to other Brazilian states and abroad.  Further, we seek to deepen our relationships with strategic clients that consume high volumes of water (more than 500 cubic meters per month) by applying special tariffs to these clients.

Seek selective opportunities to expand our business.  Since 2008 we have expanded into various activities that complement our water and sewage services, such as urban rainwater management and drainage services, urban cleaning services and solid waste management services.  For example:

·         We have cooperation agreements to exchange technology with six regional basic sanitation companies in Brazil, as well as with international providers such as Mekorot National Water Company of Israel, Sociedade General Aguas de Barcelona S/A – Agbar of Spain, Instituto Costarricence de Acueductos y Alcantarillados of Costa Rica,  Empresa Pública de Medellin of Colombian and Agua y Saneamientos Argentinos – AYSA of Argentina, which will allow us to exchange know‑how and identify future opportunities.

·         We have executed memoranda of understanding with three municipalities to study the possibility of operating landfills, for which we are currently carrying out feasibility studies.

·         We are planning to install small hydroelectric power plants in our water treatment plants in Guaraú and Cascata in conjunction with the Servitec/Tecniplan consortium.  We expect to start construction of the first two plants, with capacities of 4 and 2 MW, in the first half of 2013.

·         We are working with the basic sanitation company of the state of Alagoas to transfer technology for the reduction of water loss in the city of Maceió.

·         We have licensed our proprietary “Aqualog” software, which monitors water treatment remotely, to the basic sanitation company of the state of Espírito Santo.

·         In partnership with the consultancy firm Latin Consult, we are providing consulting services to the Instituto de Acueductos y Alcantarillados Nacionales, the company responsible for water and sewage services in the central provinces of Panama, in the field of sustainable water use and to implement a new model for commercial and operational management.

·         Also in partnership with Latin Consult, we are providing consulting services to nine municipalities in Honduras to implement a new commercial and operational management model.

·         We have set up Aquapolo Ambiental S.A., a joint venture with a private sanitation services operator, which commenced operations in the second half of 2012 and operates the largest water recycling facility in the southern hemisphere, supplying up to 1,000 liters per second to industries in the Capuava petrochemical cluster in the São Paulo metropolitan region.

·         We have set up Attend Ambiental, a joint venture with Estre Ambiental S.A., which is constructing a pre‑treatment and processing plant for non-domestic effluent in the São Paulo metropolitan region that is expected to commence operations in September 2013.

We are looking into (i) construction of a plant to produce energy from solid residue as well as (ii) the production and distribution of bio methane from gas generated in our sewage treatment processes.

We are also evaluating the formation of an investment vehicle expected to be known as Sabesp Participações through which we intend to expand our business through equity investments.

We intend to continue to selectively seek new business opportunities in which we may leverage our know‑how, size and scale.

Establish efficient and competitive ways of attracting, retaining and motivating our personnel.  We intend to become a reference in human resource management, providing our personnel with growth opportunities and recognition.  We seek to raise workplace satisfaction levels by establishing programs for the professional and personal development of our employees, setting competitive benefit packages and creating a healthy and collaborative work environment.

Streamline internal processes.  We are implementing plans to increase our speed and productivity in responding to regulatory changes; strengthen and streamline our financial, commercial and administrative structure; and increase the efficiency of our operations; while also reducing costs.  To this end, in 2012 we began implementing an enterprise resourcing planning system to integrate all of our operational systems (financial, accounting, human resources, legal, purchasing and bid preparation) into a single platform alongside our management information system. 

We believe that our overall strategy will enable us to meet the demand for high quality water and sewage services in the State of São Paulo, in other Brazilian states and abroad, while strengthening our results of operations and our financial condition and creating shareholder value.

State of São Paulo

The State of São Paulo is one of 26 states that, together with the Federal District of Brasília, constitute the Federative Republic of Brazil.  The State of São Paulo is located in the southeastern region of the country, which also includes the States of Minas Gerais, Espírito Santo and Rio de Janeiro, and which is, according to IBGE, the most developed and economically active region of Brazil.  The State of São Paulo is located on the Atlantic coast of Brazil and is bordered by the States of Rio de Janeiro and Minas Gerais to the north, the State of Paraná to the south and the State of Mato Grosso do Sul to the west.

The State of São Paulo occupies 3.0% of Brazil’s land mass and encompasses an area amounting to approximately 96,000 square miles.  According to the SEADE, the State of São Paulo had an estimated total population of 43.9 million as of December 31, 2012.  The city of São Paulo, capital of the State of São Paulo, had an estimated total population of 11.0 million, with a total population of 20.8 million inhabitants in the São Paulo metropolitan region, as of December 31, 2012.  The São Paulo metropolitan region encompasses 39 municipalities and is the largest metropolitan region in the Americas and the sixth largest metropolitan region in the world, according to the United Nations’ World Urbanization Prospects, 2011 Revision, with approximately 47% of the total population of the State of São Paulo as of December 31, 2012.

According to the IBGE, the GDP of the State of São Paulo was approximately R$1.2 trillion in 2010, representing approximately 33% of Brazil’s total GDP, and making it the largest economy of any state in Brazil based on GDP.  According to the IBGE, the State of São Paulo is also the leading Brazilian state in terms of manufacturing and industrial activity, with a strong position in car manufacturing, pharmaceuticals, computer manufacturing, steel making and plastics, among other activities, as well as a leading position in the banking and financial services industries.  The State of São Paulo is the leading export state in Brazil, according to the Brazilian Ministry of Development, Industry and Foreign Trade (Ministério do Desenvolvimento, Indústria e Comércio Exterior). 

History

Until the end of the nineteenth century, water and sewage services in the State of São Paulo were generally provided by private companies.  In 1875, the Province of São Paulo granted a concession for the provision of water and sewage services to Companhia Cantareira de Água e Esgotos.  In 1893, the government of the Province of São Paulo assumed responsibility for the provision of water and sewage services from Companhia Cantareira de Água e Esgotos and formed the Office of Water and Sewers (Repartição de Água e Esgotos), a government agency.  Since that time, water and sewage services in the São Paulo metropolitan region have been administered by the State government.  Historically, water and sewage services in substantially all other municipalities of the State were administered directly by the municipalities, either by municipal water and sewage departments or through autarquias of the municipal government.  Autarquias are relatively autonomous public bodies with separate legal standing, assets and revenues, created by law to carry out the administration of public services where the government deems that a decentralized administrative and financial structure would be advantageous.

In 1954, in response to dramatic population growth in the São Paulo metropolitan region, the State government created the Department of Water and Sewers (Departamento de Águas e Esgotos) as an autarquia of the State.  The Department of Water and Sewers provided water and sewage services to various municipalities in the São Paulo metropolitan region.

A major restructuring of the entities providing water and sewage services in the State of São Paulo occurred in 1968, with the creation of the Water Company of the São Paulo metropolitan Region (Companhia Metropolitana de Água de São Paulo), or the COMASP, the purpose of which was to provide potable water on a wholesale basis for public consumption in the various municipalities of the São Paulo metropolitan region.  All assets relating to the production of potable water for the São Paulo metropolitan region previously owned by the Department of Water and Sewers were transferred to COMASP.  In 1970, the State government created the Superintendence of Water and Sewers of the city of São Paulo (Superintendência de Água e Esgoto da Capital), or the SAEC, to distribute water and collect sewage in the city of São Paulo.  All assets relating to water services previously owned by the Department of Water and Sewers were transferred to the SAEC.  Also in 1970, the State created the Basic Sanitation Company of the São Paulo metropolitan Region (Companhia Metropolitana de Saneamento de São Paulo), or the SANESP, to provide sewage treatment services for the São Paulo metropolitan region.  All assets relating to sewage services previously owned by the Department of Water and Sewers were transferred to the SANESP.  The Department of Water and Sewers was subsequently closed.

On June 29, 1973, pursuant to State Law n. 119, COMASP, the SAEC and the SANESP merged to form our Company with the purpose of implementing the directives of the Brazilian government set forth in the National Water Supply and Sanitation Plan (Plano Nacional de Saneamento).  We were incorporated under the laws of Brazil as a limited company (sociedade anônima), for indefinite duration.  The National Water Supply and Sanitation Plan was a program sponsored by the Brazilian government, which financed capital investments in, and assisted in the development of, state‑controlled water and sewage companies.  Since our formation, other State governmental and State‑controlled companies involved in water supply and sewage collection and treatment in the State of São Paulo have been merged into our company.  The State has always been our controlling shareholder, as required by State Law No. 119.  We have therefore been integrated into the State governmental structure and our strategies have been formulated in conjunction with the strategies of the State Department of Water Resources and Sanitation.  Additionally, a majority of the members of our board of directors and our management are appointed by the State Government.

Our capital expenditure budget is subject to approval by the State legislative chamber.  This approval is obtained simultaneously with the approval of the budgets of the Department of Sanitation, of the Department of Energy and of the State of São Paulo.  We are also subject to supervision from the Court of Audit of the State of São Paulo (“Tribunal de Contas do Estado de São Paulo”), with regard to our accounting, financial and budgetary activities and our operating assets.

We provide water and sewage services directly to a large number of residential, commercial and industrial private consumers, as well as to a variety of public entities, in 363 of the 645 municipalities in the State, including in the city of São Paulo.  We also supply water on a wholesale basis to six municipalities in the São Paulo metropolitan region in which we do not operate water distribution systems, and five of these municipalities also utilize our sewage treatment services.  Currently, we are the fifth largest water and sewage service company in the world in terms of number of clients, according to the 14^th edition of the Pinsent Masons Water Yearbook (2012‑2013).

In 1994, we were registered with the CVM as a publicly-held company and are therefore subject to the CVM’s rules, including those relating to the periodic disclosure of extraordinary facts or relevant events.  Our common shares have been listed on the BM&FBOVESPA under the ticker “SBSP3” since June 4, 1997.

In 2002, we joined the Novo Mercado segment of the BM&FBOVESPA, which is the listing segment in Brazil with the highest corporate governance requirements.  In the same year, we registered our common shares with the Securities and Exchange Commission, or SEC, and started trading our shares in the form of American Depositary Receipts – level III (“ADRs”) on the New York Stock Exchange, or NYSE.

In 2004, the State of São Paulo carried out a secondary offer of common shares of our company in the Brazilian and international markets.  On December 1, 2007, we became part of the BM&FBOVESPA ISE, which reflects our high degree of commitment to sustainable environmental and social practices.

In December 2007, Law No. 1,025, which provided for the creation of regulatory agencies for the supervision of water and sewage services, created ARSESP, the regulatory agency that regulates and supervises the services we provide.

Since 2008, we have expanded into various activities that complement our water and sewage services, often through partnerships with private companies such as the following:

·         We have created four special purpose companies (SESAMM – Serviços de Saneamento de Mogi Mirim S/A; Águas de Castilho S.A.; Águas de Andradina S.A.; and Saneaqua Mairinque S.A.) to operate water and/or sewage concessions granted by four municipalities in the State of São Paulo, all of which are already operating.

·         We are planning to install small hydroelectric power plants in our water treatment plants in Guaraú and Cascata in conjunction with the Servitec/Tecniplan consortium.  We expect to start construction of the first two plants, with capacities of 4 and 2 MW, in the first half of 2013.

·         In partnership with the consultancy firm Latin Consult, we are providing consulting services to the Instituto de Acueductos y Alcantarillados Nacionales, the company responsible for water and sewage services in the central provinces of Panama, in the field of sustainable water use and to implement a new model for commercial and operational management.

·         Also in partnership with Latin Consult, we are providing consulting services to nine municipalities in Honduras to implement a new commercial and operational management model.

·         We have set up Aquapolo Ambiental S.A., a joint venture with a private sanitation services operator, which commenced operations in the second half of 2012 and operates the largest water recycling facility in the southern hemisphere, supplying up to 1,000 liters per second to industries in the Capuava petrochemical cluster in the São Paulo metropolitan region.

·         We have set up Attend Ambiental, a joint venture with Estre Ambiental S.A., which is constructing a pre‑treatment and processing plant for non-domestic effluent in the São Paulo metropolitan region that is expected to commence operations in September 2013.

Although we do not necessarily hold a majority stake in these companies, the shareholders’ agreements provide us with veto powers or qualified votes on certain business matters.

Corporate Organization

We currently have six management divisions, each of which is supervised by one of our executive officers.

Our board of directors allocates responsibilities to our executive officers following an initial proposal made by our Chief Executive Officer, in accordance with our bylaws.  The Chief Executive Officer is responsible for coordinating all management divisions in accordance with the policies and directives established by our board of directors and board of executive officers, including the coordination, evaluation and control of all functions related to the Chief Executive Officer’s office and staff, integrated planning, business management and organization, corporate communication, audit, ombudsman, and regulatory matters.  The Chief Executive Officer represents our company before third parties and certain powers can be granted to attorneys‑in‑fact.  The executive officers described below report to the Chief Executive Officer:

·         the Corporate Management Officer, who is responsible for marketing, human resources and quality control programs, legal affairs, information technology, asset management, legal and procurement, and contracts;

·         the Chief Financial Officer and Investor Relations Officer, who is responsible for financial planning, costs and tariffs, raising capital and allocating financial resources to divisions of our company, conducting capital markets and other debt incurrence transactions and managing debt levels, financial controls, accounting, corporate governance and investor relations;

·         the Technology, Enterprises and Environment Officer, who is responsible for environmental planning and management, technology and operation engineering, quality control, the development, coordination and execution of special investment programs, projects, and new businesses, and

·         the Chief Operating Officer for the São Paulo Metropolitan Region Division and the Chief Operating Officer for the Regional Systems Division, who are responsible for managing the operation, maintenance, execution of planning and works for water and sewage supply systems (including for the services that we provide on a wholesale basis), sales and call center services, and have overall responsibility for the financial and operational performance of their divisions.  The Chief Operating Officers are also responsible for sanitation advisory services to autonomous municipalities and for mediation and negotiation with communities and local governments, aimed at aligning our interests with the interests of our clients.

Capital Expenditure Program

Our capital expenditure program is designed to improve and expand our water and sewage system and to increase and protect our water sources in order to meet the growing demand for water and sewage services in the State of São Paulo.  Our capital expenditure program has four specific goals with respect to the municipalities we serve:

(i)    to continue to meet the maximum demand for treated water;

(ii)   to expand the percentage of households connected to our sewage system;

(iii)  to increase the treatment of sewage collected; and

(iv)  to increase operating efficiency and reduce water loss.

Our capital expenditures from 2010 through 2012 totaled R$7.1 billion.  These investments focused primarily on building up our infrastructure and reducing water loss.  We have budgeted investments in the total amount of R$9.9 billion from 2013 through 2016.  We invested R$2.5 billion, R$2.4 billion and R$2.2 billion in 2012, 2011 and 2010, respectively.

The following table sets forth our planned capital expenditures for water and sewage infrastructure for the years indicated.

Our capital expenditure program from 2013 through 2016 will continue to focus on achieving our targets by making regular investments to maintain and expand our infrastructure and to reduce water loss in the 363 municipalities we served as of December 31, 2012.

Main Projects of Our Capital Expenditure Program

The following is a description of the main projects in our capital expenditure program.

Metropolitan System Investment Program

Metropolitan Water Program

Demand for our water services has grown steadily over the years in the São Paulo metropolitan region and has at times exceeded the capacity of our water systems.  As a result, prior to September 1998, a portion of our customers in this region received water only on alternate days of the week.  We refer to this as “rotation.”  In order to remedy this situation, we implemented the Metropolitan Water Program (Programa Metropolitano de Água) to improve regular water supply to the entire São Paulo metropolitan region.  This program terminated in 2000 and the rotation was eliminated, but we have maintained our investment plans for the region.  In the second phase of the Metropolitan Water Program, which started in 2006 and is expected to run through 2018, we are expanding the capacity of our water storage tanks by 210,000 cubic meters and constructing 44 water pumping stations and 240 kilometers of mains pipelines.  The investment in this phase is expected to reach R$2.7 billion and the construction is expected to expand our water production capacity by 13.2 cubic meters.  At the moment, the program is being updated to meet future demands through 2020.  In 2012, we invested approximately R$95.2 million in this project.

Total investments made from 2006 to December 31, 2012 amounted to R$1.3 billion, including our own funds and financing from Caixa Econômica Federal and by Banco Nacional de Desenvolvimento Econômico e Social (“BNDES”).

São Lourenço Project

The metropolitan region suffers from a water shortage, which requires us to obtain water from increasingly distant sources.  In order to remedy this situation, we are currently developing a new supply system called São Lourenço, which will expand our production capacity by 4.7 m³/s and should be able to benefit a population of almost 1.5 million people.  We have already concluded the project’s conceptual studies and are currently developing its infrastructural projects.  In November 2012, a public notice concerning the completion of construction projects through Public-Private Partnerships (Parceria Público‑Privada) (“PPP”) was published.

Alto Tietê Public Private Partnership

In June 2008 we formed the Alto Tietê Public Private Partnership with a special purpose company known as Cab Spat, whose main shareholders are Cab Ambiental and Galvão Engenharia S.A.  The Alto Tietê PPP is part of the Metropolitan Water Program and aims to improve the reliability, flexibility and availability of the integrated water system that serves the São Paulo metropolitan region.  Through this PPP, Cab Spat carried out certain infrastructure works, which was completed in December 2011, and expanded the Alto Tietê System nominal capacity from 10 cubic meters per second to 15 cubic meters per second.  We intend to complete payment for these investments by 2024.

Cab Spat has also undertaken to perform maintenance on the Alto Tietê System’s dams on an ongoing basis.  This maintenance work consists of civil engineering, electromechanical and operational services, as well as sludge treatment, water adduction and water supply.

The total estimated cost for this project is R$1.0 billion.  As of December 31, 2012 we had invested approximately R$350 million.

Tietê Project

The Tietê river crosses the São Paulo metropolitan region and receives most of the region’s run‑off and wastewater.  The environmental status of the river reached a critical level in 1992.  In an effort to reverse the situation, the State of São Paulo created a recovery program designed to reduce pollution of the Tietê river by installing sewage collection lines along the banks of the Tietê river and its tributaries.  These lines collect raw sewage and deliver it to our sewage treatment facilities.  We carried out the first phase of the program between 1992 and 1998.

In the first phase of the Tietê Project, we completed the construction of three additional sewage treatment facilities in June 1998.  This involved total investment of US$1.1 billion, of which US$450 million was financed by the Inter‑American Development Bank, or IADB, approximately US$100 million by Caixa Econômica Federal, and approximately US$550 million by us.

The second phase of the project, which was carried out from 2000 through 2008, involved installing 290,000 sewage connections and more than 1,500 kilometers of sewage collection networks, branch collectors and interceptors.  Total investments in this phase amounted to approximately US$500 million, of which US$200 million was financed by the IADB, R$60 million by BNDES directly, and R$180 million by BNDES through another financial institution.

The main objective of the second phase was to continue expanding and optimizing the sewage system in the São Paulo metropolitan region, focusing primarily on improvements to expand the delivery of raw sewage to the sewage treatment facilities that were built in the first phase.  Upon the conclusion of the second phase of the project in 2008, we were able to collect approximately 5,000 liters of raw sewage per second and send it to the five sewage treatment plants in our integrated system for treatment.  As part of the second phase of the Tietê Project, we implemented a geographic information system named SIGNOS.  SIGNOS is a management information system which automates and integrates various business processes, including project management, maintenance, operations and customer service and maps out our entire municipal infrastructure in the São Paulo metropolitan region.

The first and second phases of the Tietê Project contributed to an increase from 70.0% to 84.0% in the sewage collection rate and an increase from 24.0% to 70.0% in the treatment of sewage collected in the São Paulo metropolitan region.  As a result, the sewage collection system covered a total of 15.8 million people (5.1 million more than the number of people served when the Tietê Project was initiated), and the sewage treatment system covered 11.1 million people (8.5 million more than the number of people served when the Tietê Project was initiated).  The five principal sewage treatment facilities in the São Paulo metropolitan region have an aggregate installed capacity of 18 cubic meters of sewage per second and currently treat an aggregate of 15.7 cubic meters of sewage per second.  We plan to build additional collection lines to direct more raw sewage to our treatment facilities.

The third phase of the Tietê Project aims to remediate the water quality in the Tietê river basin by expanding collection levels to 87.0% and sewage treatment levels to 84.0% in the São Paulo metropolitan region.  The total estimated cost of the third phase is approximately US$2 billion, of which US$600 million will be financed by a loan from the IADB entered into on September 3, 2010.  The third phase consists principally of the following items:

·         improvements to the effluent collection system through collection networks and home connections;

·         removal and transport of effluent for treatment through branch collectors and interceptors; and

·         the construction between 2009 and 2016 of new sewage treatment plants in the São Paulo metropolitan region. 

Approximately 45% of the work for the third phase is under construction, and a further 26% is in the process of public tender.  Following completion of the third phase of the Tietê Project, the sewage collection system will serve an additional 1.5 million people and the sewage treatment system will serve an additional 3.0 million people.  We have invested R$698 million in the third phase, R$328 million of which during 2012.

We are currently planning the fourth and final phase of the Tietê Project, which is expected to be constructed between 2014 and 2020.  The main objective of the fourth phase is to put an end to all discharge of untreated sewage into the Tietê river in the area for which we are the water services provider.

Corporate Program for Reduction of Water Loss

The objective of the Corporate Program for Reduction of Water Loss (Programa Corporativo de Redução de Perdas de Água) is to reduce water loss efficiently by integrating and expanding existing initiatives in our business units.  This program has a 12‑year term that began in 2009.  We have invested R$1.0 billion in this project so far, including R$328.0 million invested in 2012, and anticipate total investments of approximately R$5.5 billion throughout the term of the program.  Funding for the program will come from our own resources as well as from credit facilities provided by JICA, Caixa Econômica Federal and BNDES.  The program aims to reduce the incidence of water loss from 436 liters per connection per day in December 2008 to 280 liters per connection per day in 2020, which is equivalent to reducing water loss from 27.8% in December 2009 to 19% in 2020.  As of December 31, 2012, the water loss index remained relatively stable at 25.7%.  Our aim was to keep the water loss index at 25.2% but this was not possible due to (i) contractual difficulties in our efforts to reduce losses in the Baixada Santista area, we have since become party to new contracts, (ii) difficulty in replacing service connections, specifically in urban areas, and (iii) more accuracy in water volumes in the Guaraú Water Treatment Station which is located within our main water producing system.

New Life Program

The New Life Program (Programa Vida Nova) consists of various projects that focus on the preservation and improvement of water reserves in the São Paulo metropolitan region, especially in the Guarapiranga and Billings reservoirs.  The resources will be mostly invested in the creation of infrastructure to collect sewage and transport it to treatment plants in order to reduce the discharge of effluent into water sources.  The program also includes the protection of green spaces and the urbanization of favelas (shantytowns) and is expected to directly benefit 58,000 families by 2015.

The State government, local authorities and the federal government are expected to invest approximately R$1.3 billion in this program.  Our total investments in the program are expected to amount to R$355 million, of which we invested R$37.3 million during 2012 for a total of R$81.7 million as of December 31, 2012.  The State Secretariat for Sanitation and Water Resources coordinates the program with the involvement of our company and the Urban Development Company of São Paulo (Companhia de Desenvolvimento Habitacional e Urbano), or the CDHU, and local governments in the region.

Clean Stream Program

The Clean Stream Program (Programa Córrego Limpo), a partnership between the State, acting through our company, and the municipality of São Paulo, aims to decontaminate urban streams in the city of São Paulo by eliminating the discharge of sewage into streams and rainwater runoff routes, cleaning streams and banks, and removing and relocating of properties located on the banks of streams.  Total investments made in this program amounted to R$710.3 million as of December 31, 2012, of which we had invested R$110 million.  116 urban streams have been decontaminated since 2007, benefiting approximately 1.7 million people, and we expect to decontaminate a further 33 streams in 2013, benefiting over 305 thousand people.

Regional Systems Investment Programs

We currently have a number of projects in progress and planned for our Regional Systems.  These relate to the abstraction of water as well as to the collection, removal and disposal of sewage.  We invested approximately R$1.2 billion, R$1.1 billion and R$0.9 billion in these projects in 2012, 2011 and 2010, respectively, and we have budgeted for additional capital expenditures of approximately R$2.8 billion from 2013 through 2016.

Clean Wave Program

The main goals of the Clean Wave Program (Programa Onda Limpa) are to improve and expand the sewage systems in the municipalities comprising the Baixada Santista metropolitan region, increasing the sewage collection rate to 95%, and treating 100% of the collected sewage, thereby improving bathing water quality at 82 beaches in the region by the end of the decade.  This project is being carried out in two phases, the first of which has started and the second of which is in the planning phase.  The first stage is expected to be completed by 2016, aiming at increasing the sewage collection rate to 82%.  The funds will come from our own resources as well as from loan agreements entered with JICA and from the Government Severance Indemnity Fund for Employees (Fundo de Garantia por tempo de Serviço), or FGTS.

As of December 31, 2012, we had invested approximately R$1.7 billion in this program, of which R$135.7 million was invested during 2012.  As a result, sewage collection increased from 53% to 71%, and the treatment of collected sewage rose from 96% to 100%.

After completing the construction of sewage treatment plants and installation of networks, we are prioritizing the connection of customers to the sewage collection system.  As of December 31, 2012, we had completed 79,000 domestic connections, compared to a target of 123,000 at the same date.

Additionally, complimentary works of the first stage shall be executed between 2013 and 2016, including an addition of 37 thousand sewage connections due to the population increase motivated by the economic development of the region.  We expect to evaluate the service of sewage collection rate by 82% by the end of this phase.  These works have an approximated investment value of R$400 million and are currently being bid for.

The second phase is in planning for the period between 2015 and 2020.

Northern Coast Clean Wave Program

The Northern Coast Clean Wave Program (Programa Onda Limpa Litoral Norte) aims at expanding the collection and treatment of sewage on the northern coast of the State of São Paulo, intending to benefit 600 thousand people, including the local population as well as tourists that visit the region each year.  The program aims to increase the collection and treatment of sewage rate in the region from 36.0% in 2008 to 85.0%, thereby improving the health and well‑being of the population and stimulating economic development through an increase in tourism.

During 2012, we continued work on two sewage treatment plants in the city of São Sebastião and other sewage system projects in the cities of Ubatuba, Ilhabela and São Sebastião, which we expect to complete in 2013.  The funds will come from our own resources, as well as from loan agreements entered with BNDES, with Caixa Econômica Federal and from the FGTS.  As of December 31, 2012, we had invested R$125.9 million in this program, of which R$24.3 million was invested during 2012.  We expect to invest a total of R$500.0 million in this project by 2018.

Coastal Water Program

The Coastal Water Program (Programa Água no Litoral) combines various long‑term activities to expand water production capacity in the Baixada Santista metropolitan region and the southern coast of the State of São Paulo.  The program aims to benefit approximately three million people, including both the local population and tourists.  It aims to increase the level of reliability of the local systems, eliminating existing and potential deficiencies and irregularities in the water supply.  Through this program we aim to reach universal coverage in these regions, increase the availability of treated water and improve the quality of water available to the population.  The fund will come from our own funds and financing from Caixa.

During the first phase of this program we have focused on increasing water production from the Mambu/Branco water system in order to satisfy demand and improve water quality in the southern part of the Baixada Santista metropolitan region.  This phase, which is approaching finalization, aims to increase production from Mambu/Branco from 0.6 cubic meters per second to 1.6 cubic meters per second.

As of December 31, 2012, we had invested R$569.1 million in this program, of which R$129.3 million was invested during 2012.  We expect to invest a total of R$1.1 billion in this project by the end of 2013.

New Policies and Programs

Nossa Guarapiranga

In December 2011, we launched the Nossa Guarapiranga project, the main objective of which is to remediate the water quality in the Guarapiranga basin, which is a water source for the São Paulo metropolitan region.  The basin serves one million people directly in the areas near Guarapiranga, and indirectly serves a further two million people who consume the water from the basin.  Through capital investment of R$12.2 million, we installed 11 drains to collect residue from rivers in the Guarapiranga basin.  The fund will come from our own funds.

Pró‑Conexão

In December 2011, the municipality of São Paulo approved a project to subsidize connections to the sewage system for low‑income families.  The project involves capital expenditures of up to R$349.5 million of which 80% will be provided by the State government and 20% by us.  In the first year of the program we completed approximately 700 connections, which was less than our initial goal but focused on areas of importance for water sources such as the southern part of the São Paulo metropolitan region, near the Billings reservoir.  We believe that this program will increase the efficiency of our sewage collection programs and help improve water quality in the region’s rivers and basins, as well as improving quality of life for low‑income families.

We expect that this program will create 192,000 new connections over the next eight years, benefiting approximately 800 thousand people.

Water is Life

The Water is Life program, established in November 2011, aims to provide water and sewage services to 41 low‑income and isolated communities in the regions of Alto Paranapanema and Vale do Ribeira, covering approximately 13 thousand people.  In this project we are responsible for supplying water to, and the municipalities are responsible for installing, Individual Sanitary Units (Unidades Sanitárias Individuais), a technology designed for low‑income and isolated communities.  Regarding the supply of water, we invested approximately R$700 thousand in well drilling.  We expect to invest approximately R$15.6 million by 2014.  An amount of approximately R$6 million was estimated for sewage infrastructure contruction, to be financed by the State Government.  However, this estimated funding is currently being increased to support this project.

B.      Business Overview

Our Operations

As of December 31, 2012, we provided water and sewage services to 363 municipalities in the State of São Paulo under concession agreements, program agreements, other forms of legal arrangements or without formal agreements.  We also supply treated water on a wholesale basis to six municipalities located in the São Paulo metropolitan region.  Article 2 of our bylaws permits us to carry out the following activities:  provision of water supply and sewage services, urban rain water management and drainage services, urban cleaning services and solid waste management services.  In addition, our bylaws authorize us to carry out other related activities, including the planning, operation and maintenance of production systems, the storage, preservation and trading of energy, and the trading of services, products, benefits and rights that, directly or indirectly, result from our assets, projects and activities, and the right to operate a subsidiary anywhere in Brazil or abroad to provide the services mentioned above.

Following the enactment of the Basic Sanitation Law, which regulates the basic sanitation industry in Brazil, we currently operate under two different contractual environments:  (i) for concession agreements that have expired, we are currently renegotiating or will negotiate new agreements that follow the terms and conditions of the Basic Sanitation Law, known as “program agreements”; and (ii) for concession agreements that have not expired, we will continue to operate under the terms and conditions of the existing concession agreements, except in circumstances where the Basic Sanitation Law applies even though the concession agreement is still in force.  For further information on this topic, see “Government Regulation—Concessions—Public Consortia and Cooperation Agreement Law for Joint Management.”

As of December 31, 2012, 67 of our concessions were still in the process of being regularized through formal agreements.  See “3.D. Risk Factors—Risks Relating to Our Business—We currently lack formal agreements or concessions with 67 of the municipalities to which we provide service, and 38 of our existing concession agreements will expire between 2013 and 2034.  We may face difficulties in continuing to provide water and sewage services in return for payment in these and other municipalities, and we cannot assure you that they will continue to purchase services from us on the same terms or at all.”

Concessions

Pursuant to the Brazilian Constitution, the authority to develop public water and sewage systems is shared by the states and municipalities, with the municipalities having primary responsibility for providing water and sewage services to their residents.  The Constitution of the State of São Paulo provides that the State shall assure the correct operation, necessary expansion and efficient administration of water and sewage services in the State of São Paulo by a company under its control.

According to the Basic Sanitation Law, existing concessions will remain in effect until payment of indemnification is made based on the valuation of investments.  The Basic Sanitation Law provides that our new concession agreements be planned, supervised and regulated by the municipalities together with the State under a new model of associated management that will allow for better control, supervision, transparency and efficiency in the provision of public services.

As of December 31, 2012, we provided water and sewage services to 363 municipalities.  Substantially all of these concessions have 30‑year terms.  Due to court orders, we temporarily suspended our services in four other municipalities (Cajobi, Iperó, Álvares Florence and Macatuba) that accounted for less than 0.1% of our gross operating revenues and our intangible assets as of December 31, 2012.  For more information, see “Item 8.A. Financial Information—Consolidated Statements and Other Financial Information—Legal Proceedings—Concession‑Related Legal Proceedings.”  Between January 1, 2007 and December 31, 2012, we entered into contracts with 258 municipalities (including our services agreement with the city of São Paulo) in accordance with the Basic Sanitation Law, of which 33 were entered into in 2012.  As of December 31, 2012, these 258 municipalities accounted for 69.9% of our gross operating revenues (including revenues relating to the construction of concession infrastructure).  In addition to the contracts that have 30‑year terms, the municipalities entered into cooperation contracts with the State of São Paulo, delegating the regulation and monitoring of the provision of services to ARSESP.  As of December 31, 2012, 67 of our concessions had expired but we continued to provide water and sewage services to all 67 municipalities and were in negotiations with these municipalities to execute program agreements to substitute the expired concessions.  From January 1, 2013 through 2034, 38 concessions will expire.

Following the increase in the demand for regulatory work, we created a regulatory affairs department, which focuses on regulatory matters and has centralized communication with the regulatory agencies, driving business to the new regulatory regime and proposing matters in which we have an interest to ARSESP.

In April 2011, we created a specific area in our Financial, Economic and Investor Relations Office responsible for costs and tariffs, given the subject’s importance to the continuation of our business.  We also created a statutory Regulatory Affairs Committee.  The committee is composed of our Chief Executive Officer, our Chief Financial Officer and Investor Relations Officer, our Metropolitan Officer and our Regional Systems Officer and is responsible for defining the guidelines, strategies and regulatory recommendations for our Company and coordinating the work of the Regulatory Affairs Department.

The current concessions are based on a standard form of agreement between us and the relevant municipality.  Each agreement received the prior approval of the legislative council of each municipality.  The assets comprising the existing municipal water and sewage systems are transferred from the municipality to us in order for us to provide the contracted services.  Until 1998, we acquired municipal concessions and the existing water and sewage assets in exchange for our common shares issued at book value.  Since 1998, we have acquired concessions and water and sewage assets by paying the municipality an amount equal to the present value of 30 years of estimated cash flows from the date of acquisition of the concession, assuming a discount of at least 12%.  For reference purposes, ARSESP has set the discount rate for concession contracts at 8.06% since 2011.

The main provisions of our existing concession agreements are as follows:

·         we assume all responsibility for providing water and sewage services in the municipality;

·         according to the municipal laws authorizing the concession, we are permitted to collect tariffs for our services without prior authorization of the municipality.  Tariff readjustments follow the guidelines established by the Basic Sanitation Law and ARSESP;

·         as a general rule, to date, we are exempt from municipal taxes, and no royalties are payable to the municipality with respect to the concession;

·         we are granted rights of way on municipal property for the installation of water pipes and mains, and sewage lines; and

·         upon termination of the concession, for any reason, we are required to return the assets that comprise the municipality’s water and sewage system to the municipality and the municipality is required to pay us the non‑amortized value of the assets relating to the concession.

·         These assets have been considered to be intangible assets since January 2008.  See Note 2.10 to our financial statements.  Under concession agreements executed prior to 1998, the reimbursement for the assets may be through payment of either:

o    the book value of the assets; or

o    the market value of the assets as determined by a third‑party appraiser in accordance with the terms of the specific agreement.

In Brazil, there are three federal legal regimes for contracting water and sewage services:  (i) public concessions, regulated by Law No. 8,987/1995, which require a prior public bidding process; (ii) administration of public services through cooperation agreements between the federal government and local public authorities at State and municipal level without the need for a public bidding process, regulated by the Public Consortia and Cooperation Agreement Law; and (iii) public‑private partnerships, regulated by Law No. 11,079/2004, used to grant concessions to private companies to provide public services and used in relation to construction works associated with the provision of public services.  Until 2005, we had adopted the regime for public concessions.  Following the entry into force of the Public Consortia and Cooperation Agreement Law, we adopted the administration of public services through cooperation agreements, which can be used alongside the other two regimes.

Since 1998, our contracts with municipalities have been regulated by the Federal Concessions Law No. 8,987/1995.  Generally, these contracts have a 30‑year term, and the total value of the concession is set by the discounted cash flow method.  Under this method, when the expected contractual cash flow is reached, the total value of the concession and assets is amortized to zero on our books and we receive no payment for the assets.  If the concession is terminated prior to the end of the 30‑year term, thereby interrupting the normal contractual cash flow, we are paid an amount equal to the present value of the expected cash flow over the years remaining in the concession, adjusted for inflation.

Federal Law No. 11,107, or the Federal Public Consortia and Cooperation Agreement Law, established the legal basis for the administration of public service contracts, giving greater rights and obligations to municipalities who are responsible for sanitation services and setting out more clearly the provision of services and the responsibilities of the parties.  New agreements entered into following the expiry of concession agreements under the previous law will follow this new model.  See “—Government Regulation—Concessions—Public Consortia and Cooperation Agreement Law for Joint Management.”

Our new agreement model follows the provisions of the Basic Sanitation Law.  Its main contractual provisions include the joint execution of planning, supervision and regulation of services, the appointment of a regulatory authority for the services, and periodic disclosure of financial statements.

Furthermore, the economic and financial formulas in new agreements must be based on the discounted cash flow methodology and on the revaluation of returnable assets.  Pursuant to the Basic Sanitation Law, the preexisting assets will be returned to the grantor of the concession. We will carry out all new investments and the municipalities will record them as assets.  The municipalities will then transfer possession of these assets to us for our use and management and will also record a credit in the same amount of the assets recorded in our favor.  According to Article 42 of the Basic Sanitation Law and the new agreement model, investments made during the contractual period are the property of the applicable municipality, which in turn generates receivables for us that are to be recovered through the operation of the services.  These receivables may also be used as guarantees in funding operations.

Another important development was that the new agreement model includes exemptions from municipal taxes applicable on our operational areas and the possibility of the revaluation of our assets that existed prior to the execution of the program agreements in cases involving the early resumption of services by the concession authority.

Municipalities have the inherent power under Brazilian law to terminate concessions prior to their contractual expiration dates for reasons of public interest.  The municipalities of Diadema and Mauá, two municipalities we previously served, terminated our concessions in February 1995 and December 1995, respectively.  The municipality of Mauá terminated our concession with our consent.  The municipality of Diadema terminated our concession without our consent after asserting that we did not provide adequate water and sewage services.  In 2011 we and the municipality of Diadema agreed to develop shared infrastructure for water and sewage services through CAED.  According to the agreement, the amount owed to us by Diadema would be repaid through the issuance of shares in CAED.  However, CAED has not yet been established, and we cannot predict whether or when it will be created or begin operations.  The receivables owed to us by Mauá and Diadema total R$85.9 million and R$60.3 million, and have not been recognized in our financial statements due to the uncertainty of our ability to collect.  Despite these developments, we currently supply water on a wholesale basis to both Diadema and Mauá.  For further information on these matters, see “Item 8.A. Financial Information—Consolidated Statements and Other Financial Information—Legal Proceedings – Concession – Related Legal Proceedings.”

We currently do not anticipate that other municipalities will seek to terminate concessions due to our close relationship with municipal governments, recent improvements in the water and sewage services we provide, and the obligation of the municipality to repay us for the return of the concession.  However, we cannot be certain that other municipalities will not seek to terminate their concessions in the future.  See “Item 3.D. Risk Factors—Risks Relating to Our Business—The municipalities may terminate our concessions before they expire in certain circumstances.  The indemnification payments we receive in such cases may be less than the value of the investments we made.”  

In addition, we are currently involved in litigation with respect to municipalities that intend to expropriate our water and sewage systems, or to terminate concession agreements before paying us any indemnification.  For a detailed discussion on these proceedings, see “Item 8.A. Financial Information—Consolidated Statements and Other Financial Information—Legal Proceedings—Concession‑Related Legal Proceedings.”

Operations in the City of São Paulo and Certain Metropolitan Regions

As of December 31, 2012, 67 concessions had expired which jointly accounted for 18.6% of our gross revenues.  We entered into 33 agreements in the year ended December 31, 2012, bringing the total number of program agreements entered into between 2007 and 2012 to 258.  These 33 new agreements accounted for 4.3% of our total revenues and 4.2% of our intangible assets as of December 31, 2012.

On June 23, 2010 the State and the City of São Paulo executed an agreement in the form of a convênio, to which we and ARSESP consented, under which they agreed to manage the planning and investment for the basic sanitation system of the city of São Paulo on a joint basis.  The principal terms of this convênio  were as follows:

·         The State and the City of São Paulo would execute a separate agreement with us, granting us exclusive rights to provide water and sewage services in the city of São Paulo.

·         ARSESP would regulate and oversee our activities regarding water and sewage services in the city of São Paulo, including tariffs.

·         A management committee (Comitê Gestor) would be responsible for planning water and sewage services for the city and for reviewing our investment plans.  The management committee consists of six members appointed for two-year terms.  The State and the City of São Paulo have the right to appoint three members each.  We may participate in management committee meetings but may not vote.

In application of the convênio, we executed a separate contract with the State and the city of São Paulo, also dated June 23, 2010, to regulate the provision of these services for the following 30 years.  The principal terms of this contract are as follows:

·         The total investment stated in the contract must be equal to 13% of gross revenues from the provision of services to the city of São Paulo, net of the taxes on revenues, which total approximately R$500 million per year. 

·         We must transfer 7.5% of the gross revenues we derive under the convênio, and subtract (i) COFINS and PASEP taxes, and (ii) unpaid bills of publicly owned properties in the city of São Paulo, to the Municipal Fund for Environmental Sanitation and Infrastructure (Fundo Municipal de Saneamento Ambiental e Infraestrutura),  established by Municipal Law No. 14,934/2009.

·         Our investment plan must be compatible with the sanitation plans of the State, the City of São Paulo and, if necessary, the Metropolitan region.

·         ARSESP will ensure that the tariffs will adequately compensate us for the services we provide and that tariffs may be adjusted in order to restore the original balance between each party’s obligations and economic gain (equilíbrio econômico‑financeiro). 

·         We currently have an investment plan in place that reflects these obligations and addresses their compatibility with the sanitation plans for the 363 municipalities in which we operate, that include, the City of São Paulo and, if necessary, the Metropolitan region.  The investment plan is not irrevocable and will be reviewed by our management committee every four years, particularly with respect to the investments to be executed in the subsequent period.

Wholesale Operations

Wholesale Water Services

We provide water services on a wholesale basis to six municipalities located in the São Paulo metropolitan region (Diadema, Mauá, Santo André, São Caetano do Sul, Guarulhos and Mogi das Cruzes).  Agreements to provide water services on a wholesale basis must comply with the Basic Sanitation Law, which designates these services as “interdependent activities” and regulates each stage of the service.  The law requires that the service be supervised by an independent agency, stipulates registration of the cost of the service, and requires assurance of payment among the several service providers in order to continue the provision of the services, in accordance with the rules to be published by ARSESP.  Our agreements currently comply with the provisions of the Basic Sanitation Law.  In 2012, the revenues from wholesale water services were R$187.4 million.

In 2011, we and the municipality of Diadema agreed to develop shared infrastructure for water and sewage services through a mixed capital company to be called Companhia de Agua e Esgoto de Diadema, or CAED.  According to the agreement, the amount owed to us by Diadema would be repaid through the issuance of shares in CAED.  However, CAED has not yet been established, and we cannot predict whether or when it will be created or begin operations.  Feasibility studies have been completed and indicate that CAED would have a viable business, but the Diadema municipal authorities have started new negotiations to amend the legislation that provided for the setting up of CAED.  We can give no assurance that we will recover the amount owed to us by Diadema, whether through an investment in CAED or otherwise.  For further information on this outstanding debt, see Note 9 to our consolidated financial statements included elsewhere in this annual report.

Wholesale Sewage Services

We provide sewage services on a wholesale basis to the municipalities of Mogi das Cruzes, Santo André, São Caetano, Mauá and Diadema.  Our agreement with Santo André for these services was executed with the intervention of the Public Prosecution Office.  Our agreements with the other municipalities resulted from our environmental efforts and municipal authorities’ awareness of environmental issues.  Through these agreements, in 2012 we treated approximately 35 million cubic meters of sewage from these municipalities.  We believe this illustrates our commitment to social and environmental responsibility.  In 2012, our revenues from wholesale sewage services were R$23.8 million.

In December 2008, we entered into a five‑year agreement for the collection and treatment of 20% of the sewage generated by the city of Guarulhos.  We have not yet started to provide these services, and such services will only commence when the works on linking the Guaralhos sewage to our sewage system are finalized.  These works are the responsibility the Guarulhos sanitation company.

Description of Our Activities

As set forth in Article 2 of our bylaws, we are permitted to render basic sanitation services with the goal of providing basic sanitation services to the entire population in the municipalities where we conduct our activities without harming our long‑term financial sustainability.  Our activities comprise water supply, sanitary sewage services, urban rainwater management and drainage services, urban cleaning services, solid waste management services and related activities, including the planning, operation, maintenance and commercialization of energy, and the commercialization of services, products, benefits and rights that directly or indirectly arise from our assets, operations and activities.  We are allowed to act in a subsidiary form in other Brazilian locations and abroad.  See “—Government Regulation—Concessions—Public Consortia and Cooperation Agreement Law for Joint Management.”  For a description of our operating segments please see Note 21 to our consolidated financial statements as of and for the year ended December 31, 2012.

Operating segments are presented in our annual report in a manner consistent with the internal reporting provided to management, comprised of the board of directors and the board of executive officers, pursuant to IFRS 8.  Under Brazilian GAAP, prior to our conversion to IFRS, the financial information for construction services was not separately presented and construction costs related to concessions were capitalized within property, plant and equipment. As a result, our management did not review the results of this business. Following our conversion to IFRS, our management decided to continue to exclude the construction results from the management reporting of our revenues and expenses, thus not basing his decisions on discrete financial information for that business.  The characteristics described in paragraph 5(b) of IFRS 8 for separate operating segments are thus not fulfilled for this particular business. Nonetheless, after our conversion to IFRS and for IFRS consolidation purposes only, we started to record such results separately as construction revenue and costs under IFRIC 12.  Although such information is available discretely, however, it is not analyzed by our management as such and is not the basis for operational decisions.

We set forth below a description of our activities.

Water Operations

Our supply of water to our customers generally involves abstraction of water from various sources, subsequent treatment and distribution to our customers’ premises.  In 2012, we produced approximately 3.1 million cubic meters of water.  The São Paulo metropolitan region (including the municipalities to which we supply water on a wholesale basis) currently is, and has historically been, our core market, accounting for approximately 71% of water invoiced by volume in 2012.

The following table sets forth the volume of water that we produced and invoiced for the periods indicated.

The difference between the volume of water produced and the volume of water invoiced generally represents both physical and non‑physical water loss.  See “—Water Loss.”  In addition, we do not invoice:

·         water discharged for periodic maintenance of water mains and water storage tanks;

·         water supplied for municipal uses such as firefighting;

·         water consumed in our own facilities; and

·         estimated water loss associated with water we supply to favelas (shantytowns). 

Seasonality

Although seasonality does not affect our results in a significant way, in general, higher water demand is observed during the summer and lower water demand during the winter.  The summer coincides with the rainy season, while the winter corresponds to the dry season.  The demand in the coastal region is increased by tourism, with the greatest demand occurring during the Brazilian summer holiday months.

Water Resources

We can abstract water only to the extent permitted by DAEE pursuant to water usage rights granted by it.  Depending on the geographic location of the river basin or if the river crosses more than one state (federal domain), the approval of the National Water Agency (Agência Nacional de Águas), or ANA, a federal agency under the Ministry of the Environment is required.  We currently abstract substantially all of our water supply from rivers and reservoirs, with a small portion being abstracted from groundwater.  Our reservoirs are filled by impounding water from rivers and streams, by diverting the flow from nearby rivers, or by a combination of both methods.

In order to supply water to the São Paulo metropolitan region, we rely on 20 reservoirs of non‑treated water and 210 reservoirs of treated water, which are located in the areas under the influence of the eight water producing systems comprising the interconnected water system of the São Paulo metropolitan region.  The capacity of the water sources available for treatment in this area is 72 cubic meters per second.  Total current installed capacity is 73.2 cubic meters per second, which can be treated from the interconnected water system of the São Paulo metropolitan region.  Average verified production during 2012 on the interconnected water system of the São Paulo metropolitan region was 69.4 cubic meters per second.  The Cantareira, Guarapiranga and Alto Tietê systems, as a whole, supplied 84.7% of the water we produced for the São Paulo metropolitan region in 2012.

In 2012, the Cantareira system accounted for 47.1% of the water that we supplied to the São Paulo metropolitan region (including the municipalities to which we supplied water on a wholesale basis), which represented 74.1% of our gross operating revenues (excluding revenues relating to the construction of concession infrastructure) for the year.  The authorization (outorga) for the Cantareira system to use the water in the Piracicaba water basin was renewed on August 6, 2004, for a ten‑year period.

Water basin committees are authorized to charge both for water usage and the dumping of sewage into water bodies.  Since February 2003, we have been incurring expenses in connection with the use of water from the Paraíba do Sul river basin and, since January 2006, from the Piracicaba, Capivari and Jundiaí river basins.  At the end of 2010, we started to incur expenses in connection with the use of water from the Sorocaba and Médio Tietê river basins and, since 2012, from Baixada Santista basin.  During 2013 we may start to incur expenses in connection with the use of water from the Alto Tietê basin – where the metropolitan region of São Paulo is located, and also in the basins of Baixo Tietê, Tietê/Batalha, Tietê/Jacaré, Baixo Pardo e Grande, Mogi Guaçu, Pardo, Sapucaí Mirim/Grande, Serra da Mantiqueira, Ribeira do Iguape/Litoral Sul, Pontal do Paranapanema and Turvo/Grande.

ARSESP has adjusted our tariffs according to the formula that we have used since 2003.  According to the formula, “non‑controllable” costs, such as costs related to water use, are passed on to our customers through our tariffs.  Although we expect to continue to pass on these expenses to our customers through our tariffs, we are uncertain as to whether the river basin committees will change the terms of the charges currently applied and whether we will be able to pass on these costs to our customers.  On March 2013, ARSESP disclosed Resolution 406, in which the annual tariff readjustment formula was approved, which will be used in the second tariff cycle.  This formula consists of IPCA percentage variation for the referred period adjusted by the efficiency factor which transfers part of the productivity gains to the users and by an adjustment factor for the variations in the quality of the services rendered, and this last adjustment is still to be defined and applied from the second tariff cycle in three years’ time.  Regarding the mentioned resolution, the cost for the use of water shall be included in our consumers’ bill.  For more information on water usage regulation, see “—Water Usage.”

The following table sets forth the water production systems from which we produce water for the São Paulo metropolitan region:

______________

(1)   Average of the twelve months ended December 31, 2012, 2011 and 2010.

We own all of the reservoirs in our production systems other than the Guarapiranga and Billings reservoirs and a portion of some of the reservoirs of the Alto Tietê system, which is owned by other companies controlled by the State.  We currently do not pay any charges with respect to the use of these reservoirs.  In December 2001, we entered into an agreement with the State whereby the State, among other things, agreed to transfer the remaining reservoirs in the Alto Tietê system to us.  We accepted, on a temporary basis, the reservoirs in the Alto Tietê System as part of the payment until the State transfers the property rights with respect to the reservoirs to us.  We are unable to assure you whether and when these reservoirs will be transferred to us because the Public Prosecution Office of the State of São Paulo filed a civil public action alleging that a transfer to us of ownership of the Alto Tietê System reservoirs is illegal.

In January 2009, we began operating, monitoring and maintaining the reservoirs in the Alto Tietê system, formed by the Ponte Nova, Paraitinga, Biritiba, Jundiaí and Taiaçupeba reservoirs.  In the cities of the interior region of São Paulo, our principal source of water consists of surface water from nearby rivers and from wells.  The coastal region is provided with water principally by surface water from rivers and mountain springs.

Statewide, we estimate that we are able to supply nearly all of the demand for water in all of the areas where we operate, subject to droughts and extraordinary climate events.  We were able to meet the demand for water in the São Paulo metropolitan region, primarily as a result of our water conservation program, reductions in water loss, and the installation of new water connections.  We installed 212,775, 207,900 and 189,400 new water connections in 2012, 2011 and 2010, respectively.

The interconnected water system of the São Paulo metropolitan region serves 30 municipalities, of which 24 are operated directly by us under this system.  Through this system, we serve the other six municipalities on a wholesale basis, and the distribution is made by other companies or departments related to each municipality.

In order to reach the final customer, the water is stored and transported through a complex and interconnected system.  This water system requires permanent operational supervision, engineering inspection, maintenance, and quality monitoring and measurement control.

To ensure the continued provision of regular water supply in the São Paulo metropolitan region, we intend to invest R$3.7 billion from 2013 to 2016 to increase our water production and distribution capacities as well as to improve the water supply systems.  In 2012, our total investment in water supply systems amounted to R$1.0 billion.

Water Treatment

We treat all water at our water treatment facilities prior to placing it into our water distribution network.  We operate 214 treatment facilities, of which the eight largest, located in the São Paulo metropolitan region, account for approximately 70% of all water we produced in 2012.  The type of treatment used depends on the nature of the source and quality of the untreated water.  Water abstracted from rivers requires extensive treatment, while water drawn from groundwater sources requires less treatment.  All water treated by us also receives fluoridation treatment.

Water Distribution

We distribute water through our own networks of water pipes and mains, ranging in size from 2.5 meters to 100 millimeters in diameter.  Storage tanks and pumping stations regulate the volume of water flowing through the networks to maintain adequate pressure and continuous water supply.  The following table sets forth the total number of kilometers of water pipes and mains and the number of connections in our network as of the dates indicated.

More than 90.0% of the water pipes in our water distribution network are made of cast iron or polyvinylchloride, or PVC.  Distribution pipes at customers’ residences typically are made from high‑density polyethylene tubing.  Our water mains are mostly made of steel, cast iron or concrete.

As of December 31, 2012, our water distribution pipes and mains included:  (i) 34,816 kilometers in the São Paulo metropolitan region; and (ii) 32,832 kilometers in the Regional systems.

As of December 31, 2012, we had 405 storage tanks in the São Paulo metropolitan region with a total capacity of 2.0 million cubic meters, and 1,759 storage tanks in the Regional systems.  As of that date, we had 124 treated water pumping stations in the São Paulo metropolitan region aqueduct system, including stations at treatment facilities, intermediate trunk transfer pumping stations and small booster stations serving local areas.

Water mains that require maintenance are cleaned and their lining is replaced.  We are typically notified of water main fractures or breaks by the public through a toll‑free number maintained by us.  We consider the condition of the water pipes and mains in the São Paulo metropolitan region to be adequate as of the date of this annual report.  Due to age, external factors such as traffic, the dense population, and commercial and industrial development, water pipes and mains in the São Paulo metropolitan region are somewhat more susceptible to degradation than those in the Regional systems.  To counter these effects, we have a maintenance program in place for water pipes and mains that is intended to address anticipated fractures and clogs due to brittleness and encrustation, and to help ensure water quality in the region.  The new customers are responsible for covering part of the costs of connecting to our water distribution network that is related to the connection of customers water pipes that are more than 20 meters away from the water mains.  Thereafter, the customer must cover the costs of connecting to the network from the customer’s premises, including costs of purchasing and installing the water meter and related labor costs.  We perform the installation of the water meter and conduct periodical inspections and measurements.  After completion of installation, the customer is responsible for the water meter.

The following table sets forth projected new water connections for the periods indicated.

Water Loss

The difference between the amount of water produced and the amount of water invoiced generally represents both physical and non‑physical water loss.  Water loss percentage represents the quotient of (i) the difference between (a) the total amount of water produced by us less (b) the total amount of water invoiced by us to customers minus (c) the volume of water set out below that we exclude from our calculation of water loss, divided by (ii) the total amount of water produced by us.  We exclude the following from our calculation of water loss:  (i) water discharged for periodic maintenance of water mains and water storage tanks; (ii) water supplied for municipal uses such as firefighting; (iii) water we consume in our facilities; and (iv) estimated water loss associated with water we supply to favelas (shantytowns). 

Among the principal indicators utilized to measure rates of water loss are the following:

·         Index of Revenue Loss (IRL), in %; and

·         Index of total loss per connection, (TLdC) in liters/connection per day.

These indicators are calculated by applying the following formulas:

V_produced – (V_billed + V_used)
IRL  = ^{______________________________________}
                                V_produced

V_produced – (V_{micromeasured} + V_used)
(TLdC)   = ^{_____________________________________________________}
                                N_{connection x  nº  of days of a given period}

Where:

V_produced:  corresponds to the volume of water produced at a given period;

V_billed:  corresponds to the volume of water billed at a given period;

V_{micromeasured}:  corresponds to the volume of water micromeasured at a given period;

V_used:  corresponds to the volume of water used for operational, public, private and social needs (supply shantytown areas) at a given period; and

N_connections:  corresponds to the average number of active water connections.

Since 2005, we have used a method of measuring our water loss based on worldwide market practice for the industry.  According to this measurement method, average water loss is calculated by dividing (i) average annual water loss by (ii) the average number of active water connections multiplied by 366.  The result of this calculation is the number of liters of water lost per connection per day.

Using this calculation method, as of December 31, 2012, we experienced 474 liter/connection per day of water loss in the São Paulo metropolitan region and 270 liter/connection per day in the Regional systems, averaging 393  liter/connection per day.  We plan to reduce total water loss to around 280 liters/connection and, in terms of percentage, to 19% by 2020.

Our strategy to reduce water loss has two approaches:

·         reduction in the level of physical loss, which results mainly from leakage. To this end we are primarily replacing and repairing water mains and pipes, and installing probing and other equipment, including strategically located pressure‑regulating valves; and

·         reduction of non‑physical loss, which results primarily from the inaccuracy of our water meters installed at our customers’ premises and at our water treatment facilities, and from clandestine and illegal use. To this end we are upgrading and replacing inaccurate water meters and expanding our anti‑fraud personnel.

We are taking measures to decrease physical loss by reducing response time to fix leakages to less than 24 hours and by better monitoring non‑visible water mains fractures.  Among other initiatives, we have adopted the following measures to reduce physical water loss:

·         the introduction of technically advanced valves to regulate water pressure throughout our water mains in order to maintain appropriate water pressure downstream.  These valves are programmed to respond automatically to variations in demand.  During peak usage, the flow of water in the pipes is at its highest point; however, when demand decreases, pressure builds up in the water mains and the resulting stress on the network can cause significant water loss through cracks and an increase in ruptures of the pipes.  The technically advanced valves are equipped with probes programmed to feed data to the valve in order to reduce or increase pressure to the water mains as water usage fluctuates.  As of December 31, 2012, we had installed 1,828 valves at strategic points in the network, with 1,077 valves being installed in the São Paulo metropolitan region and 751 in the Regional systems;

·         the reconfiguration of interconnected water distribution to permit the distribution of water at lower pressure;

·         the implementation of routine operational leak detection surveys in high water pressure areas to reduce overall water loss;

·         the monitoring of and improved accounting with respect to water connections, especially for large volume customers;

·         regular checking on inactive customers and monitoring non‑residential customers that are accounted for as residential customers and, therefore, billed at a lower rate;

·         preventing fraud with the use of new, more sophisticated water meters that are more accurate and less prone to tampering;

·         installing water meters where none are present; and

·         conducting preventive maintenance of existing and newly installed water meters.

Water Quality

We believe that we supply high quality treated water that is consistent with standards set by Brazilian law, which are similar to the standards set in the United States of America and Europe.  Pursuant to the Brazilian Ministry of Health (Ministério da Saúde) regulations, we have significant statutory obligations regarding the quality of treated water.  These laws set certain standards that govern water quality.

In general, the State of São Paulo has excellent water quality from underground or superficial water sources.  However, high rates of population growth, increased urbanization and disorganized occupation of some areas of the São Paulo metropolitan region has reduced the quantity and quality of water available to serve the population in the southern area of the São Paulo metropolitan region and in the coastal region.  Currently, we successfully treat this water to make it potable.  We also work to recover the quality of water of mains and invest in improvements of our treatment systems to ensure the quality and availability of water for the upcoming years.

Water quality is monitored at all stages of the distribution process, including at the water sources, water treatment facilities and on the distribution network.  We have 15 regional laboratories, one central laboratory, and laboratories located in all water treatment facilities that monitor water quality, as required by our standards and those set by statute.  Our laboratories analyze an average of 50,000 samples per month on distributed water, with samples collected from residences.  Our central laboratory located in the city of São Paulo is responsible for organic compound analysis using the chromatographic and spectrometric methods, as well as heavy metals analysis by atomic absorption technique.  All of our laboratories have obtained the ABNT NBR ISO 9001 certification and our central laboratory and 12 of our regional laboratories have obtained the ABNT NBR ISO IEC 17025 accreditation (accreditation for general requirements for the competence of testing and calibration laboratories) awarded by the INMETRO.

All chemical products used for water treatment are analyzed and follow strict specifications set out in recommendations made by the National Health Foundation (Fundação Nacional de Saúde), or NHF, the Brazilian Association of Technical Rules (Associação Brasileira de Normas Técnicas), or the ABNT, and the American Water Works Association, to eliminate toxic substances that are harmful to human health.  From time to time, we face problems with the proliferation of algae, which may cause an unpleasant taste and odor in the water.  In order to mitigate this problem, we work on:  (i) fighting algae growth at the water source and (ii) using advanced treatment processes at the water treatment facilities, which involve the use of powdered activated carbon and oxidation by potassium permanganate.  The algae growth creates significant additional costs for water treatment because of the higher volumes of chemicals used to treat the water.  In 2012, we did not detect significant algae growth.  We participate in the New Life Program which includes a Water Source Program (Programa Mananciais), together with other organizations engaged in the promotion of urban development and social inclusion to mitigate the pollution problem in the São Paulo metropolitan region.  In addition, we also participate in the Clean Stream Program to clean up important streams in the city of São Paulo.  Other initiatives also aimed at improving the water quality in our water sources located in the metropolitan region of São Paulo are Guarapiranga and Pró‑Conexão.  See “—Capital Expenditure Program—Main Projects of Our Capital Expenditure Program—Metropolitan System Investment Program—New Life Program and Clean Stream Program.”

We believe that there are no material instances where our standards are not being met.  However, we cannot be certain that future breaches of these standards will not occur.

Fluoridation

As required by Brazilian law, we have adopted a water fluoridation program designed to assist in the prevention of tooth decay among the population.  Fluoridation primarily consists of adding fluorosilicic acid to water at 0.7 parts per million.  We add fluoride to the water at our treatment facilities prior to its distribution into the water supply network.

Sewage Operations

We are responsible for the collection and removal of sewage through our sewage systems and for its subsequent disposal with or without prior treatment.  As of December 31, 2012, we collected approximately 87% of all the sewage produced in the municipalities in which we operate in the São Paulo metropolitan region.  In addition, during the year ended December 31, 2012, we collected approximately 76% of all the sewage produced in the municipalities in which we operate in the Regional systems.  During 2012, we collected approximately 83% of all the sewage produced in the municipalities in which we operated in the State of São Paulo.  We installed 240,687, 246,400 and 233,500 new sewage connections in 2012, 2011 and 2010, respectively.

Sewage System

The purpose of our sewage system is to collect and treat sewage and to adequately dispose of the treated sewage.  As of December 31, 2012, we were responsible for the operation and maintenance of 45,778 kilometers of sewage lines, of which approximately 24,087 kilometers are located in the São Paulo metropolitan region and 21,691 kilometers are located in the Regional systems, respectively.

The following table sets forth the total number of kilometers of sewage lines and the total number of sewage connections in our network for the periods indicated.

Our sewage system comprises a number of systems built at different times and constructed primarily from clay pipes and, more recently, PVC tubing.  Sewage lines larger than 0.5 meters in diameter are primarily made of concrete.  Our sewage system is generally designed to operate by gravitational flow, although pumping stations are required in certain parts of the system to ensure the continuous flow of sewage.  Where pumping stations are required, we use sewage lines made of cast iron.

The public sewage system operated by us was structured in order to receive industrial sewage and sewage from non‑domestic sources for treatment together with domestic sewage.  Industrial sewage has physical, chemical and/or biological characteristics that are qualitatively different from household effluents.  As a result, the discharge of industrial sewage into the public sewage system is subject to compliance with specific legal demands with the purpose of protecting the sewage collection and treatment systems, the health of operators and the environment.  The current environmental legislation establishes standards for the discharge of these effluents into the public sewage system.  These standards are defined in Article 19A of State Decree No. 8,468 dated September 8, 1976.  To ensure compliance with legislation, periodic inspections of the sewage produced by all industrial clients are conducted, and we also request self‑monitoring reports from non‑domestic sewage‑producing sources.

The discharge of these effluents into the public sewage system is based on technical and administrative procedures.  Before the discharge is permitted, we carry out acceptance studies that assess the capacity of the public sewage system to receive the discharge as well as the compliance with regulations.  Upon the conclusion of these studies, the technical and commercial conditions for receiving the discharge are established, which are then formalized in a document signed by us and the effluent producer.  Failure to comply with these conditions can lead to the application of penalties and the obligation of the effluent producer to conduct certain adjustments to their business practices in a given time frame.  Non‑compliance with these penalties and adjustments may ultimately result in the suspension of the connection and notification of the environmental protection agency (Companhia Ambiental do Estado de São Paulo), or the CETESB, in order for the applicable measures to be taken.  Effluents from our treatment facilities must comply with effluent limitation guidelines and meet the water quality standards of the receiving water bodies established by federal and state legislation.  Effluent limitation guidelines consist of a set of parameters that must be verified before the effluents are discharged into a water body.  Water quality standards are based on the classification of water bodies, and take into account the current and expected use of water.  These standards have historically become more and more rigorous as water is a scarce resource.

We considered the condition of the sewage lines in the São Paulo metropolitan region to be adequate as of the date of this annual report.  Due to a greater volume of sewage collected, a higher population and more extensive commercial and industrial development, the sewage lines in the São Paulo metropolitan region are more deteriorated than those of the Regional systems.  To counter the effects of deterioration, we maintain an ongoing program for the maintenance of sewage lines intended to address anticipated fractures arising from obstructions caused by system overloads.

Unlike the São Paulo metropolitan region, the interior region of São Paulo State does not generally suffer obstructions caused by sewage system overload.  The coastal region, however, experiences obstructions in its sewage lines primarily due to infiltration of sand, especially during the rainy season in the summer months.  In addition, the sewage coverage ratio in the coastal region is lower than in the other regions served by us, with approximately 59% of all residences in the coastal region currently connected to our sewage network as of December 31, 2012.

New sewage connections are made on substantially the same basis as connections to water lines:  we assume the cost of installation for the first 20 meters of sewage lines from the sewage network to all customers’ sewage connections and the customer is responsible for the remaining costs.

The following table sets forth projected new sewage connections for the periods indicated.

Sewage Treatment and Disposal

In 2012, approximately 68% and 94% of the sewage we collected in the São Paulo metropolitan region and the Regional systems, respectively, or 77% of the sewage we collected in the State of São Paulo, was treated at our treatment facilities and afterwards discharged into receiving water bodies such as inland waters and the Atlantic Ocean, in accordance with applicable legislation.  Our sewage treatment facilities have a limited capacity.  The sewage collected that is not directly connected to sewage treatment plants is discharged directly, untreated, to inland waters.

We currently operate 493 sewage treatment facilities and nine ocean outfalls, of which the five largest, located in the São Paulo metropolitan region, have treatment capacity of approximately 18 cubic meters of sewage per second.

In the São Paulo metropolitan region, the treatment process used by most treatment facilities is the activated sludge process, where there is a liquid phase and a solid phase that generates sludge.  During the first stage, a biological mass grows, forms flakes and is continually re‑circulated and put in contact with organic matter, always with the presence of oxygen (aerobic).  The activated sludge process is strictly biological and aerobic, in which the raw sewage and the activated sludge are mixed, agitated and aerated in units known as secondary decanters where the solid part is separated from the treated wastewater.  The settled sludge returns to the aeration tank or is removed for specific treatment.

Sewage treatment in the Regional systems will vary according to the particularities of each area.  In the interior region of São Paulo State, treatment consists largely of stabilization ponds where the organic matter is treated and discharged to receiving waters.  There are 402 secondary treatment facilities in the interior region of São Paulo State that have treatment capacity of approximately 13.7 cubic meters of sewage per second.

The majority of sewage collected in the coastal region receives treatment and disinfection and is then discharged into rivers and into the Atlantic Ocean through our ocean outfalls.  We have 72 sewage treatment facilities in the coastal region.

Our sewage collection system is currently not sufficiently extensive to transport all sewage collected by us to our treatment facilities.  As a result, a portion of the sewage collected by us is discharged untreated into receiving waters.  We are a party to a number of legal proceedings related to environmental matters.  See “Item 8.A. Financial Information—Consolidated Statements and Other Financial Information—Legal Proceedings.”  In addition, our capital expenditure program includes projects to increase the amount of sewage that we treat.  See “Item 4.A. History and Development of the Company—Capital Expenditure Program” and “4.B Business Overview—Government Regulation—Environmental Regulation—Sewage Requirements.”

Sludge Disposal

The creation of sludge is inherent to the sanitation cycle.  The treatment of water and sewage produces residue which needs to be disposed of appropriately to prevent harm to the environment.  Sludge removed from the treatment process typically contains water and a very small proportion of solids.  We use filter presses, belt presses, drying beds and centrifugation machines to abstract the water from the sludge.

Sludge generated in our sanitation activities is disposed of in landfill in conformity with applicable law.  Since landfills have low available capacity throughout the State of São Paulo, we are seeking other alternatives to disposal in order to reduce the total volume deposited in landfills. Amongst other proposed techniques, we plan to incinerate and compost sludge, which would produce energy and soil for agricultural use as by products, respectively.

In 2013, under the partnership with Fapesp (Fundação de Amparo à Pesquisa do Estado de São Paulo), we aim to encourage the use of sludge generated in our water treatment processes to cover landfills, the use of sludge from sewage treatment processes to recover degraded areas and using it for civil construction projects.

Sludge disposal must comply with State and Federal law requirements, such as Resolution No. 375 of August 29, 2006 of the CONAMA, Federal Law No. 12,305/2010, Federal Decree No. 7,404/2010, State Law No. 12,300/2006 and State Decree No. 54,645/2009.

Principal Markets in Which We Operate

As of December 31, 2012, we operated water and sewage systems in 363 of the 645 municipalities in the State of São Paulo as well as sewage systems in 362 of them.  In addition, we currently supply water on a wholesale basis to six municipalities located in the São Paulo metropolitan region with an urban population of approximately 3.5 million.

The following table provides a breakdown of gross revenues from water supply and sewage services by geographic market for the periods indicated.

The following table provides a breakdown of gross revenues from water supply and sewage services by category of activity for the periods indicated.

Competition

In the State of São Paulo, there are approximately 277 municipalities that operate their own water and sewage systems and that collectively have a total population of approximately 13.5 million, or approximately 31% of the population of the State of São Paulo, excluding the population of the municipalities to which we provide water services on a wholesale basis.

The competition for municipal concessions arises mainly from the municipalities, as they may resume the water and sewage services that were granted to us and start providing these services directly to the local population.  In this case, the municipal governments would be required to indemnify us for the unamortized portion of our investment.  See “—Business Overview—Our Operations—Concessions.”  In the past, municipal governments have terminated our concessions agreements before the expiration date.  Furthermore, municipal governments have tried to expropriate our assets in an attempt to resume the provision of water and sewage services to local populations.  See “Item 8.A. Financial Information—Consolidated Statements and Other Financial Information—Legal Proceedings.”  We negotiate expired concession agreements and concession agreements close to expiration with the municipalities in an attempt to maintain our existing areas of operations.  In the State of São Paulo we face competition from private and municipal water and sewage service providers.

In recent years, we have also experienced an increasing level of competition in the market of water supply to large customers.  Several large industrial customers located in municipalities served by us use their own wells to supply themselves with water.  In addition, competition for the disposal of non‑residential, commercial and industrial sludge in the São Paulo metropolitan region has increased in recent years as private companies offer stand‑alone solutions inside the facilities of their customers.  We have also established new tariff schedules for commercial and industrial customers in order to assist us in retaining these customers.  For this group of customers, we have a special authorization from ARSESP to establish different tariffs than the ones that agency establishes for regular consumers.

Billing Procedures

The procedure for billing and payment of our water and sewage services is largely the same for all customer categories.  Water and sewage bills are based upon water usage determined by monthly water meter readings.  Larger customers, however, have their meters read every 15 days to avoid non‑physical loss resulting from faulty water meters.  Sewage billing is included as part of the water bill and is based on the water meter reading.

The majority of the bills for water and sewage services are delivered to our customers in person, mainly through one of our employees or through independent contractors who are also responsible for reading water meters.  The remainder, by judicial determination, is sent by mail.  Water and sewage bills can be paid at some banks and other locations in the State of São Paulo.  These funds are paid over to us after deducting average banking fees ranging from R$0.29 to R$1.15 per transaction for collection and remittance of these payments.

Customers must pay their water and sewage bills by the due date if they wish to avoid paying a fine.  We generally charge a penalty fee and interest on late bill payments.  In 2012, 2011 and 2010, we received payment of 94.7%, 94.8% and 95.5%, respectively, of the amount billed to our retail customers, and 95.5%, 94.7% and 94.4%, respectively, of the amount billed to those customers other than State entities, within 30 days after the due date.  In 2012, 2011 and 2010, we received 100.7%, 96.0% and 97.1%, respectively, of the amount billed to the State entities.  Amounts in excess of 100.0% reflect our recovery of amounts billed in prior years.  With respect to wholesale supply, in 2012, 2011 and 2010, we received payment of 50.1%, 54.7% and 58.3%, respectively, of the amount billed within 30 days.

We monitor water meter readings by use of hand‑held computers and transmitters.  The system allows the meter reader to input the gauge levels on the meters into the computer and automatically print the bill for the customer.  The hand‑held computer tracks water consumption usage at each metered location and prepares bills based on actual meter readings.  Part of the water meter monitoring for billing purposes is carried out by our own personnel, trained and supervised by us, and part of it is carried out by third‑party contractors that employ and train their own personnel whose training we supervise.

Tariffs

Tariff adjustments follow the guidelines established by the Basic Sanitation Law and ARSESP.  The guidelines also establish procedural steps and the terms for the annual adjustments.  The adjustments have to be announced 30 days prior to the effective date of the new tariffs, which take effect in September and last for a period of at least 12 months.

Tariffs have historically been adjusted once a year and for periods of at least 12 months.  See “—Government Regulation—Tariff Regulation in the State of São Paulo” for additional information regarding our tariffs.

With the publication of the Basic Sanitation Law, the regulation of basic sanitation services, including tariff regulation, became the responsibility of an independent regulator.  To exercise this assignment, the State of São Paulo created ARSESP, which regulates and supervises the services we provide to the State and also to the municipalities that have agreed to its jurisdiction through a cooperation agreement entered into by that municipality.

In regards to municipalities that have not explicitly selected ARSESP as their regulator, the Basic Sanitation Law allows the municipality to create other regulatory agencies of their own.  In 2007, the municipality of Lins decided to create its own regulatory authority, although it revised this decision in 2010, transferring to ARSESP the regulation of the water activities performed in Lins, including for the setting of tariffs.  The municipality of Lins has reserved, however, the power to ultimately approve the tariff set by ARSESP.  The municipalities in which the hydrographic basins of the Piracicaba, Capivari and Jundiaí rivers are located created a consortium for the regulation and supervision of our activities in that area in 2011.  We are currently involved in legal proceedings in which this consortium is claiming that it has jurisdiction over our activities in the municipality of Piracaia and that ARSESP has no right to regulate our activities or set tariffs in the municipality.  We cannot predict the outcome of these proceedings or how it may impact our business.  See “Government Regulation—Tariff Regulation in the State of São Paulo” for additional information.

In August 2010, ARSESP approved a 4.05% adjustment for our water and sewage tariffs, starting on September 11, 2010.  In 2012 and 2011, we readjusted our prices by 5.15% and 6.83% starting on September 11, 2012 and on September 11, 2011, respectively. On April 22, 2013, ARSESP approved a revision to tariff index to a rate of 2.3509% to be applied linearly on tariffs. These adjustments were valid for all municipalities served by us, except for the municipalities of Lins and Magda, which have different rules and readjustment dates.  The tariffs in the municipality of São Bernardo do Campo are adjusted pursuant to a different methodology due to the difference between the tariffs charged in that municipality when we assumed the service and the tariffs we were charging in other metropolitan municipalities we serve.  The adjustments in São Bernardo do Campo were set so that in September 2012 the tariff charged in this municipality and the tariff charged in the other municipalities of the region became the same.  With respect to the municipality of Lins, our tariff is adjusted in January according to the variation of the IPCA for the last twelve‑month period ended November 30.  In regards to Magda, adjustments are expected to be made by 2015.

Regarding the tariff revision process, led by ARSESP, it was agreed that we should have delivered a proposal of a new tariff structure by the end of April, 2013. However, we have requested that the deadline be extended a year and we still cannot say whether this request will be accepted by the regulator. Until the new tariff structure we propose is approved by ARSESP, we will continue to use our current tariff structure.  As such, we currently divide tariffs into two categories:  residential and non‑residential.  The residential category is subdivided into standard residential, residential social and favela (shantytowns).  The residential social tariffs apply to residences of low‑income families, residences of persons unemployed for up to 12 months and collective living residences.  The favela tariffs apply to residences in shantytowns characterized by a lack of urban infrastructure.  The latter two sub‑categories were instituted to assist lower‑income customers by providing lower tariffs for consumption.  The non‑residential category consists of:  (i) commercial, industrial and public customers; (ii) ”not‑for‑profit” entities that pay 50.0% of the prevailing non‑residential tariff;  (iii) government entities that have entered into a water loss reduction agreement with us and pay 75.0% of the prevailing non‑residential tariff; and (iv) public entities that have entered into program agreements, for municipalities with a population of up to 30,000 and with half or more classified according to their degree of social vulnerability by the Social Vulnerability Index of São Paulo (Índice Paulista de Vulnerabilidade Social) 5 and 6, of the SEADE, obtained through the analysis of the 2000 Census figures, and start to receive tariff benefits, in accordance with our normative ruling, for the category of public use, at the municipality level.  The tariffs are equal to those offered to the commercial/entity of social assistance and that corresponds to 50.0% of the public tariffs without contractual provisions referred to in item (iv) above.

We established a new tariff schedule, effective May 2002, for commercial and industrial customers that consume at least 5,000 cubic meters of water per month and that enter into fixed demand agreements (take‑or‑pay) with us for at least one‑year terms.  In October 2007, the minimum volume for entering into these agreements was reduced from 5,000 cubic meters per month to 3,000 cubic meters per month.  We believe this tariff schedule will help prevent our commercial and industrial customers from switching to the use of private wells.  Since 2008, we have been authorized by ARSESP to establish tariffs for non‑residential customers, such as industrial and commercial customers, that consume more than 3,000 cubic meters per month, with a maximum tariff equal to the tariffs applicable to non‑residential customers that consume more than 50 cubic meters per month.  In 2010, ARSESP authorized a reduction in the minimum volume of consumption for customers that enter into demand agreements with us to a minimum of 500 cubic meters per month.

We establish separate tariff schedules for our services in each of the São Paulo metropolitan regions and each of the interior region of São Paulo State and coastal regions which comprise our Regional systems.  Each tariff schedule incorporates regional cross‑subsidies, taking into account the customers’ type and volume of consumption.  Tariffs paid by customers with high monthly water consumption rates exceed our costs of providing water service.  We use the excess tariff billed to high‑volume customers to compensate for the lower tariffs paid by low‑volume customers.  Similarly, tariffs for non‑residential customers are established at levels that subsidize residential customers.  In addition, the tariffs for the São Paulo metropolitan region generally are higher than tariffs in the interior region of São Paulo State and coastal regions.

Sewage charges in each region are fixed and are based on the same volume of water charged.  In the São Paulo metropolitan region and the coastal region, the sewage tariffs equal the water tariffs.  In the interior São Paulo State region, sewage tariffs are approximately 20.0% lower than water tariffs.  Wholesale water rates are the same for all municipalities served.  We also make available sewage treatment services to those municipalities in line with the applicable contracts and tariffs.  In addition, various industrial customers pay an additional sewage charge, depending on the characteristics of the sewage they produce.

Each category and class of customer pays tariffs according to the volume of water consumed.  The tariff paid by a certain category and class of customer increases progressively according to the increase in the volume of water consumed.  The following table sets forth the water and sewage services tariffs by (i) customer category and class and (ii) volume of water consumed, charged in cubic meters during the years and period stated in the São Paulo metropolitan region.

______________

(1)     The minimum volume charged is for ten cubic meters per month.

(2)     From September 11, 2010 to September 10, 2011.

(3)     From September 11, 2011 to September 10, 2012.

(4)     From September 11, 2012 to April 21, 2013.

(5)   Since April 22, 2013.

In 2012, 2011 and 2010, the average tariff calculated for the Regional systems was approximately 30% below the average tariff of the São Paulo metropolitan region.

The Basic Sanitation Law requires states to establish independent regulators with the responsibility of monitoring basic sanitation services and regulating tariffs.  Federal law No. 11,445/07 and São Paulo State Law No. 1,025/07 established the ARSESP, which regulates and supervises the basic sanitation services that we provide in municipalities that have agreed to come under ARSESP’s jurisdiction.  For the municipalities that have not yet agreed to come under ARSESP’s jurisdiction for which we currently provide basic sanitation services, we determine tariffs based on State Decree 41,446/96. ARSESP has proposed or enacted a number of regulatory changes, including the following:

·         In 2008, the tariff adjustment formula was reviewed. In 2009, ARSESP opened the methodology for tariff revisions for public discussion and hearings. In 2010, ARSESP published Resolution No. 156.  This resolution established the methodology and general criteria for the valuation of our regulatory asset base to be used for purposes of tariff review processes and auditing. During 2011 and 2012 ARSESP held further public consultations regarding the methodology for tariff revisions, which was finally specified and disclosed in April 2012.  In November 2012, ARSESP published a preliminary technical note for public consultation, proposing a preliminary initial maximum average tariff (P0) and efficiency gains factor (X), based on a preliminary evaluation of assets held by us.  Following further public consultations, in March 2013 ARSESP published two resolutions, Resolution No. 406 and Resolution No. 407.

·         Resolution No. 406 sets out the following:  (i) an initial maximum average tariff (P0) and a preliminary asset base value to apply until the conclusion of an external audit of our asset base, resulting in a tariff revision of 2.3509%; (ii) authorizes the repayment to consumers of the regulation and supervision rate of 0.5% immediately after the conclusion of the operational adjustments necessary for the inclusion of this rate in the bills in the municipalities where it will be charged; (iii) ARSESP also establishes an annual tariff adjustment formula, to be implemented during the second tariff cycle, consisting of the IPCA variation (a consumer price index) for the period, adjusted by an efficiency factor designed to transfer a portion of our productivity gains to consumers, and further adjusted to reflect changes in service quality to be defined and applied as of the third year of the second tariff cycle.  According to ARSESP’s timetable the final maximum average tariff (P0) will be announced in August 2013 after the asset base value presented by us is audited.

·         A tariff revision of to a rate of 2.3509% was implemented in April 2013 pursuant to Resolution No. 406. Additionally, we will pass an inspection fee of 0.5% to consumers immediately after the conclusion of the operational adjustments necessary for the inclusion of this rate in the bills to municipalities where it will be charged.

·         Resolution No. 407 authorizes us to pass on to the service bill legal charges defined by municipal legislation, which under the Program Contracts and the Sewage and Water Supply Service Contracts must be considered in the tariff revision.

In April 2013, ARSESP passed Resolution No. 413, which effectively suspended Resolution No. 407, thereby postponing the authorization for the passing on to consumers of billing of taxes to municipalities, which prior to this Resolution had been established in Resolution No. 407. The final decision regarding Resolution No. 407 has been postponed until August 2013.

In August 2012, ARSESP published Resolution No. 346, which established the principle that users should be compensated for any interruptions in water supply.  Implementation of this regulation has been suspended pending further technical discussions.

Marketing Channels

As of December 31, 2012, we were the concessionaire for the provision of water supply and collection, treatment and disposal of sewage services directly to end consumers for 363 municipalities of the State of São Paulo.  We also supply water on a wholesale basis to six municipalities located in the São Paulo metropolitan region.  It is the responsibility of these municipalities to then distribute the water to end consumers.  We provide sewage services to five of these municipalities.  Because of our distribution infrastructure, end consumers to whom we offer water services on a wholesale basis cannot alternatively acquire such services directly from us.  For more information on service concessions, see “4.B. Business Overview—Wholesale Operations.”

Energy Consumption

Energy is essential to our operations, and as a result we are one of the largest users of energy in the State of São Paulo.  In the year ended December 31, 2012, we used 1.76% of the total energy consumption in the State of São Paulo.  To date, we have not experienced any major disruptions in energy supply.  Any significant disruption of energy to us could have a material adverse effect on our business, financial condition, results of operations or prospects.  See “Item 3.D. Risk Factors—Risks Relating to Our Business—We are exposed to risks associated with the provision of water and sewage services.”

Energy prices have a significant impact on our results of operations.  An average increase in energy prices of 17.6% in 2003 negatively affected our results of operations in 2004.  In 2012, 44% of our total energy consumption occurred within the “free market,” where we can more efficiently negotiate the supply of energy.  This energy was provided by Companhia Energética São Paulo, or CESP, pursuant to a long‑term contract expired in October 2012.  As of October 2012, we entered into long‑term contracts with AES Tiête (39%) and Tractebel Energia S.A. (61%) to provide these services until 2015.

Insurance

We maintain insurance covering, among other things, fire or other damage to our property and office buildings and third‑party liability.  We also maintain insurance coverage for directors’ and officers’ liability (D&O insurance).  We currently obtain our insurance policies by means of public bids involving major Brazilian and international insurance companies that operate in Brazil.  As of December 31, 2012, we had paid a total aggregate amount of R$6.5 million in premiums.  In addition, we paid R$1.5 million for a D&O insurance policy, covering R$4.4 billion in assets, third‑party liabilities and D&O insurance.  We do not have insurance coverage for business interruption risk because we do not believe that the high premiums for such insurance are justified by the low risk of major interruption of our activities.  In addition, we do not have insurance coverage for liabilities arising from water contamination or other problems involving our water supply to customers and for environmental related liabilities and damages.  We believe that we maintain insurance at levels customary in Brazil for our type of business.

Environmental Matters

Our environmental policy establishes environmental management directives that allow us to become a contributing force to environmental sustainability and excellence.  These directives are based on a systematic approach to the environment, which allows us to develop a plan that integrates economic, environmental and social dimensions of our work with sustainable use of natural resources.

In order to coordinate the environmental demands with the specific needs of the different places we operate, we have implemented 20 Environmental Management Centers (Núcleos de Gestão Ambiental), or NGAs.  The NGAs are closely involved in operational matters, providing decision‑making support at a local level and seeking to ensure that environmental guidelines are respected throughout our organization.  In this manner, they help contribute to the ongoing improvement of our environmental performance.

We have the following environmental management programs:

·         execution of an Environmental Management System, or EMS, in our water and sewage treatment stations (“WTS” and “STS”).  The EMS is present in 65 stations and we intend to expand it to 129 plants by the end of 2013.  We also expect to have it implemented in 302 WTSs and STSs by 2018.  Additionally, we pursue the ISO 14001 certification for our strategic plants.  As of December 31, 2012, we have ISO 14001 certification for 50 STSs.

·         participation in the Carbon Disclosure Project;

·         conception and formation of the Corporate Management of Greenhouse Gas Program (Programa Corporativo de Gestão de Emissões de Gases de Efeito Estufa); 

·         formation and implementation of a corporate program for obtaining and maintaining environmental licenses and granting of water usage rights (Programa Corporativo de Manutenção e Obtenção do Licenciamento Ambiental); 

·         the implementation of the Environmental Education Program (PEA SABESP), including over one hundred environmental education actions and projects involving the community and other stakeholders;

·         management of our institutional representation in the State and National Systems of Water Resources Management, including training of company representatives to participate in councils of the National and State Systems for the Management of Water Resources (Sistemas Nacional e Estadual de Gerenciamento de Recursos Hídricos e Meio Ambiente), training of the representatives for participation in the process of establishing criteria for the charging of water usage, monitoring of water basin plans (Planos das Bacias), water bodies classification programs and the establishment or review of specific legislation on the matter;  and

·         implementation of the SABESP 3‑Rs Program (Programa SABESP 3Rs) for the reduction, re‑use and recycling of waste of administrative activities, a program involving the two largest administrative areas of our Company with plans to include all other administrative areas.

In addition to corporate environmental management initiatives, since 2008, we have launched several projects to benefit the environment by engaging the community and third parties with non‑governmental organizations, including:

·         Oil Recycling Program (Programa de Reciclagem de Óleo de Fritura);

·         Program of Lectures on Environmental Management (Ciclos de Conferências de Gestão Ambiental);

·         Supporters of Sustainability (Audiências de Sustentabilidade);

·         ‘Nossa Guarapiranga’ Project (Programa Nossa Guarapiranga);

·         Environmental Support Actions (ecomobilizações);

·         First Green Building (Primeiro Predio Verde Certificado);

·         Recycling programs;

·         Reforestation Program and Seedling Plantation Program

·         Green Post (Ecoposto Sabesp);

·         Maintaining of environmentally protected areas;

·         Green Life Program (Programa Verde Vida); and

·         Support and sponsoring of environmentally important projects and initiatives;

Climate Change Regulations:  Reduction of Greenhouse Gases (GHG)

We are required to comply with laws and regulations related to climate change, including international agreements and treaties to which Brazil is a signatory.

The São Paulo State Climate Change Policy (Law No. 13,798), enacted on November 9, 2009, seeks to reduce global emissions of carbon dioxide by 20.0% by 2020 compared with 2005 levels.  Brazil’s Climate Change Policy (Law No. 12,187), enacted on December 29, 2009, establishes a voluntary national commitment to reduce Brazil’s currently projected GHG emissions for 2020 by a percentage between 36.1% and 38.9%.  If legislation requires us to reduce our emissions, we may do so by transforming biogas from the treatment of sewage into energy, for example, which may lead to potential economic gains.

We have begun significant initiatives, such as the corporate program for water loss reduction and the implementation of small hydroelectric power plants, to reduce GHG emissions during the coming years.  We recently launched the Aquapolo project, the fifth largest project in the world to use reclaimed water production for industrial purposes, which uses treated sewage as input.  This project, capable of producing 1,000 liters per second (Ps) of reclaimed water, will increase the supply of treated water for the São Paulo metropolitan region and may potentially reduce GHG emissions.  Our investments in the Aquapolo project amounted to approximately R$252 million.  We created our inventory of GHG emissions for the year 2008 and in 2012 updated this inventory for the years 2009 and 2010.  Moreover, we are developing a management program for GHG emissions. 

At this point, it is still not possible to predict if climate change policies will provide opportunities or generate new costs for us.  Reducing our emissions of carbon dioxide will involve costs and expenses related to implementing more stringent control mechanisms, adopting pollution prevention measures and actions to minimize the generation of GHGs.  We may not receive financial incentives to offset all or part of these costs.  In addition, if limitations in GHG emissions affect our supply chain and increase our costs, we may not be able to pass on these costs to our end consumers.  See “4.B.  Business Overview—Tariffs.”

Regulation of GHG emissions could also benefit us in the short term, since we may be able to obtain subsidies, financial investments and tax incentives for projects to protect and restore water sources, conserve water, treat sewage, conserve energy, increase energy efficiency, and promote self‑generated energy, among other projects that seek to reduce the impact of climate change.

Carbon Disclosure Project

·         Carbon Disclosure Project Investors.  We participate in the Carbon Disclosure Project, a global initiative focused on the financial risks related to climate change.  Through this project, main international institutional investors ask the world’s largest companies to demonstrate that they are managing carbon effectively.  We have received and responded to the project’s questionnaires since 2006.  The companies that opt to have their answers disclosed to the public, as in our case, have their answers published in an international website of public interest.  The questionnaire asks mainly questions related to the aspects of climate change and corporate governance, the physical, financial and regulatory effects of climate change, and opportunities that affect or could positively or negatively affect us.

·         Carbon Disclosure Project Supply Chain.  On December 2010, we adhered to the Carbon Disclosure Project Supply Chain 2011.  We only participated in this program in 2011 due to the low support of suppliers.

Physical Effects of Climate Change

Since our financial performance is closely linked to climate patterns that influence the availability of water (in terms of quantity and quality of water resources), extreme weather conditions may adversely affect our business and operations.  If long‑term climate change causes significant alterations in environmental conditions, such as an increase in the frequency of extreme weather conditions, this could affect the quality and quantity of water available for abstraction, treatment and supply, affecting the costs of services and tariffs.

An increase in heavy rainfall can impact water quality and the regular operation of water sources, including abstraction of water from our dams, through increased soil erosion, silting, pollution and eutrophication of aquatic ecosystems.  In addition, increased flows of rainwater into sewage systems may overwhelm the capacity of sewage treatment plants.  We may need to build larger reservoirs, since it is not feasible to increase the size of our existing reservoirs, or increase operational capacity by further automating our existing equipment.  To increase automation, we would need to purchase and operate tools to measure dam levels and volumes, river output and the rain in hydrographic basins, create mathematical models for real time operations, and train technicians to operate these systems.  As an alternative, we may need to implement new production systems.

In the case of prolonged periods of drought, for example, reduced water levels in dams can cause an increase in the concentration of plant matter by increasing eutrophication and, consequently, increasing water treatment costs and operational complexity.  In addition, prolonged periods of drought in watersheds such as the São Paulo metropolitan region, where most of our production is concentrated, may result in the growth of vegetation in the reservoir flooding areas, which can impact water quality due to the accumulation of organic matter.  In such cases our production costs may increase, affecting our financial margins and the quality of water we produce.  Droughts also lower reservoir levels available for hydroelectric plants, which may lead to power shortages, particularly since hydroelectric power accounts for most of Brazil’s electric energy supply.  A lack of rainwater could lead to instability in domestic water supplies and in sewage collection and treatment services, which could damage our reputation.  In addition, because we are one of the largest consumers of electricity in the State of São Paulo, a potential increase in electricity tariffs due to a shortage of hydroelectric power could have a significant economic impact on us.

We are also the concessionaire for water and sewage services for all the coastal municipalities of the State of São Paulo.  A rise in the sea level would result in increased salinity of inland water supplies, which may affect water treatment in these areas.  Rising sea levels may also increase infiltration rates and alter the runoff regime of the sewage systems, which may affect the sanitary system.

Extreme climate changes may also affect the extraction, production and transportation of the materials necessary for our operations, such as water treatment materials, and may lead to an increase in the cost of these materials.  A rise in air temperature could also increase consumer demand for water, increasing the need to expand both water supply and sewage treatment.

See “Item 3.D. Risk Factors—Risks Relating to Our Business—New laws and regulations relating to climate change and changes in existing regulation, as well as the physical effects of climate change, may result in increased liabilities and increased capital expenditures, which could have a material adverse effect on us.”

Government Regulation

Basic sanitation services in Brazil are subject to an extensive federal, state and local legislation and regulation that, among other matters, regulates:

·         the granting of concessions to provide water and sewage services;

·         the development of public private partnerships;

·         the need of a public bidding process for the appointment of private water and sewage services providers;

·         the need of setting up an agreement for the appointment of public water and sewage services providers;

·         the joint management of public services through cooperation, allowing for a program agreement without the need for a public bidding process for the service provider, subject to the condition that the planning, execution and monitoring activities are not executed by the service provider;

·         minimum requirements for water and sewage services;

·         water usage;

·         water quality and environmental protection; and

·         governmental restrictions on the incurrence of indebtedness applicable to state‑controlled companies.

General

Pursuant to Article 23 of the Brazilian Constitution, water and sewage services are the joint responsibility of the federal government, the states and the municipalities.  Article 216 of the Constitution of the State of São Paulo provides that, by law, the State must provide the conditions for efficient management and adequate expansion of water and sewage services rendered by its agencies and State‑controlled companies or any other concessionaire under its control.  State law authorized our formation to plan, provide and operate water and sewage services in the State and also acknowledged the autonomy of the municipalities.

Pursuant to Article 175 of the Brazilian Constitution, the rendering of public services, such as water and sewage services, is the responsibility of the applicable public authority.  However, any such public authority has the right to render these services directly or through a concession granted to a third party.

In Brazil, there are three federal legal regimes for contracting water and sewage services:  (i) public concessions, regulated by Law No. 8,987/1995, which require a prior public bidding process; (ii) administration of public services through cooperation agreements between the federal government and local public authorities at State and municipal level without the need for a public bidding process, regulated by the Public Consortia and Cooperation Agreement Law; and (iii) public‑private partnerships, regulated by Law No. 11,079/2004, used to grant concessions to private companies to provide public services and used in relation to construction works associated with the provision of public services.  Until 2005, we had adopted the regime for public concessions.  Following the entry into force of the Public Consortia and Cooperation Agreement Law, we adopted the administration of public services through cooperation agreements, which can be used alongside the other two regimes.

The Public Consortia and Cooperation Agreement Law and the Basic Sanitation Law have caused significant impacts in the development of the state sanitation policy and the regulatory structuring of the industry.

Because we are the legal concessionaire for the State of São Paulo for water and sewage services, serving approximately 59% of the State’s population and providing sanitation services through concession agreements, the Consortium Law affects us on the expiry of our concession agreements entered into in the 1970s when the Brazilian Sanitation Plan (Plano Nacional de Saneamento), or PLANASA, was created.  The Consortium Law has caused important changes in the relationship among municipalities, states and public sanitation service providers, most notably in mixed capital companies, such as us, because of the implementation of the program agreements as a substitute for concession agreements.

In addition, the Basic Sanitation Law in its role as a general guideline for the development of the Brazilian sanitation industry, addresses the conditions for the delegation of water and sewage services, the exercise of ownership by the granting authority and the regulatory conditions for the industry.  The Basic Sanitation Law also provides for a significant amendment to Article 42 of the Concessions Law, which establishes the termination of concessions prior to the expiration date and the reversibility conditions for unamortized assets.  The amendment requires that the service provider be compensated for unamortized assets, prioritizing an agreement between the parties setting out the criteria for calculation and payments of indemnity.

The Basic Sanitation Law

On January 5, 2007, Federal Law No. 11,445, or the Basic Sanitation Law, was enacted, establishing nationwide guidelines for basic sanitation and seeking to create appropriate solutions for the situation of each state and municipality, facilitating the technical cooperation between the state and municipalities.  In addition, the federal government will enact its public policy to facilitate access to financing alternatives that are compatible with the costs and terms of the sanitation industry, in substitution of the PLANASA model.  On June 21, 2010, the federal government enacted Federal Decree No. 7,217, regulating the Basic Sanitation Law.  See “Risk Factors—Risks Relating to our Business—The Brazilian Basic Sanitation Law is still in the process of implementation and interpretation, and doubts remain as to its full impact on the industry.  ARSESP, the regulator, has the function to implement regulations under the Basic Sanitation Law within the State of São Paulo, and is in the process of reviewing, implementing and proposing changes to São Paulo State water and sewage regulations, including potentially significant changes to the tariff methodology and structure applicable to our business.  The current regulatory uncertainty, and any of the changes that are currently proposed, may have an adverse effect on our business.”

The Basic Sanitation Law establishes the following principles for basic sanitation public services:  universalization, integrality, efficiency and economic sustainability, transparency of actions, social control and integration of infrastructure and services with the management of water resources.  It does not define the ownership of the sanitation services, but establishes the minimum liability for the exercise of ownership, such as the development of the sanitation plan, definition of the person responsible for regulation and control and, establishment of the rights and obligations of the users and of the social control mechanisms.  It also defines the regionalized performance of the services (i.e., one single provider serves two or more owners, for which there may be one plan for the combination of services).

In addition, the Basic Sanitation Law defines the guidelines and objectives of the federal basic sanitation policy to be observed when securing public funds generated or operated by agencies or entities of the federal government, and foresees the possibility of having subsidies as an instrument of social policy to ensure access to basic sanitation services to everyone, particularly the low‑income population.  The subsidies may be granted either directly, through tariffs or indirectly, depending on the characteristics of the beneficiaries and on the source of the funds.

Furthermore, the Basic Sanitation Law also provides that the sanitation services may be interrupted by the service provider, in the event of default of payment of the tariffs by the customer, among other reasons, after written notice, as long as minimum health requirements are met.

The Basic Sanitation Law also establishes the criteria for the reversal of assets at the time of termination of the agreement and with regard to the concessions, such as those that have expired or are effective for an indefinite term, or those that were not formalized by an agreement.  In addition, the Basic Sanitation Law provides the basis for calculating the amount of an indemnity due, which must be calculated by a specialized institution chosen by mutual agreement between the parties.

Pursuant to the Basic Sanitation Law, the parties of the concession may enter into an agreement with respect to the payment of the indemnification due to the concessionaire.  However, in the absence of an agreement, the Basic Sanitation Law establishes that the indemnification must be paid in no more than four equal and successive annual installments, with the first installment payable by the last business day of the fiscal year in which the assets are reversed.

Tariff Regulation in the State of São Paulo

The tariffs for our services are subject to Federal and State regulation.

On December 16, 1996, the governor of the State of São Paulo issued a decree which approved the existing tariff system and allowed us to continue to set our own tariffs.  We used to set our tariffs based on the general objectives of maintaining our financial condition and preserving “social equality” in terms of the provision of water and sewage services to the population while providing a return on investment.  The governor’s decree also directs us to apply the following criteria in determining our tariffs:

·         category of use;

·         capacity of the water meter;

·         characteristics of consumption;

·         volume consumed;

·         fixed and floating costs;

·         seasonal variations of consumption; and

·         social and economic conditions of residential customers.

With the enactment of the Basic Sanitation Law and Federal Consortium Law, we are prohibited from planning, overseeing and regulating services, which includes determining the tariff policy to be adopted.  Such activities are to be exercised by the owner of the concession.  Other than the responsibility for planning, the remaining activities may not be delegated.

The current tariff structure maintains different tariff schedules, depending upon whether a customer is located in the São Paulo metropolitan region or the Regional systems.  There are four levels of volume consumed for each category of customer, except for the residential social and favelas (shantytowns).  The residential social tariffs apply to residences of low income families, residences of persons unemployed for up to 12 months and collective living residences.  The favela tariffs apply to residences in shantytowns characterized by a lack of urban infrastructure.  The latter two sub categories were instituted to assist lower income customers by providing lower tariffs for consumption.  Customers are billed on a monthly basis.  Water and sewage bills are based upon water usage determined by monthly water meter readings.  Larger customers, however, have their meters read every 15 days to avoid nonphysical loss resulting from faulty water meters.  Sewage billing is included as part of the water bill and is based on the water meter reading.  We are also authorized to enter into individual contracts with certain customers, such as municipalities, to supply water or sewage services on a wholesale basis.

The Basic Sanitation Law requires states to establish independent regulators with the responsibility of monitoring basic sanitation services and regulating tariffs.  Federal law No. 11,445 and São Paulo State Law No. 1,025/07 established the ARSESP, which regulates and supervises the basic sanitation services that we provide in municipalities that have agreed to come under ARSESP’s jurisdiction.  For the municipalities that have not yet agreed to come under ARSESP’s jurisdiction for which we currently provide basic sanitation services, we determine tariffs based on State Decree 41,446/96. ARSESP has proposed or enacted a number of regulatory changes, including the following:

·         In 2008, the tariff adjustment formula was reviewed. In 2009, ARSESP opened the methodology for tariff revisions for public discussion and hearings. In 2010, ARSESP published Resolution No. 156.  This resolution established the methodology and general criteria for the valuation of our regulatory asset base to be used for purposes of tariff review processes and auditing. During 2011 and 2012 ARSESP held further public consultations regarding the methodology for tariff revisions, which was finally specified and disclosed in April 2012.  In November 2012, ARSESP published a preliminary technical note for public consultation, proposing a preliminary initial maximum average tariff (P0) and efficiency gains factor (X), based on a preliminary evaluation of assets held by us.  Following further public consultations, in March 2013 ARSESP published two resolutions, Resolution 406 and Resolution 407.

·         Resolution No. 406 sets out the following:  (i) an initial maximum average tariff (P0) and a preliminary asset base value to apply until the conclusion of an external audit of our asset base, resulting in a tariff revision of 2.3509; (ii) authorizes the repayment to consumers of the regulation and supervision rate of 0.5% immediately after the conclusion of the operational adjustments necessary for the inclusion of this rate in the bills in the municipalities where it will be charged; (iii) ARSESP also establishes an annual tariff adjustment formula, to be implemented during the second tariff cycle, consisting of the IPCA variation (a consumer price index) for the period, adjusted by an efficiency factor designed to transfer a portion of our productivity gains to consumers, and further adjusted to reflect changes in service quality to be defined and applied as of the third year of the second tariff cycle.  According to ARSESP’s timetable the final maximum average tariff (P0) will be announced in August 2013 after the asset base value presented by us is audited.

·         A tariff revision of to a rate of 2.3509% was implemented in April 2013 pursuant to Resolution No. 406. Additionally, we will pass an inspection fee of 0.5% to consumers immediately after the conclusion of the operational adjustments necessary for the inclusion of this rate in the bills to municipalities where it will be charged.

·         Resolution No. 407 authorizes us to pass on to the service bill legal charges defined by municipal legislation, which under the Program Contracts and the Sewage and Water Supply Service Contracts must be considered in the tariff revision.

In April 2013, ARSESP passed Resolution No. 413, which effectively suspended Resolution No. 407, thereby postponing the authorization for the passing on to consumers of billing of taxes to municipalities, which prior to this Resolution had been established in Resolution No. 407. The final decision regarding Resolution No. 407 has been postponed until August 2013.

In August 2012, ARSESP published Resolution No. 346, which established the principle that users should be compensated for any interruptions in water supply.  Implementation of this regulation has been suspended pending further technical discussions.

Furthermore, since Law No. 11,445 permits municipalities to create their own regulatory agencies rather than being subjected to overview by ARSESP, a number of municipalities created their own regulatory agencies.  The municipality of Lins, which had decided in 2007 to create its own regulatory authority, revised this decision in 2010 and transferred the regulation of the water activities performed in Lins, including the setting of tariffs, to ARSESP.  Lins has retained, however, the power to ultimately approve the tariff set by ARSESP.  The municipalities of São Bernardo do Campo and Magda retained the power to readjust the tariffs applied therein.  Additionally, the municipalities in which the hydrographic basins of the Piracicaba, Capivari and Jundiaí rivers are located created a consortium for the regulation and supervision of our activities in that area in 2011.  We are currently involved in legal proceedings in which this consortium is claiming that it has jurisdiction over our activities in the municipality of Piracaia and that ARSESP has no right to regulate our activities or set tariffs in the municipality.  We cannot predict the outcome of this case or how it may impact our business.  See “Risk Factors—Risks Relating to Our Business—The Brazilian Basic Sanitation Law is still in the process of implementation and interpretation, and doubts remain as to its full impact on the industry.  ARSESP, the regulator, has the function to implement regulations under the Basic Sanitation Law within the State of São Paulo, and is in the process of reviewing, implementing and proposing changes to São Paulo State water and sewage regulations, including potentially significant changes to the tariff methodology and structure applicable to our business.  The current regulatory uncertainty, and any of the changes that are currently proposed, may have an adverse effect on our business.”

Consumer Relations in the State of São Paulo

In 2011 ARSESP altered the standard contract that we are required to use in our relationships with retail customers, requiring that invoices be sent to the consumer of the service rather than the owner of the property.  We estimate that this change will affect ongoing legal disputes, particularly those regarding collection procedures, as well as business discussions in general.  Since this change is still being implemented, we are not currently able to predict its impact on our business.

In 2009 ARSESP enacted rules regarding the following:

·         general terms and conditions for water and sewage services;

·         procedures for communication regarding any failure in our services;

·         penalties for deficiencies in the provision of basic sanitation services; and

·         procedures for confidential treatment of our customers’ private information.

We are currently evaluating the enforceability and legality of some of these rules.  Implementation of these rules started during 2011, is currently ongoing, and is expected to continue for the next few years.  The implementation of these rules will impact our commercial and operations processes, and may adversely affect us in ways we cannot currently predict.

Regarding changes to the communication process for the reporting of failures, ARSESP has modified the rules and standards for supervision and reporting of incidents.  We have implemented these requested changes.  Currently, part of the reporting of incidents occurs online, through the Incident Reporting System (“Sistema de Comunicação de Incidentes”) established by ARSESP, which introduces greater transparency and control to our operations.

We are attentive to these regulatory changes, have been working toward meeting ARSESP’s requirements and recommendations, and have presented technical, legal and factual reasons for any conduct that ARSESP may find irregular.  As a result, we are subject to few regulatory infractions and to limited fines.  See “Risk Factors—Risks Relating to Our Business—The Brazilian Basic Sanitation Law is still in the process of implementation and interpretation, and doubts remain as to its full impact on the industry.”  ARSESP, the regulator, has the function of implementing regulations under the Basic Sanitation Law within the State of São Paulo, and is in the process of reviewing, implementing and proposing changes to São Paulo State water and sewage regulations, including potentially significant changes to the tariff methodology and structure applicable to our business.  The current regulatory uncertainty, and any of the changes that are currently proposed, may have an adverse effect on our business.”

Concessions

Concessions for providing water and sewage services are formalized by agreements executed between the state or municipality, as the case may be, and a concessionaire to which the performance of these services is granted in a given municipality or region.  Our concessions normally have a contractual term of up to 30 years.  However, our concessions in general can be revoked at any time if certain standards of quality and safety are not met, or in the event of default of the terms of the concession agreement.

A municipality that chooses to assume the direct control of its water and sewage services must terminate the current relationship by duly compensating the service provider.  Subsequently, the municipality will be in charge of rendering services or of conducting a public bidding process to grant the concession to potential concessionaires, including agreements with public companies directly.  Although the Constitution of the State of São Paulo determines that the relevant municipality would have to pay us for the unamortized book value of the assets related to any concession and assume any corresponding debt, with the exclusion of any amounts that have been paid to us by the municipality, upon termination or non‑renewal of the concession, the payment for termination may not be effected immediately, and any termination could negatively affect our cash flows, operating results and financial situation.  The Basic Sanitation Law reduced the maximum time period for payment of indemnification in such cases to four years.  See “Item 3.D. Risk Factors—Risks Relating to Our Business—The municipalities may terminate our concessions before they expire in certain circumstances.  The indemnification payments we receive in such cases may be less than the value of the investments we made.”

The Federal Concessions Law No. 8,987/1995 and the State Concessions Law No. 7,835/1992 require that the granting of a concession by the government be preceded by a public bidding process.  However, the Federal Public Bidding Law No. 8,666/1993, which establishes the rules for the public bidding process, provides that a public bidding process can be waived under certain circumstances, including in the case of services to be provided by a public entity created for such specific purpose on a date prior to the effectiveness of this law, provided that the contracted price is compatible with what is practiced in the market.  Furthermore, a provision of the Federal Public Bidding Law, as amended by the Public Consortia and Cooperation Agreement Law, provides that the program contracted can be executed with waiver of a public bidding process.

In the majority of municipalities where we operate, the new contracts have been formalized pursuant to the provisions of the Federal Public Bidding Law that allows the public bidding process to be waived under certain circumstances.  In addition, there are pending cases before the Brazilian Supreme Court regarding whether the right to execute concession and program agreements in the metropolitan regions belongs to the State or the municipal government. On February 28, 2013 the Brazilian Supreme Court decided a pending case on this matter related to the State of Rio de Janeiro.  A majority of the court held that the State and municipal governments must set up new joint entities to oversee the planning, regulation and auditing of basic sanitation services in metropolitan regions.  On March 6, 2013, the court ruled that this decision would come into effect after a 24-month period with respect to the State of Rio de Janeiro. The São Paulo metropolitan region accounted for 74.1% of our gross operating revenue in 2012 (excluding revenues relating to the construction of concession infrastructure).  We cannot predict how the shared management of these operations will be carried out in the São Paulo metropolitan region and other metropolitan regions we operate in or what effect it may have on our business, financial condition or results of operation.  See “Item 3.D. Risk Factors—Risks Relating to Our Business –”The Brazilian Basic Sanitation Law is still in the process of implementation and interpretation, and doubts remain as to its full impact on the industry.  ARSESP, the regulator, has the function of implementing regulations under the Basic Sanitation Law within the State of São Paulo, and is in the process of reviewing, implementing and proposing changes to São Paulo State water and sewage regulations, including potentially significant changes to the tariff methodology and structure applicable to our business.  The current regulatory uncertainty, and any of the changes that are currently proposed, may have an adverse effect on our business.”

On June 18, 2009, Municipal Law No. 14,934/2009 was enacted and this law revoked Law No. 13,670/2003, which had originally created the discussion on whether the State or the Municipality was the one with the power to grant and monitor formal concessions for water and sewage services in the city of São Paulo.  On June 23, 2010, we entered into a formal agreement with both the State and the city of São Paulo to regulate the provision of water and sewage services in the city of São Paulo for a 30‑year period, which may be extended for an additional 30‑year period.

Public Consortia and Cooperation Agreement Law for Joint Management

On April 6, 2005, the federal government enacted Federal Law No. 11,107, or the Federal Public Consortia and Cooperation Agreement Law, which regulates Article 241 of the Brazilian Constitution.  This statute provides general principles to be observed when a public consortia enters into contracts with the Brazilian political divisions and subdivisions (the federal government, states, the Federal District and municipalities) aiming at the joint management of public services of common interests.

Federal Decree No. 6,017/2007 details the conditions of establishment of joint management and the execution of the program agreement regulating the Public Consortia and Cooperation Agreement Law.  This federal legislation introduces significant changes in the relationship among municipalities, states and companies providing public sanitation services, prohibiting the latter from exercising activities of planning, oversight and regulation, including tariff regulation, of the services and creating the program agreement for contracting entities whose share control is held by one of the Brazilian political divisions and subdivisions upon waiver of the public bidding process and compliance with concession legislation, as applicable.

On January 13, 2006, the Governor of the State of São Paulo enacted State Decree No. 50,470, amended by State Decrees No. 52,020, dated July 30, 2007, and No. 53,192, dated July 1, 2008, which provide for the rendering of water and sewage services in the State of São Paulo.  According to these decrees, we may enter into agreements with municipalities in connection with the provision of water and sewage services by means of the so‑called “program agreement without a public bidding process.”  In addition, these decrees establish that we will continue to render services in the areas covered by the concession granted by the State.

Based on these statutes, in January 2007 we executed our first program agreement with the municipality of Lins, located in the State of São Paulo.  Subsequently, we formalized agreements with other municipalities in the State of São Paulo.  These other municipalities transferred the oversight and regulation of our services to the State of São Paulo through a cooperation agreement.

On June 8, 2006, the State of São Paulo enacted Decree No. 50,868 creating the Commission for the Regulation of Sanitation Service of the State of São Paulo (Comissão de Regulação do Serviço de Saneamento do Estado de São Paulo – CORSANPA) to regulate sanitation services.  The Commission for the Regulation of Sanitation Service of the State of São Paulo is directly subordinated to the State Secretariat for Sanitation and Water Resources.

The main duty of the Commission for the Regulation of Sanitation Service of the State of São Paulo was conducting studies for the creation of a regulatory agency for the basic sanitation industry and the presentation of legal and regulatory measures.  The completion of such duties resulted in the publication of supplementary Law No. 1,025 of December 7, 2007, which created ARSESP.  Furthermore, Supplementary Law No. 1,025/2007 maintained the State Sanitation Council (Conselho Estadual de Saneamento – CONESAN), created by Supplementary Law No. 7,750/92, as an advisory council to define and implement the state basic sanitation policy, and the State Sanitation Fund (Fundo Estadual de Saneamento ‑FESAN).  The State Sanitation Fund is connected to the State Secretariat for Sanitation and Water Resources, and collects and manages resources that support State‑approved programs, as well as the development of technology, management and human resources and a sanitation information system, in addition to other support programs.

ARSESP regulates the basic sanitation services that belong to the State, relating to the federal and municipal jurisdictions and prerogatives, and is responsible for: 

·         the compliance with and enforcement of state and federal basic sanitation legislation;

·         the publication of the organizational platform for the services, indicating the types of services provided by the State, as well as the equipment and facilities that compose the system;

·         the acceptance, where applicable, of the legal attributions of the jurisdictional authority;

·         the establishment, in accordance with the tariff guidelines defined by Decree No. 41,446/96, of tariffs and other methods that provide compensation for our services, adjustment and review of such tariffs and methods to ensure the financial‑economic balance of services and low‑cost tariffs through mechanisms that increase service efficiency and lead to the distribution of productivity gains to society; and

·         the approval, oversight and regulation (including tariff issues) of the sewage treatment and wholesale water supply agreements entered into between the state supplier and other suppliers, pursuant to Article 12 of the Basic Sanitation Law.

With respect to municipal basic sanitation, ARSESP oversees and regulates services (including tariff issues) that have been delegated by municipalities to the State as a result of cooperation agreements that authorize program agreements between the municipalities and us for as long as it is convenient to the municipality’s public interest.

For its services, ARSESP charges 0.50% of the annual total invoice from gross operating revenue (excluding revenues relating to the construction of concession infrastructure) of the municipality.  This fee is collected from municipalities that have a signed program agreement with us and the municipalities located in the metropolitan regions.

In connection with the scope of our services, Supplementary Law No. 1,025/2007 expanded the range of services that we can render, with the inclusion of urban rainwater drainage and management, urban cleaning and solid waste management, as well as the operation of power generation, storage, conservation and sales activities, for our own or third‑party use.

In addition, the rules simplified the process for the expansion of our business in Brazil and abroad, authorizing us:

·         to participate in the controlling block or the capital of other companies;

·         to create subsidiaries, which may become majority or minority shareholders in other companies; and

·         to establish partnerships with national or foreign companies, including other state or municipal basic sanitation companies, in order to expand our activities, share technology and expand investments related to basic sanitation services.

Public‑Private Partnerships

The PPP is a form of agreement with the public administration used for the concession of services to private enterprises, as well as for construction works coupled with the provision of services.  PPPs are regulated by the State of São Paulo through Law No. 11,688, which was enacted on May 19, 2004.  PPPs may be used for:  (i) implantation, expansion, improvement, reform, maintenance or management of public infrastructure; (ii) provision of public services; and (iii) exploitation of public assets and non‑material rights belonging to the State.

Payment is conditioned upon performance.  The payment may be collected through:  (i) tariffs paid by users; (ii) use of resources from the budget; (iii) assignment of credits belonging to the State; (iv) transfer of rights related to the commercial exploitation of public assets; (v) transfer of real property and other property of assets; (vi)  public debts securities; and (vii) other revenues.

In our case, payment is conditional upon performance and is collected through the use of resources from the budget.

Public Bidding Procedures

Pursuant to the Federal Public Bidding Law, the public bid process commences with publication by the granting authority in a federal, state or municipal official newspaper, as the case may be, and another leading Brazilian newspaper.  The publication announces that the granting authority will carry out a public bidding contest pursuant to provisions set forth in an edital (invitation to bid).  The invitation to bid must specify, among other terms:  (i) the purpose, duration and goals of the bid; (ii) the participation of bidders, either individually or forming a consortium; (iii) a description of the qualifications required for adequate performance of the services covered by the bid; (iv) the deadlines for the submission of the bids; (v) the criteria used for the selection of the winning bidder; and (vi) a list of the documents required to establish the bidder’s technical, financial and legal capabilities.

The invitation to bid is binding on the granting authority.  Bidders may submit their proposals either individually or in consortia, as provided for in the invitation to bid.  After receiving proposals, the granting authority will evaluate each proposal according to the following criteria, which must have been set forth in the invitation to bid:

·         the technical quality of the proposal;

·         lowest cost or lowest public service tariff offered;

·         a combination of the criteria above; or

·         the largest amount offered in consideration for the concession.

The provisions of State Law No. 6,544 of November 2, 1989, as amended, or the State Public Bidding Law, parallel the provisions of the Federal Public Bidding Law.  The Federal and State bidding laws will apply to us in the event that we seek to secure new concessions.  Moreover, these bidding laws currently apply to us with respect to obtaining goods and services from third parties for our business operations or in connection with our capital expenditure program, in each case subject to certain exceptions.

Water Usage

State law establishes the basic principles governing the use of water resources in the State of São Paulo in accordance with the State constitution.  These principles include:

·         rational utilization of water resources, ensuring that their primary use is to supply water to the population;

·         optimizing the economic and social benefits resulting from the use of water resources;

·         protection of water resources against actions which could compromise current and future use;

·         defense against critical hydrological events which could cause risk to the health and safety of the population or economic and social losses;

·         development of hydro‑transportation for economic benefit;

·         development of permanent programs of conservation and protection of underground water against pollution and excessive exploitation; and

·         prevention of soil erosion in urban and rural areas, with a view to protecting against physical pollution and silting of water resources.

Under State law, implementation of any project that involves the use of surface or underground water requires prior authorization or licensing from the competent government authority.  In order to implement these principles, authorizations granting a right of use are required from the relevant public authority for water usage (whether for collection, release of effluents or otherwise), modification of the regime and modification of the quality or the quantity of the existing water.  In the case of rivers under the federal government’s domain (rivers crossing more than one state), ANA is the public authority which grants the authorization.  With respect to the rivers under a state’s domain, the applicable state authority has jurisdiction to grant the right of use.  In the State of São Paulo, DAEE is the public authority responsible for granting such authorizations.  DAEE has, as its objectives, establishing (i) a policy for the use of water resources with a view to developing the water business of the State, and (ii) plans, studies and projects related to the use of water resources, directly or by means of agreements with third parties.

Our main operating units have been granted water usage rights; however, we also have several operating units where water rights are not in place.  To help obtain the remaining water rights, we have established a corporate program for obtaining and maintenance of grants.  We expect to receive water usage rights for all of our operating units by 2013.

In July 2000, ANA was established to develop the National System for Water Resources Management.  According to existing law, the hydrographic basins committees are authorized to charge users, such as us, for the abstraction of water from, or dumping of sewage into, water bodies controlled by these agencies.  Since 2003 and as of December 31, 2012, we have paid R$119.5 million to ANA, DAEE and water basins agencies.  These institutions have used these amounts to pay for expenses related to the National and the State Systems for the Management of Water Resources (Sistema Nacional e Sistema Estadual de Gerenciamento de Recursos Hídricos) and principally to sponsor studies, programs, projects and constructions provided for in the Water Basin Plan (Plano de Bacia).  Resources for these projects may be loaned or provided to governmental agencies and corporations, including us, for use in projects related to the conservation and recovery of water resources.

State Law No. 12,183, which was enacted on December 29, 2005, established the basis for charging for the use of the water resources under the domain of the State of São Paulo.  To apply such charging, the law provides for, among other provisions, the formulation of criteria by the basin committees, the creation of basin agencies and the organization of a registered list of water resource users.  The basin committee’s proposals regarding the criteria to calculate the amounts to be charged at each basin must be approved by the State Water Resource Council, and formalized by a decree issued by the State Governor.

Water Quality

Administrative Rule No. 2,914/2011, issued by the Ministry of Health of the federal government, provides the standards for potable water for human consumption in Brazil.  This rule is similar to the U.S. Safe Drinking Water Act and the regulations enacted by the U.S. Environmental Protection Agency, which establishes rules for sampling and limits related to substances that are potentially hazardous to human health.

In compliance with Brazilian law, the physical‑chemical, organic and bacteriological analyses carried out for water quality control follow the methodologies of the Standard Methods for Water and Wastewater (21^st edition) of the American Water Works Association.

Decree No. 5,440/2005 provides that the quality of water must be disclosed to consumers.  We have been complying with this regulation by publishing the required information in monthly bills and annual reports delivered to all consumers that we serve.

Environmental Regulation

The implementation and operation of water and sewage systems are subject to strict federal, state and municipal laws and regulations on environmental and water‑resource protection.  The National Environmental Council (Conselho Nacional de Meio Ambiental), or the CONAMA, is the federal agency responsible for the regulation of potentially polluting activities.  In the State of São Paulo, the Companhia Ambiental do Estado de São Paulo, or CETESB, is the governmental entity responsible for the control, supervision, monitoring and licensing of polluting activities, pursuant to State Law No. 997 of 1976 and State Law No. 13,542 of 2009.  The CETESB regulates the control of environmental pollutants.

The control and environmental planning instruments are defined by several legal instruments, such as State Law No. 997/1976, which regulates environmental pollution control; CONAMA Resolution No. 05/1988, which requires licensing of sanitation projects that cause significant alterations to the environment; CONAMA Resolution No. 237/1997, which regulates (i) environmental licenses, (ii) federal, state and local jurisdiction over environmental issues, (iii) the list of activities subject to licensing; and (iv) environmental impact studies and reports; State Decree No. 47,400/2002 and related articles from State Law No. 9,509/1997 regarding environmental licensing; and State Decree No. 8,468/76, CONAMA Resolution No. 357/2005, CONAMA Resolution No. 397/08 and CONAMA Resolution No. 430/11 and the granting of rights for using and interfering with water resources (Portaria Departamento de Águas e Energia Elétrica 717/96).  Projects with significant environmental impact are subject to specific studies prepared by multidisciplinary teams that present a series of recommendations focused on minimizing the environmental impact.  These studies are then submitted for analysis and approval by the government authorities.  The licensing process is composed of three stages, including the following licenses: 

·         preliminary license – granted in the planning stage, approving the location and concept and attesting to the project’s environmental feasibility;

·         installation license – authorizing the beginning of works for the installation of the project, subject to compliance with approved plans, programs and projects, including environmental control measures and other necessary technical requirements; and

·         operation license – authorizing the operation of a unit or activity, subject to compliance with the technical requirements contained in the installation license.

We have established a program (Programa Corporativo de Manutenção e Obtencão do Licenciamento Ambiental) to obtain all necessary licenses in an effort to bring us into full compliance with environmental regulations by 2015.  As of the date of this annual report, we were not in possession of all licenses required in connection with our operations.  Our failure to obtain such licenses may result in the imposition of fines and penalties.  With respect to new operations, feasibility and environmental compliance are carried out throughout respective projects.

Sewage Requirements

State law sets forth regulations regarding pollution control and environmental preservation in the State of São Paulo.  State law establishes the conditions and limitations for waste discharge that impact water, air and soil resources.  According to this law, in areas in which there is a public sewage system, all effluents of a “polluting source” must be discharged to such system.  It is the responsibility of the polluting source to connect itself to the public sewage system.  All effluents to be discharged are required to meet the standards and conditions established by the applicable environmental law, which allows such effluents to be treated by our treatment facilities and discharged in an environmentally safe manner.  Effluents that do not comply with such criteria are prohibited from being discharged into the public sewage system.  State legislation also establishes that liquid effluents, except those related to basic sanitation, be subjected to pre‑treatment so that they meet the required mandatory levels before being discharged into the public sewage system.  National sanitation guidelines are also established in Article 45 of Federal Law No. 11,455/2007.

The CETESB is authorized under State law to monitor discharges of pollutants into the environment and to enforce the requirements of State law.  The CETESB is responsible for issuing preliminary installation and operation licenses granted to the pollution sources, including sewage treatment facilities.

The CETESB also regulates the discharge of effluents into water bodies and must approve all of our treatment facilities in accordance with federal and state regulations.  State and federal water resource legislation establishes the charging of fees for the discharge of treated effluents into water bodies.  This provision is already in force in relation to some water basins, and is in different stages of implementation in remaining basins.  See “—Government Regulation—Water Usage.”

Governmental Restrictions on Incurrence of Debt

On June 30, 1998, the CMN issued Resolution No. 2,515/98 amending certain conditions that must be observed with respect to external credit operations (i.e., foreign currency borrowings) of states, the Federal District of Brasilia, municipalities and their respective autarquias (agencies), foundations and non‑financial companies, including us.  This resolution provides, among other things, that, with certain exceptions applicable to the importation of goods and services:

·         the proceeds of external credit operations must be exclusively used to refinance outstanding financial obligations of the borrower, with preference given to those obligations that have a higher cost and a shorter term, and, until used for such purposes, the proceeds shall remain deposited, as directed by the Central Bank, in a pledged account; and

·         the total amount of the contractual obligation must be subject to monthly deposits in a pledged account, equal to the total debt service obligation, including principal and interest, divided by the number of months that the obligation is to be outstanding.

The CMN resolution further provides that the requirements described above do not apply to financing transactions involving multilateral or official organizations such as the International Bank for Reconstruction and Development, or IBRD, the IADB or the JICA.  The Central Bank regulation implementing this resolution provides, among other things, that the account referred to in the first bullet point above must be an account opened in a federal financial institution, which is to hold such funds until released for the purpose of refinancing outstanding obligations of the borrower.  The Central Bank regulation further provides that the account described in the second bullet point above must be an escrow account to be opened in a federal financial institution and to secure the payment of principal and interest on the external debt.

Our foreign currency‑denominated transactions are also subject to the approval of the National Secretariat of Treasury (Secretaria do Tesouro Nacional) and the Central Bank.  After reviewing the financial terms and conditions of the transaction, the National Secretariat of Treasury and the Central Bank will issue an approval for the closing of the foreign exchange transaction relating to the entry of the funds into Brazil and, following such entry and at our request, an electronic certificate of registration through which all scheduled payments of principal, interest and expenses will be remitted by us.  The electronic certificate of registration grants the borrower access to the market for foreign exchange.

Lending Limits of Brazilian Financial Institutions

The CMN Resolution No. 2,827 dated as of March 30, 2001, as amended, limits the amount that Brazilian financial institutions may lend to public sector companies, such as us.  Financing of projects which are put up for international bid and any financing in reais provided to the Brazilian counterpart of such international bids are excluded from these limits.

Scope of Business