UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

FORM 20-F

OR

For the fiscal year ended December 31, 2003
OR

For the transition period from ________________________ to ______________________

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)

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.

28,479,577,827 Common Shares, without par value, as of December 31, 2003

     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.

x    Yes    o    No

Indicate by check mark which financial statement item the registrant has elected to follow.

o     Item 17    xItem 18

TABLE OF CONTENTS

PRESENTATION OF FINANCIAL INFORMATION

In this annual report, references to “real”, “reais” or “R$” are to the Brazilian real, the official currency of Brazil. All references to “U.S. dollars” or “US$” are to United States dollars. Solely for the convenience of the reader, we have translated some of the real amounts contained in this annual report into U.S. dollars at a rate equal (unless otherwise indicated) to R$2.8892 to US$1.00, the commercial selling rate on December 31, 2003 as reported by the Central Bank of Brazil, or the Central Bank. As a result of the recent fluctuations in the real/U.S. dollar exchange rate, the commercial selling rate may not be indicative of current or future exchange rates. Therefore, you should not read these translations as representations that any such amounts have been, could have been or could be converted into U.S. dollars at that or at any other exchange rate. See “Item 3. Key Information-Exchange Rates” for information regarding exchange rates allocable to the Brazilian currency since January 1, 1999.

Our audited financial statements on December 31, 2002 and 2003 and for the years ended December 31, 2001, 2002 and 2003 are included in this annual report. The financial statements for the years ended December 31, 2001 and 2002 have been audited by PricewaterhouseCoopers Auditores Independentes, São Paulo, Brazil, and the financial statements for the year ended December 31, 2003 have been audited by Deloitte Touche Tohmatsu Auditores Independentes, São Paulo, Brazil.

Our audited financial statements are presented in reais and are prepared in accordance with Corporate Law Method, which are based on the Brazilian corporation law (Law No. 6,404/76, as amended), the rules and regulations issued by the Comissão de Valores Mobiliários (CVM), or the Brazilian securities commission, and the accounting standards issued by the Brazilian Institute of Independent Auditors (Instituto dos Auditores Independentes do Brasil, or IBRACON), hereinafter referred to as the Corporate Law Method.

Like other Brazilian companies, we have the option of presenting our primary financial statements on the basis of accounting principles established in accordance with the Corporate Law Method with a reconciliation to generally accepted accounting principles in the United States of America, or U.S. GAAP. Unless otherwise indicated, our financial statements and all financial data included in this annual report have been prepared in accordance with the Corporate Law Method.

The Corporate Law Method differs in significant respects from U.S. GAAP. Note 25 to our audited financial statements provides a description of the differences between the Corporate Law Method and U.S. GAAP as they relate to our financial statements and a reconciliation from the Corporate Law Method to U.S. GAAP, for periods presented therein, of our net income (loss) and shareholders’ equity. The reconciliation from the financial statements prepared in accordance with the Corporate Law Method to U.S. GAAP includes, among others, adjustments for differences related to the accounting for past revaluations of property, plant and equipment, historical inflation accounting and accounting for pension and other employee benefits.

We do not have any subsidiaries.

Some figures in this annual report may not total due to rounding adjustments.

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FORWARD-LOOKING STATEMENTS CONTAINED IN THIS ANNUAL REPORT

This annual report includes forward-looking statements, principally 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 things:

The words “believes”, “may”, “will”, “estimates”, “continues”, “anticipates”, “intends”, “expects” 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.

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PART I

ITEM 1. IDENTITY OF DIRECTORS, SENIOR MANAGEMENT AND ADVISERS

Not applicable.

ITEM 2. OFFER STATISTICS AND EXPECTED TIMETABLE

Not applicable.

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ITEM 3. KEY INFORMATION

Selected Financial Data

The following table presents our selected financial information at and for each of the periods indicated. The selected financial information on December 31, 2002 and for the two years in the period ended December 31, 2002 are derived from our financial statements audited by PricewaterhouseCoopers Auditores Independentes included in this annual report. The selected financial information on December 31, 2003 and for the year ended December 31, 2003 is derived from our financial statements audited by Deloitte Touche Tohmatsu Auditores Independentes, also included in this annual report.

Our financial statements have been prepared in accordance with the Corporate Law Method, which differs in significant respects from U.S. GAAP. You should read the selected financial information in conjunction with our audited financial statements and notes thereto included elsewhere in this annual report, as well as “Presentation of Financial Information” and Item 5. Solely for the convenience of the reader, real amounts as at and for the year ended December 31, 2003 have been translated into U.S. dollars at the commercial selling rate on December 31, 2003 of R$2.8892 to US$1.00.

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Exchange Rates

There are two principal legal foreign exchange markets in Brazil:

On January 25, 1999, the Brazilian government announced the unification of the operational limits applicable to both markets. However, each market continues to have a specific regulation. Most trade and financial foreign-exchange transactions are carried out on the commercial rate exchange market. These transactions include the purchase or sale of common shares or the payment of dividends or interest with respect to common shares. The Floating market rate generally applies to transactions to which the commercial market rate does not apply. Prior to February 1999, the exchange rate in each market was established independently, resulting in different rates during some periods. Since February 1, 1999, financial institutions operating in the commercial market have been authorized to unify their positions in the two different markets, which caused a reduction in the difference between their respective rates. These markets are now differentiated solely for regulatory purposes and offer similar pricing and liquidity, despite the potential for distinct treatment for regulatory purposes in the future. Foreign currencies may only be purchased through a Brazilian bank authorized to operate in these markets. In both markets, rates are freely negotiated but may be strongly influenced by intervention from the Brazilian Central Bank.

From March 1995 through January 1999, the Brazilian Central Bank allowed the gradual devaluation of the real against the U.S. dollar. In January 1999, the Brazilian Central Bank abolished the band system and allowed the real/U.S. dollar exchange rate to float freely. Since then, the real/U.S. dollar exchange rate has been established mainly by the interbank market, and has fluctuated considerably. The real devalued to a low of R$2.165 per U.S.$1.00 on March 3, 1999, but subsequently appreciated to R$1.789 per U.S.$1.00 on December 31, 1999, representing a net devaluation against the U.S. dollar of 32.4% during 1999. In 2000, the real devalued by a further 8.5% against the U.S. dollar.

Further deterioration in the political and economic environment in 2001, in addition to the Brazilian energy crisis, resulted in the real devaluing by 15.7% against the U.S. dollar in the year. In the final quarter of 2001, however, the real appreciated by 15.1% from R$2.671 per U.S.$1.00 at September 30, 2001 to R$2.3204 per U.S.$1.00 at December 31, 2001.

In 2002, as a reaction to political and economic uncertainties, the global economic downturn, the crisis in Argentina and the Brazilian presidential elections, the U.S. dollar appreciated by 34.3% against the real to R$3.5333 per U.S.$1.00 at December 31, 2002. The real recovered in 2003, appreciating by 22.3% to R$2.8892 per U.S.$1.00, at December 31, 2003. During the first four months of 2004, the real has devalued approximately ·1.9% against the U.S. dollar. Recently the Brazilian Central Bank has only intervened occasionally to control unstable movements in the foreign exchange rate. At the present time, we cannot predict whether the Brazilian Central Bank will continue to let the real float freely or if the real will remain at its present level. The real may devalue substantially in the near future.

As of April 30, 2004, the commercial selling rate published by the Brazilian Central Bank was R$2.9447 per U.S.$1.00.

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The following table shows the commercial selling rate for U.S. dollars for the periods and dates indicated. The information in the “Average” column represents the average of the exchange rates on the last day of each month during the years presented.

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Risk Factors

Risks Relating to our Control by the State of São Paulo

We are controlled by the State of São Paulo, whose interests may be contrary to the interests of other holders of our common shares and holders of our ADSs.

The State of São Paulo (the “State”), through its ownership of our common shares, has the ability to control the election of a majority of the members of our Conselho de Administração (“Board of Directors”), the appointment of our senior management and our operations and strategy. The State owned 71.5% of our common shares on April 30, 2004.

The State has from time to time in the past used and may in the future use its controlling interest in our company to direct that we engage in certain business activities and make certain expenditures which are designed primarily to promote the political, economic or social goals of the State and not necessarily to enhance our business and results of operations. As a result, actions taken by the State in relation to Sabesp could be contrary to the interests of the other holders of our common shares and holders of ADSs.

Most of our Board of Directors and senior management are political appointees of the Governor of the State, who are subject to periodic change unrelated to our business needs.

Each newly-elected Governor of the State typically makes significant changes in our Board of Directors and senior management and, historically, the Chairman of our Board of Directors has been the Secretary of the Energy, Water Resources and Sanitation Secretariat of the State. In 2002, the current Governor, Mr. Geraldo Alckmin, appointed new senior officials for his administration, including Mr. Mauro Guilherme Jardim Arce as the new Secretary of the Energy, Water Resources and Sanitation Secretariat. Mr. Arce was also elected as Chairman of our Board of Directors. In addition, during the last twelve months our Board of Directors has appointed new executive officers, including our new chief executive officer and our new chief financial officer.

Changes in government or government policy could lead to changes in our senior management which in turn could have a material adverse effect on our business strategy, results of operations, financial condition or prospects.

We have overdue accounts receivables owed by the State and some State entities, as well as a substantial amount of recently negotiated long-term receivables owed by the State, and we cannot assure you as to when or whether the State will pay amounts owing to us.

Historically, the State and some State entities have had substantial overdue accounts payable to Sabesp relating to (1) the provision of water and sewage services and (2) 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.

On December 31, 2003, we had accounts receivables due from the State and some State entities relating to the provision of water and sewage services totaling approximately R$164.2 million, net of R$401.7 million of amounts applied in respect of dividends due to the State Government. In addition, on December 31, 2003, we had R$491.0 million in accounts receivable due from the State in respect of State-mandated special retirement and pension payments to some of our

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former employees. Under a federal law enacted in December 1996, we are not permitted to write-off any amounts owing to Sabesp from the State, our controlling shareholder, or entities controlled by the State. We have not established any provisions for any amounts owed to us by the State.

In September 1997, December 2001 and March 2004 we entered into agreements with the State under which the State agreed to settle amounts the State owes us in respect of water and sewage services provided to the State and State-controlled entities and for State-mandated special retirement and pension payments which we made to some of our former employees for which the State is required to reimburse us. Under the terms of these agreements, the amounts may be settled through the application of dividends payable by us to the State and by the transfer to us of certain reservoirs which we use but which are owned by the State. However, some of the agreements do not require the State to apply all dividends payable by us to the State to the repayment of amounts owed to us by the State. In addition, the agreements provide for an extended period of time before any transfer of the reservoirs to us is effected. Since the State entered into these agreements, it has applied some, but not all, of the dividend received by it from Sabesp to the repayment of amounts it owes to Sabesp.

Under the December 2001 agreement, we converted a substantial amount of overdue accounts receivables due from the State and some State entities into long-term accounts receivables.

We cannot assure you as to when or whether the State will pay overdue amounts owing to us, or as to whether the State will continue to apply dividends payable to the State to settle amounts owing to us by the State and some State-controlled entities. Furthermore, due to the State’s history of not making timely payments to us in respect of services provided by us and of not reimbursing us in a timely manner for the State-mandated special retirement and pension payments we make, we cannot assure you that the amount of accounts receivables owed to us by the State and some State entities will not significantly increase in the future. If the State does not pay the amounts it owes us, our cash flows, results of operations and financial condition will be adversely affected.

A portion of long-term accounts payable by the State to us will be settled by the transfer to us of State-owned reservoirs in the Alto Tietê System, and we cannot assure you of the value to be given to these reservoirs or the timing of these transfers.

Under the December 2001 agreement referred to above, the State agreed to transfer the reservoirs in the Alto Tietê System to us in exchange for the cancellation of a portion of the accounts receivables due from the State and of reimbursements due from the State for State-mandated special pension payments we have made. Under this agreement, the value of these reservoirs will be determined by an appraisal process prior to their transfer and amounts owing to us from the State are subject to an audit by a State-appointed auditor.

Under the December 2001 agreement, in July and August 2002 a State-owned construction company, on behalf of the State, and an independent appraisal firm, on behalf of Sabesp, presented their valuation reports relating to the reservoirs. The appraisals contained in these reports were in the amounts of R$335.8 million and R$341.2 million, respectively. Under the December 2001 agreement, the arithmetic average of these appraisals will be deemed to be the fair value of the reservoirs. Since we have made investments in these reservoirs, the arithmetic average of the appraisals submitted to our Board of Directors, R$300.9 million, was net of a

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percentage corresponding to these investments. Our Board of Directors approved the valuation reports which will now have to be submitted for approval by an extraordinary general meeting of shareholders. However, we cannot assure you as to when such meeting will take place and a final determination as to the fair value of these reservoirs will be made, when the transfer of the reservoirs will occur, or when the reimbursement of the values paid by us in relation to the State-mandated special pension and benefits will take place.

The December 2001 agreement also provided that the State’s legal advisors would carry out specific analyses, which have commenced, to ensure agreement among the parties as to the methodology employed in determining the amount of reimbursement for pension benefits owed to Sabesp by the State. The commencement of reimbursement payments with respect to pension amounts owed to Sabesp by the State has been postponed until these analyses are completed, the appraisal report is approved and the credit assignments relating to the transfer of the reservoirs described above are formalized. Under the December 2001 agreement, the original first payment was to be made in July 2002, but no payment in this respect has been made as of the date of this document. We cannot assure you as to when agreement among the parties will be reached or when the State will commence making payments in respect of these pension amounts.

We may be required to acquire reservoirs that we use that are owned by a State-controlled company, and we may be required to pay substantial fees, rent and additional operational and maintenance expenses with respect to our use of such reservoirs.

In connection with the provision of water services, we use the Billings and Guarapiranga reservoirs that are owned by a State-controlled company. The State, through its control of our Board of Directors, could require us to acquire the Billings and Guarapiranga reservoirs. As a result of such acquisition, our cash position and overall financial condition could be adversely affected. In addition, since we are not currently charged for the use of these reservoirs, we are uncertain as to whether in the future we will continue to be able to use the reservoirs without paying a fee, or what the likely fee scale would be if so imposed. We may also be required to pay additional maintenance and operational costs for our use of the Billings and Guarapiranga reservoirs. If we were required to pay substantial fees or additional maintenance or operational costs for these properties, our results of operations could be adversely affected.

Risks Relating to Our Business

The basic sanitation sector is not regulated in Brazil and the approval of any proposed regulations for the water and sewage industry may negatively affect our operations in the São Paulo Metropolitan Region as well as other areas that we serve.

The Brazilian Federal Congress has, from time to time, discussed proposals for regulation, which would establish directives for basic sanitation services. Any proposed regulation, when and if approved, could establish a new municipal regulatory authority for our industry that may, in part, preempt the existing state regulatory authorities under which we operate.

Law Project No. 4,147, for example, has been under the analysis of the Brazilian Federal Congress since February 21, 2001. This proposed new legislation and regulatory regime may grant to the new regulatory authorities the power to deny renewals of our concessions after they expire or to cancel existing ones. In addition, the proposed new legislation could modify the

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way we charge for our water and sewage services businesses, as well as our capital expenditure program. Any of these changes, if they were to occur, could have an adverse effect on our revenues, by causing us to loose concessions we currently hold, or on our operating margins, by limiting our ability to pass our costs on to our customers. In addition, some changes have been introduced to the proposed legislation by which the State would share the authority with municipalities comprising the São Paulo metropolitan region. These changes, if adopted, could negatively affect our operations in the São Paulo Metropolitan Region as well as other metropolitan areas which we serve.

As of the date of this annual report, neither Law Project No. 4,147 or any other proposed federal regulation for the water and sewage industry has been voted by the Brazilian Federal Congress or been sent to the Brazilian Senate for debate. However, representatives of the federal government have repeatedly informed the press that new regulation is expected to be proposed to the Brazilian Congress in the near future. Our Board of Directors has recently become aware that such new regulation, if proposed to the Brazilian Congress in the form presented to us, will have a negative effect on our operations in the São Paulo Metropolitan Region, as well as in other areas that we serve. Accordingly, we cannot anticipate when, in what terms, or if, Law Project No. 4,147 or any other proposed federal regulation will become effective.

We may become subject to substantial water and sewage related charges imposed by governmental water agencies of the State of São Paulo and of the Federal Government.

Governmental water agencies of the State of São Paulo may be, and the Federal Government is, authorized to collect fees from persons, including Sabesp, that either abstract water from, or dump sewage into, water resources controlled by these agencies. The fees collected by these agencies are to be used to develop new water resources and to maintain existing water resources and may be loaned or provided as grants or subsidies to governmental agencies and corporations, including Sabesp, for use in the development and maintenance of water resources. The State legislature of the State of São Paulo is currently debating new legislation that would establish procedures for the collection of these fees. The Federal Government recently enacted legislation under which we must pay fees to the Federal Government or an agency in respect of the use of water from specified sources. We are uncertain as to the likely fees that may be assessed, or whether we will be able to pass on the cost of any of these fees to our customers.

We do not hold formal concessions for the City of São Paulo and several other municipalities that we serve, and therefore we may not be able to enforce our rights to continue to provide services in these municipalities.

We do not hold formal concessions in the City of São Paulo, which accounts for a substantial majority of our sales and services rendered, and in 41 other municipalities in the State of São Paulo. We believe, however, that we have a vested or implied right to provide water and sewage services in these municipalities based upon, among other things, our ownership through our predecessor entities of the water and sewage systems serving the City of São Paulo and these other municipalities and certain rights of succession resulting from the merger of state governmental agencies and the state-controlled companies which formed Sabesp in 1973 that were involved in providing water and sewage services in the City of São Paulo and these other municipalities. Because we do not hold concessions or formal contract rights to provide services in these municipalities, we may not be able to effectively enforce our right to continue to provide services or to be paid for the services we provide. In the future, our rights in respect of the City of São Paulo and these other municipalities could be modified or adversely affected by Brazilian federal, state or local governmental actions or other factors.

From time to time mayors of the City of São Paulo, including the present mayor, have initiated or proposed discussions with the State of São Paulo regarding entering into a formal concession

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contract with Sabesp to provide water and sewage services in the City of São Paulo. The City of São Paulo legislature approved Law 13,670 of November 25, 2003 that regulates articles 148 and 149 of the Organic Law of the City of São Paulo (Lei Orgânica do Município de São Paulo) in relation to public water supply and sewage services. The law establishes the Municipal System for the Regulation of Public Water Supply and Sewage Services (Sistema Municipal de Regulação dos Serviços de Abastecimento de Água e Esgotamento Sanitário or “SIRE”), creates and provides for the organization and operation of the São Paulo Regulatory Authority for Public Water Supply and Sewage Services (Autoridade Reguladora dos Serviços de Abastecimento de Água e Esgotamento Sanitário de São Paulo or “ARSAE”), and establishes the Municipal Sanitation Plan (Plano Municipal de Saneamento or “PMS”). Following the enactment of Law No. 13,670, the Governor of the State of São Paulo has filed a legal action alleging that the Law is unconstitutional, a result of which the enforcement of Law No. 13,670 has been suspended. The merits of such lawsuit have not yet been judged. We cannot assure when or if the suspension of Law 13,670 of November 25, 2003 will end, or if its renewed application would result in the City of São Paulo granting us a formal concession contract, or the terms of any concession contract.

Municipalities for which we hold concessions may choose not to renew their concessions.

We provide water and sewage services in 325 municipalities pursuant to concessions granted by the municipalities. Substantially all of these concessions have 30-year terms: 273 of these concessions expire between 2004 and 2010; and the rest expire between 2011 and 2030. Each of these concessions is automatically renewable for a period equal to its initial term, unless we or the municipality exercise the right to terminate the concession prior to the six-month period ending on the expiration date of the concession. If a substantial number of these municipalities choose not to renew their concessions, it could adversely affect our revenues and cash flows.

Municipalities may terminate our concessions for any “good public reason” or if we fail to meet our contractual obligations.

Municipalities may terminate our concessions under some circumstances, including if we fail to comply with our obligations under the relevant concession contracts. In addition to contractual termination provisions in concession contracts, municipalities have the inherent power under Brazilian law to terminate concessions prior to their contractual expiration dates for any “good public reason”. The meaning of “good public reason” has not been defined by Brazilian law or conclusively determined by Brazilian courts. In the event of the termination of a concession, we may receive inadequate compensation from the concessionaire municipality. We may also incur material litigation costs related to termination of concessions and compensation.

In 1997, the municipality of Santos enacted a law expropriating the water and sewage systems of Sabesp in Santos. In response, we filed an action seeking an injunction against this expropriation which was denied by the lower court. This decision was later reversed by the Court of Appeals of the State of São Paulo, which issued a preliminary order suspending that law. On August 2, 2002, a decision on this matter was rendered in favor of Sabesp by a lower court, but such decision is still subject to appeal, and we cannot assure you that the ultimate determination will be favorable to us. Despite the pending lawsuit, we continue to provide water and sewage services to Santos.

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We cannot assure you that other municipalities will not seek to terminate their concessions. Exercise of concession termination rights by substantial numbers of municipalities could have a material adverse effect on our business and results of operations.

We may be required to compete through a public bidding process in order to obtain new or renew existing concessions.

Substantially all of our concessions were granted without a public bidding process. Under current Brazilian Federal and State law, however, for any new concession we may be required to participate in a bidding process. In addition, if a public entity from which we hold a concession granted prior to the enactment of the concession laws determines that in order to comply with such laws it must engage in a public bidding process, we could be required to compete in order to renew our existing concession. While in certain cases we may be able to obtain concessions without participating in a bidding process, we cannot assure you that the Brazilian courts will continue to interpret the concessions laws to permit municipalities to grant concessions without a public bidding process or that we will be able to secure all new water and sewage concessions that we may wish to obtain.

The conditions attached to the renewal of our authorization to abstract water from the Cantareira System may be unreasonably burdensome and could result in an increase in costs and a higher capital expenditure requirement.

We may abstract water from rivers or reservoirs only to the extent permitted by the Department of Water and Energy of the State of São Paulo (Departamento de Águas e Energia Elétrica do Estado de São Paulo). Under some circumstances, depending on the geographic location of the relevant river basin or reservoir, the approval of the National Water Agency (Agência Nacional de Águas — ANA) is also required. The term of these authorizations will vary depending on the granting authority, and their renewal must be approved by their original grantors.

The authorization to abstract water from the Cantareira System, which supplies approximately 48% of the water produced by Sabesp for the São Paulo Metropolitan Region, will expire in August 2004. Accordingly, we have filed a request for the renewal of the authorization before the Department of Water and Energy of the State of São Paulo on February 27, 2004, and before ANA on April 7, 2004.

The conditions upon which such governmental authorities will renew our authorization to abstract water from the Cantareira system are still unknown, and will only be disclosed on August 2004. If we are unable to negotiate any burdensome condition imposed by the State government we may be exposed to increase in costs and capital expenditures, which may negatively affect our results of operation.

We may experience difficulty in collecting substantial overdue accounts receivables due from municipalities.

On December 31, 2003, we had accounts receivables totaling R$506.3 million from municipalities to which we provide water on a bulk basis. Of this amount, we estimate that approximately R$63.2 million was between 90 and 360 days overdue and R$382.1 million was more than 360 days overdue. In some cases, the Brazilian courts have required that we continue to provide water on a bulk basis to municipalities, even if they fail to pay our invoices.

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Although we have entered into negotiations with municipalities to reschedule such accounts receivables and have also filed legal proceedings against municipalities to collect the overdue amounts, some municipalities are currently not paying our invoices in full or on a timely basis. In addition, some governmental entities located in municipalities we serve are also not paying us on a regular basis. We cannot assure you as to whether or when these municipalities will resume making regular payments or pay overdue amounts owing to us. If these municipalities do not pay amounts they owe us, our cash flows, results of operations and financial condition will be adversely affected.

Our financial performance will be adversely affected if we are unable to increase customer tariffs in line with increases in inflation and operating expenses.

Our results of operations and financial condition are highly dependent upon our ability to set and collect adequate tariffs for our water and sewage services. Although we generally have broad power to establish tariffs, this power is, in practice, subject to political and legal constraints. Since 1995, we have generally been able to raise tariffs yearly in line with increases in inflation or operating expenses, and to support our liquidity and capital resource requirements. However, from mid-1999 until mid-2001 we did not raise our tariffs, due to a State policy of not increasing tariffs for public services. In June 2001, we increased our average tariffs by approximately 13.1% which was broadly in line with the prevailing inflation rates in Brazil since mid-1999 and, in August 2002 we raised our tariffs by approximately 8.2%. In August 2003 we were able to raise our tariffs by 18.9%, except for the social and favela categories, which tariffs were increased by 9.0%. Also in August 2003 a new readjustment formula was approved by our Board of Directors. See "Information on the Company — Customers — Tariffs” below. We will continue to rely upon tariff revenues, among other things, to provide funds for our capital expenditure program and to meet our debt service requirements. Any failure to establish or maintain tariffs commensurate with these and our other needs could have an adverse effect on our results of operations and financial condition.

We have substantial liquidity and capital resource requirements, and any failure to obtain new financing may have a material adverse effect on the operation and development of our business.

Our capital expenditure program calls for expenditures of approximately R$4.3 billion in the period from 2004 through 2008, including approximately R$883.0 million in 2004 and R$880.0 million in 2005. We plan to fund these expenditures and our other liquidity and capital resource needs out of funds generated by operations and domestic and foreign currency borrowings on acceptable terms. See “Operating and Financial Review and Prospects - Liquidity and Capital Resources” below.

Historically, a significant portion of our financing needs has been met by financing provided by lenders controlled by the federal government. To the extent the policies of the federal government regarding the financing of water and sewage services change, our ability to finance our capital expenditure program may be impaired.

We cannot assure you that we will be able to obtain sufficient funds to complete our capital expenditure program or satisfy our other liquidity and capital resources requirements. Failure to obtain the requisite funds could delay or prevent completion of our capital expenditure program

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and other projects, which may have a material adverse effect on the operation and development of our business.

Brazilian regulations as well as contractual provisions may limit our ability to incur indebtedness in the future.

Brazilian regulations provide that a state-owned company, such as Sabesp, may only use the proceeds of “external credit operations” (i.e., foreign currency borrowings) to refinance outstanding financial obligations. These regulations do not apply to import financing and financing transactions involving multilateral organizations, such as the World Bank and the Inter-American Development Bank. As a result of these regulations, our ability to incur foreign currency-denominated debt is limited.

Under our existing debt instruments, we are subject to covenants limiting our ability to incur additional indebtedness, whether denominated in reais or foreign currency. Under these covenants, we would have been able to borrow up to an additional R$517.4 million at December 31, 2003. If, however, these and other limitations prevent us from completing our capital expenditure program or executing our business plans generally, we may be unable to satisfy all of our liquidity and capital resources requirements, which could have a material adverse effect on our business.

Droughts and our water consumption reduction program may result in a decrease in the volume of water billed and the revenues from water supplies, which may have a material adverse effect on our company.

We experience decreases in our water supply from time to time due to droughts. Brazil recently experienced a prolonged and severe drought, which commenced in 1999 and ended in 2001. As a result of this drought, our volume of water billed decreased and our costs increased as a result of additional capital expenditures required to alleviate the effects of this drought on our water production systems. Throughout 2003 rain levels were again below average resulting in a weak replenishment of our reservoirs, particularly in the Cantareira System, the largest system of the Metropolitan Region of São Paulo. In order to minimize the effects of this drought, in March 2004 Sabesp approved a water consumption reduction incentive program based on a bonus system, pursuant to which customers who achieve their consumption reduction goal will be entitled to a 20% discount on their water bill. This incentive program is scheduled to last 6 months as from March 15, 2004 and will encompass most of the customers in the São Paulo Metropolitan Region supplied by the Metropolitan Aqueduct System. Although we expect our billing amount to decrease, we are unable to estimate the impact of this program on our revenues. We cannot assure you that any continuous drought in the future will not materially adversely affect our water supply and, accordingly, our business and results of operations.

Potential costs of environmental compliance as well as potential environmental liability may have a material adverse effect on our company.

Our facilities are subject to many Brazilian federal, state and local laws and regulations relating to the protection of human health and the environment. We have made, and will continue to make, substantial expenditures to comply with these provisions. In addition, because environmental laws and their enforcement are becoming more stringent, our capital expenditures and expenses for environmental compliance may increase substantially in the

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future. The amount of investments that we make in any given year is subject to limitations imposed by the State Government. Expenditures required for compliance with environmental regulation may result in reductions in other strategic investments that we have planned, which could negatively affect our profitability. We could also be exposed to criminal and administrative penalties, in addition to indemnification obligations, for possible damage for non-compliance with environmental laws and regulations. Any material unforeseen environmental costs and liabilities may have a material adverse effect on our future financial performance.

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

We are a party to a number of legal proceedings involving significant monetary claims. These legal proceedings include, among others, tax, labor, condemnation and other proceedings. A substantial monetary judgment against us in one or more of these legal proceedings may have a material adverse effect on our business or financial condition. Based on advice we received from our lawyers, we have provisioned a total aggregate amount of R$403.8 million to cover losses related to legal proceedings considered probable. This provision does not cover, however, all legal proceedings involving monetary claims filed against us. Any unfavourable judgment in relation to these proceedings may have an adverse effect on our cash-flow and results of operation.

Because we are not insured for all business- and environmental-related contingencies, the occurrence of any such contingency may have a material adverse effect on our future financial performance.

We do not have insurance coverage for business interruption risk or for liabilities arising from contamination or other problems involving our water supply to customers. In addition, we do not have insurance coverage for liabilities relating to non-compliance with environmental laws and regulations relating to our sewage services. As a result, any major business interruption or environmental-related liability may have a material adverse effect on our future financial performance.

Risks Relating to Brazil

Brazilian economic, political and other conditions may have a material adverse effect on our company.

The Brazilian economy has been characterized by significant involvement on the part of the Brazilian government, which often changes monetary, credit and other policies to influence Brazil’s economy. The Brazilian government’s actions to control inflation and affect other policies have often involved wage and price controls, currency devaluations, increases in the Central Bank’s base interest rates, capital controls and limits on imports, as well as other measures, such as the freezing of bank accounts, which occurred in 1990.

Actions taken by the Brazilian government concerning the economy may have important effects on Brazilian corporations and other entities, including Sabesp, and on market conditions and prices of Brazilian securities, including our equity and debt securities. Our financial condition

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and results of operations may be adversely affected by the following factors or the Brazilian government’s response to them:

Brazil’s President, Luiz Inacio Lula da Silva, was elected in October 2002 and took office on January 1, 2003. In the period leading up to and following his election, there was substantial uncertainty regarding the policies that the new government would pursue, including the potential implementation of macroeconomic policies that differed significantly from those of the prior administration. This uncertainty resulted initially in a loss of confidence in the Brazilian capital markets and the devaluation of the real. The new administration has, however, continued most of the former administration’s economic and administrative policies and the initial adverse market sentiment towards the new administration has substantially reversed during 2003. Accompanying this positive sentiment the real appreciated 22.3% against the U.S. dollar in 2003. However, there remains some uncertainty over the possibility of different policies being adopted by the government which may, once again, contribute to economic uncertainty in Brazil and to heightened volatility in Brazilian securities. Any substantial negative reaction to the policies adopted by the Brazilian government from time to time could adversely affect the Company’s business, condition (financial or other), revenues, results of operations and prospects and the market price of our common shares and ADSs.

A devaluation of the real could adversely affect our ability to service our foreign currency-denominated debt, and could lead to a decline in the market price of our common shares and ADSs.

The Brazilian currency has been devalued frequently during the last four decades. Throughout this period, the Brazilian government has implemented various economic plans and utilized various exchange rate policies, including sudden devaluations, periodic mini-devaluations (during which the frequency of adjustments has ranged from daily to monthly), exchange controls, multiple exchange rate markets and floating exchange rate system. From time to time, there have been significant fluctuations in the exchange rates between the Brazilian currency and the U.S. dollar and other currencies. For example, in 2000, 2001 and 2002, the real

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devalued 8.5%, 15.7%, 34.3% respectively, while appreciating 22.3% in 2003 against the U.S. dollar.

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, particularly as our tariff revenues and other sources of income are based solely in reais. In addition, because we have substantial foreign currency-denominated indebtedness, any significant devaluation of the real during a financial period will increase our financial expenses as a result of foreign exchange losses that we must record. We had total foreign currency-denominated indebtedness of R$3,012.7 million on December 31, 2003, and we anticipate that we may incur substantial amounts of foreign currency-denominated indebtedness in the future. For example, our overall results of operations for 2003 were significantly positively affected by 65% due to the appreciation of the real against the U.S. dollar in 2003.

A devaluation would reduce the U.S. dollar value of distributions and dividends on our ADSs and could reduce the market price of our common shares and ADSs.

The Brazilian government’s actions to combat inflation and public speculation about possible future action may contribute significantly to economic uncertainty in Brazil and cause the price of our equity and debt securities to fall.

Historically, Brazil experienced high rates of inflation. Inflation itself, as well as the governmental efforts to combat inflation, has had significant negative effects on the Brazilian economy in general. Inflation, action taken to combat inflation and public speculation about possible future action has also materially contributed to economic uncertainty in Brazil and to heightened volatility in the Brazilian securities markets.

Inflation, as measured by the Índice Geral de Preços de Mercado (the General Price Index-Market, or the IGP-M), was 20.1% in 1999, 10.0% in 2000, 10.4% in 2001, 25.3% in 2002 and 8.7% in 2003. There can be no assurance that levels of inflation in Brazil will not increase in future years and have a material adverse effect on our business, financial condition, results of operations or prospects.

If Brazil experiences significant inflation in the future, 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 investor confidence in Brazil, so that the market price of our equity and debt securities declines.

Brazilian law might permit claims against our shareholders for harm to the environment.

Brazilian Law No. 9,605 of February 12, 1998 provides that the corporate structure of a company may be disregarded if it impedes recovery for undue harm to the environment. We cannot assure you that, in the case of claim for environmental damage under this law, liabilities would be limited to shareholders capable of exercising control over the company at the time of the environmental damage. Accordingly, if we were unable to redress claims against us for environmental damages, which might happen, for example, if we were to become insolvent, our shareholders and the members of our management might become liable for those claims. We

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are not aware of any successful assertion of claims against any shareholders of any Brazilian corporation under this law and cannot predict the circumstances in which this might happen.

Risks Relating to our Common Shares and ADSs

Restrictions on the movement of capital out of Brazil may impair the ability of holders to receive dividends and distributions on, and the proceeds of any sale of, the common shares underlying our ADSs.

The Brazilian government may impose temporary restrictions on the conversion of Brazilian currency into foreign currencies and on the remittance to foreign investors of the proceeds of their investments in Brazil. Brazilian law permits the government to impose these restrictions whenever there is a serious imbalance in Brazil’s balance of payments or there are reasons to foresee a serious imbalance.

The Brazilian government imposed remittance restrictions for approximately six months in 1990. Similar restrictions, if imposed, would impair or prevent the conversion of dividends, distributions, or the proceeds from any sale of common shares, as the case may be, from reais into U.S. dollars and the remittance of the U.S. dollars abroad. We cannot assure you that the Brazilian government will not take similar measures in the future. In such a case, the depositary for our ADSs will hold the reais it cannot convert for the account of the ADR holders who have not been paid. The depositary will not invest the reais and it will not be liable for the interest.

If a holder exchanges ADSs for common shares, he or she risks losing the ability to remit foreign currency abroad and Brazilian tax advantages.

The Brazilian custodian for the common shares underlying our ADSs must obtain a certificate of registration from the Central Bank to be entitled to remit U.S. dollars abroad for payments of dividends and other distributions relating to our common shares or upon the disposition of our common shares. If a holder decides to exchange his or her ADSs for the underlying common shares, he or she will be entitled to continue to rely — for five business days from the date of exchange — on the custodian’s certificate of registration. After that period, the holder may not be able to obtain and remit U.S. dollars abroad upon the disposition of our common shares, or distributions relating to our common shares, unless he or she obtains his or her own certificate of registration or register under Resolution No. 2,689, of January 26, 2000, of the National Monetary Council, which entitles registered foreign investors to buy and sell on the Brazilian stock exchanges. If the holder does not obtain a certificate of registration or register under Resolution No. 2,689, he or she 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, he or she 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. We cannot assure you that the custodian’s certificate of registration or any foreign capital registration obtained by a holder may not be affected by future legislative changes, or that additional restrictions applicable to the holder, the disposition of the underlying common shares or the repatriation of the proceeds from disposition will not be imposed in the future.

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The relative volatility and illiquidity of the Brazilian securities market may substantially limit a holder’s ability to sell the common shares underlying our ADSs at the prices and time he or she desires.

The Brazilian securities markets are substantially smaller, less liquid, more concentrated and more volatile than major securities markets in the United States and other jurisdictions, and are not as highly regulated or supervised as some of these other markets. The relatively small market capitalization and illiquidity of the Brazilian equity markets may substantially limit a holder’s ability to sell the common shares underlying our ADSs at the price and time he or she desires.

A holder of common shares or ADSs may face difficulties in protecting his or her interests as a shareholder, because we are subject to different corporate rules and regulations as a Brazilian company and holders may have fewer and less well-defined shareholders’ rights.

Our corporate affairs are governed by our by-laws and the Brazilian corporation law, which differ from the legal principles that would apply if we were incorporated in a jurisdiction in the United States, such as the State of Delaware or the State of New York, or in other jurisdictions outside Brazil. In addition, the rights of holders of our ADSs or common shares under the Brazilian corporation law to protect their interests relative to actions by our Board of Directors may be fewer and less well-defined than under the laws of those other jurisdictions.

Although insider trading and price manipulation are crimes under Brazilian law, the Brazilian securities markets are not as highly regulated and supervised as the U.S. securities markets or markets in some other jurisdictions. In addition, rules and policies against self-dealing and regarding the preservation of shareholder interests may be less well-defined and enforced in Brazil than in the United States, putting holders of our common shares and ADSs at a potential disadvantage. Corporate disclosures may be less complete or informative than what may be expected of a U.S. public company.

A holder of common shares or ADSs may face difficulties in protecting his or her interests as a shareholder because we are a Brazilian 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 fixed 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 difficulties 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 as payment of such judgment must be made pursuant to the State’s budget in a subsequent fiscal year. None of the public property of our controlling shareholder is subject to execution or attachment, either prior to or after judgment.

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Actual or anticipated sales of a substantial number of our common shares could decrease the market prices of our common shares and ADSs.

Sales of a substantial number of our common shares — or the anticipation of such sales — could decrease the trading price of our common shares and ADSs. As of March 31, 2004, we had 28,479,577,827 common shares outstanding, including 20,376,674,058 shares held by the State of São Paulo. As a consequence of the issuance of common shares or sales by the State of São Paulo or other existing shareholders, the market price of our common shares and, by extension, our ADSs may decrease significantly. As a result, a holder may not be able to sell his or her securities at or above the price he or she paid for them.

A holder of ADSs might be unable to exercise preemptive rights with respect to the common shares underlying our ADSs.

A holder may not be able to exercise the preemptive rights relating to the common shares underlying his or her ADSs unless a registration statement under the U.S. Securities Act of 1933 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 preemptive 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, a holder may receive only the net proceeds from the sale of his or her preemptive rights by the depositary or, if the preemptive rights cannot be sold, they will be allowed to lapse.

A non-Brazilian holder of our ADSs may find it more difficult than our Brazilian shareholders do 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 ADSs only in accordance with the deposit agreement relating to our ADSs. There are no provisions under Brazilian law or under our by-laws that limit the exercise by ADS holders of their voting rights through the depositary with respect to the underlying common shares. However, there are practical limitations upon the ability of ADS holders to exercise their voting rights due to the additional procedural steps involved in communicating with these holders. 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. ADS 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 will, in turn, as soon as practicable thereafter mail to holders of ADSs the notice of the meeting and a statement as to the manner in which instructions may be given by holders. To exercise their voting rights, ADS holders must then instruct the depositary as to voting the common shares represented by their ADSs. Due to these procedural steps involving the depositary, the process for exercising voting rights may take longer for ADS holders than for holders of common shares. ADSs for which the depositary fails to receive timely voting instructions will not be voted at any meeting.

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Developments in other emerging market countries may adversely affect the Brazilian economy and, therefore, the market prices of our common shares and ADSs, as well as of our debt securities.

In the past, the Brazilian economy and the securities of Brazilian companies have been, to varying degrees, influenced by economic and market conditions in other emerging market countries as well as investors’ responses to those conditions.

In addition, although economic conditions are different in each country, investors’ reactions to adverse developments in one country may affect the market price of securities of issuers in other countries, including Brazil. For example, the 1997 Asian economic crisis and the 1998 Russian debt moratorium and devaluation of the Russian currency triggered market volatility in Latin America and securities markets in other emerging market countries. Accordingly, adverse developments in other emerging market countries could lead to a reduction in the demand for, and market prices of, our common shares and ADSs, as well as our debt securities.

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ITEM 4. INFORMATION ON THE COMPANY

General

Companhia de Saneamento Básico do Estado de São Paulo-SABESP is a sociedade de economia mista, a mixed capital company with limited liability of unlimited duration, duly organized and operating under Brazilian corporation law. 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 111 Eighth Avenue, New York, New York 10011. As set forth in Article 2 of our by-laws, our corporate purpose is to plan, execute, and operate basic sanitation services throughout the territory of the State of São Paulo, including the capture, collection, processing and distribution of water, as well as the collection, removal, processing and final disposal of sewage and sludge.

We believe we are one of the largest water and sewage companies in the Americas based upon net revenues in 2003. We operate public water and sewage systems in the State of São Paulo in which the City of São Paulo, Brazil’s largest city, is located. According to the Brazilian Institute of Geography and Statistics, or IBGE, the State of São Paulo is Brazil’s most populous and economically productive state. We had net operating revenue of R$4,109.9 (US$1,422.5 million) and net income of R$833.3 million (US$288.4 million) in 2003. We had total assets of R$16,530.7 million (US$5,721.5 million) and shareholders’ equity of R$7,576.9 million (US$2,622.5 million) on December 31, 2003.

We provide water and sewage services to a broad range of residential, commercial, industrial and governmental customers in the City of São Paulo and in 367 of the 645 other municipalities in the State of São Paulo. We also supply water on a bulk basis to municipalities in the São Paulo Metropolitan Region in which we do not operate water systems. Until December 2002 we divided our service territories into three regions: the São Paulo Metropolitan Region, comprised of 31 municipalities in the metropolitan area of the City of São Paulo, the Interior Region (comprised of 306 municipalities along the São Paulo state countryside), and the Coastal Region (comprised of 29 municipalities in the São Paulo coastline). During 2003 we performed a reorganization of our internal organizational chart, according to which the Interior and Coastal Region divisions were consolidated into one single unit named “Regional Systems”. The São Paulo Metropolitan Region remained the same. According to this new structure, the São Paulo Metropolitan Region and the Regional Systems accounted for 76% and 24% of our sales and services rendered in 2003, respectively.

On December 31, 2003, we distributed water to approximately 21.3 million persons, which we believe includes approximately 58% of the urban population of the State of São Paulo, through approximately 56.8 thousand kilometers of water pipes and mains to more than 6.0 million water connections. We provided sewage services to approximately 17.2 million persons, or 80% of our water customers, through approximately 35.8 thousand kilometers of sewer lines, trunk lines, interceptors and outfalls to approximately 4.5 million sewage connections. At December 31, 2003, we sold water in bulk to 6 other municipalities having an estimated population of approximately 3.8 million.

The State of São Paulo, our controlling shareholder, is required by State law to own at least one-half plus one of our common (voting) shares. On April 30, 2004, approximately 71.5% of our

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outstanding common shares were owned by the State of São Paulo. As a state-controlled company, we are an integral part of the governmental structure of the State of São Paulo. Our strategy and major policy decisions are formulated in conjunction with the Energy, Water Resources and Sanitation Secretariat of the State of São Paulo as part of the overall strategic planning for the State of São Paulo. The majority of the members of the Board of Directors and the Executive Committee of Sabesp are nominated by the State Council for Protection of Capital of the State of São Paulo (Conselho de Defesa de Capitais do Estado de São Paulo — CODEC), a State agency presided over by the Secretary of the State Treasury and reporting directly to the Governor.

In addition, our capital expenditure budget is subject to approval by the State Legislature and is approved in conjunction with the budget of the Energy, Water Resources and Sanitation Secretariat and of the State of São Paulo as a whole. However, the Governor of the State of São Paulo has the power to modify our capital expenditure budget after it has been approved. Our financial statements and accounting records are subject to review by the State Accounts Tribunal (Tribunal de Contas), as are all accounts of the State of São Paulo.

State of São Paulo

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

The State of São Paulo occupies 3% of Brazil’s land mass and encompasses an area totaling approximately 96,000 square miles. According to IBGE, the State is the most populous state in Brazil, with an estimated population on December 31, 2003 of 39.0 million.

On December 31, 2003, the City of São Paulo, the State’s capital, had an estimated population of 10.6 million, with 18.7 million inhabitants in the greater metropolitan region of São Paulo. The São Paulo Metropolitan Region encompasses 39 cities, the second largest metropolitan area in the Americas and among the four largest metropolitan areas in the world, according to the United Nations’ World Urbanization Prospects, 1999 Revision. The São Paulo Metropolitan Region accounted for approximately 48% of the population of the State.

According to IBGE, in 2001, the most recent year for which this data is available, the GDP of the State of São Paulo was approximately R$401 billion, representing approximately 33.4% of Brazil’s total GDP, making it the largest economy of any state in Brazil, based on GDP. The State is the leading Brazilian state in terms of manufacturing and industrial activity, according to IBGE, with a strong position in car manufacturing, pharmaceuticals, computer production, steel making and plastics, among others, as well as the leading position in the banking and financial services industries. The State is the most important exporting state in Brazil, according to the Brazilian Ministry of Development, Industry and Foreign Trade.

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History

Until the end of the 19th Century, water and sewage services in the State of São Paulo were generally provided by private companies. In 1877, 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 the Companhia Cantareira de Água e Esgotos and formed the Office of Water and Sewers (Repartição de Água e Esgotos), a governmental agency. Since that time, water and sewage services in the São Paulo Metropolitan Region have been administered by the government of the State of São Paulo. Historically, water and sewage services in substantially all other municipalities of the State of São Paulo were administered by the municipalities directly 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 undertake administration of public services, which are considered to be better managed by a decentralized administrative and financial structure.

In 1954, in response to dramatic population growth in the São Paulo Metropolitan Region, the government of the State of São Paulo created the Department of Water and Sewers (Departamento de Águas e Esgotos), as an autarquia of the State Government. 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 Companhia Metropolitana de Água de São Paulo, or COMASP, whose purpose was to provide potable water in bulk for public consumption in the municipalities making up 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 Superintendência de Água e Esgoto da Capital, or SAEC, was created by the government of the State of São Paulo to distribute water and collect sewage in the City of São Paulo. All assets previously owned by the Department of Water and Sewers in connection with such activities were transferred to SAEC. Also in 1970, the State Government created the Companhia Metropolitana de Saneamento de São Paulo, or SANESP, to provide sewage treatment services for the São Paulo Metropolitan Region. All assets previously owned by the Department of Water and Sewers in connection with such activities were transferred to SANESP. The Department of Water and Sewers was subsequently closed.

On June 29, 1973, COMASP, SAEC and SANESP merged to form Sabesp 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). 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 the formation of Sabesp, 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 Sabesp.

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Recovery Program

We experienced significant operational and financial problems beginning in the mid-1980’s, which culminated in 1994. These problems were due, in part, to adverse economic conditions in Brazil prior to implementation of the Real Plan in mid-1994, but also to our position as a state-controlled enterprise whose financial performance was only a secondary consideration of the State of São Paulo. The tariff structure then in place did not generate sufficient revenues to enable Sabesp to provide adequate service to existing or new customers or to satisfy its liquidity and capital requirements, but instead was reflective of political considerations which viewed water and sewage services as a public entitlement.

As a result of our operational and financial problems, we experienced difficulties in providing basic water and sewage services to our then existing customer base and in maintaining our water and sewage systems. We had a net loss of R$223.1 million for the year ended December 31, 1994 and had some difficulty meeting all of our debt and other obligations. We also had significant and increasing levels of unpaid accounts receivables from our customers, including the State of São Paulo and municipal governments. In terms of operations, we were unable to meet the demand for water from our customers and in late 1994 approximately six million persons in the municipalities that we served were subject to water rationing on a regular basis. Because we did not have the resources to make necessary capital expenditures to maintain our water and sewage systems, we experienced frequent breakdowns in our water distribution and sewage collection networks. The weakened condition of our system exacerbated water shortages and threatened, in some cases, water supplies. The general deterioration in service led, in turn, to negative relationships with the municipalities served by Sabesp and a poor overall public image for Sabesp.

During 1995, we, in conjunction with the administration of the State of São Paulo, initiated a “recovery” program designed to restore our business operations and financial condition, including the organizational restructuring, the implementation of the initial stages of our strategy and the development of a new “for-profit” orientation. Under the organizational restructuring, we reordered our organizational structure into six divisions and sixteen business units in an effort to be more responsive to the requirements of the customers and municipalities served.

Our capital expenditure program since 1994 has been designed to improve and expand our water and sewage systems and to increase and protect our water sources. The work completed to date has helped to limit rationing and to permit Sabesp to install additional water and sewage connections to respond to growing demand for services, particularly in the City of São Paulo. We believe that the above-mentioned actions and the continuing implementation of our overall strategy have, to date, permitted a recovery in terms of our business operations and financial performance and should provide the basis for our long-term operational and financial development, although there can be no assurance in this regard.

Strategy

Our primary mission is to improve the quality of life of the population of the State of São Paulo and, in particular, to meet the growing demand for water and sewage services in an environmentally responsible manner. We are seeking to improve our operations so that we can fulfill our primary mission and at the same time strengthen our financial condition.

Our overall strategy is based upon three guiding principles:

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These three global strategic principles are broken down in the following seven elements:

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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 and, at the same time, to bolster our results of operations and financial condition.

Corporate Organization

During 2003 we have reorganized our corporate management structure. As a result we presently have six divisions, each of which is supervised by one of our executive officers.

The allocation of responsibilities among the executive officers is made by the Board of Directors, in accordance with the by-laws and following receipt of an initial proposal from the President.

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Each business unit providing water and sewage services to customers participates in a regional assembly consisting of the mayors of the municipalities covered by such unit and our officers. In addition, for each unit, a regional management commission comprised of five to eight mayors and five to eight of our officers has been established to facilitate discussions and decision-making over such issues as the unit’s budget, capital expenditure program, tariffs, and water and sewage services generally.

As a result of the establishment of the regional management commissions, we believe that we have improved our relationships with the municipalities and with our customers generally and that we have been able to balance better the service requirements of our customers with our own operational and financial objectives. The increased interaction between Sabesp and the municipalities has been responsible for renewed indications of interest in our water and sewage services on the part of those municipalities not currently being served by Sabesp.

Concessions

Under 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 State Constitution provides that the

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State of São Paulo 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. Under applicable law, we are responsible for planning basic water and sewage services and operating the related systems in the State of São Paulo, whilst respecting the autonomy of its municipalities. The municipalities are empowered to, and commonly do, grant long-term concessions to water and sewage companies to provide such services.

We do not hold a formal concession to provide water and sewage services in the City of São Paulo, which accounts for a substantial majority of our sales and services rendered, and in 41 other municipalities in the State of São Paulo. None of these other municipalities has a significant population, other than Santos, which has a population exceeding 400,000. We believe that we have a vested right to provide water and sewage services based upon, among other things, our ownership of the water and sewage systems serving the City of São Paulo and these other municipalities and certain succession rights resulting from the merger which formed Sabesp.

We also provide water and sewage services in 325 additional municipalities in the State of São Paulo pursuant to concessions granted by the municipalities. Substantially all of these concessions have 30-year terms, 273 of which expire between 2004 and 2010 and the rest of which expire between 2011 and 2030. Each of these concessions is automatically renewable for a period equal to its initial term, unless the municipality or we exercise the right to terminate the concession prior to the six-month period ending on the expiration date of the concession.

The concessions are based on a standard form of contract between Sabesp and the relevant municipality. Each contract must receive the prior approval of the legislative council of the relevant municipality. The principal terms of the concession contracts are as follows:

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Concession contracts we have entered into since 1998 provide that after a period of 30 years from the commencement of the concession, the total value of the concession and assets will be 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 period, we are paid an amount equal to the present value of the cash-flow from the concession over the years remaining in the concession, using the same assumptions as were used to determine the value of the concession at its inception (adjusted for inflation).

Municipalities have the inherent power under Brazilian law to terminate concessions prior to their contractual expiration dates for reasons of public interest. Diadema and Mauá, two municipalities previously served by Sabesp, terminated their concessions to Sabesp in February 1995 and December 1995, respectively. Diadema terminated its concession to Sabesp after asserting that we did not provide adequate water and sewage services, while Mauá did so with the consent of Sabesp. In December 1996, we have commenced legal action to collect payment due from Diadema. The lower courts have issued a decision against Sabesp and in November 2000 we appealed such decision. As of April 2004 the appeal has not yet been judged. This legal action was followed by several other related legal proceedings, which are currently pending. We entered into a settlement agreement with Mauá at the time the concession was terminated in which Mauá agreed to make the payments owed to Sabesp in connection with the return of water and sewage systems. However, to date Mauá has not yet made any payments to Sabesp under the settlement agreement. We commenced legal action in December 1996 against Mauá and, as of the date of this document, no decision has been issued by the lower court.

Diadema and Mauá are currently operating their own water and sewage systems, and we are supplying them with water on a bulk basis. On December 31, 2003, both Diadema and Mauá were in arrears with respect to amounts owed to Sabesp for water sold on a bulk basis prior to 1997, as well as for a portion of water sold since 1997.

In addition, in 1997, the municipality of Santos enacted a law expropriating the water and sewage systems of Sabesp in Santos. In response, Sabesp filed an action seeking an injunction against this expropriation which was denied by the lower court. This decision was later reversed by the Court of Appeals of the State of São Paulo, which issued a preliminary order suspending that law. On August 2, 2002, a decision on this matter was rendered in favor of Sabesp by a lower court, but such decision is still subject to appeal and we can give no assurance that the ultimate determination will be favorable to us. Despite the pending lawsuit, we continue to provide water and sewage services to Santos.

We currently do not anticipate that other municipalities will seek to terminate concessions due to, among other factors, our development of closer relationships with municipal governments, recent improvements in the water and sewage services we provide and the obligation of the municipality to repay Sabesp for the return of the concession as described above. We cannot be

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certain, however, that other municipalities will not seek to terminate their concessions in the future.

We have recently acquired the right to operate water and sewage services in the municipality of São Bernardo do Campo through the transfer of all related assets from the municipality to us. Previously, we provided water to São Bernardo do Campo on a bulk basis. The amount paid for the purchase of assets was estimated by an economic-financial valuation report, which included the liquidation of the water wholesale supply accumulated debt. See “Operating and Financial Review and Prospets — Recent Developments” for information with respect to the São Bernardo do Campo transaction.

Water Operations

The supply of water by Sabesp to our customers generally involves abstraction of water from various sources, subsequent treatment and distribution to customers’ premises. In 2003, we produced approximately 2,819.6 million cubic meters of water.

The following table sets forth the amount of water produced and invoiced by Sabesp for the periods stated.

The difference between the amount of water produced and the amount of water invoiced generally represents both physical and non-physical water loss. See "Water Distribution” below. In addition, we do not invoice:

The São Paulo Metropolitan Region experiences its highest levels of demand during the summer months when water use increases. Water use generally decreases significantly during the winter months. The summer months, when demand is highest, coincide with the rainy season, while the winter, when demand for water is lowest, corresponds to the dry season in the São Paulo

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Metropolitan Region. Demand within the Regional Systems will vary depending on the area; while the Interior Region experiences seasonality in demand similar to the São Paulo Metropolitan Region, the demand in the Coastal Region is chiefly a function of tourism, with the greatest demand occurring during the Brazilian summer holiday months.

The following table provides information on our revenues by geographic region:

Water Resources

We can abstract water only to the extent permitted by the Department of Water and Energy of the State of São Paulo (Departamento de Águas e Energia Elétrica do Estado de São Paulo) and pursuant to authorization contracts executed with it. Under some circumstances, depending on the geographic location of the relevant river basin or reservoir, the approval of the National Water Agency (Agência Nacional de Águas — ANA) is also 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 flow from nearby rivers, or by a combination of these sources.

In order to supply the São Paulo Metropolitan Region with water, we operate 19 reservoirs located in 8 water production systems. The availability of resources in such region is 66.1 cubic meters per second and should increase to 72.8 cubic meters per second in 2006 with the completion of planned improvements to the water system. The total production capacity currently reaches 67.7 cubic meters per second during peak demand periods. We estimate that demand for water currently averages 64.8 cubic meters per second and will reach an average up to 69.7 cubic meters per second by 2006. The main water production systems for the São Paulo Metropolitan Region are Cantareira and Guarapiranga, which collectively supply approximately 70% of the water produced by Sabesp for the São Paulo Metropolitan Region.

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

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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 of São Paulo. We currently do not pay any fees 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 cannot assure you as to when this transfer of reservoirs will take place. See “Item 7. Major Shareholders and Related Party Transactions-Related Party Transactions”.

Because of limited rainfall from 2000 to 2003, the São Paulo Metropolitan Region faced its worst drought in 65 years. From mid-June to mid-September in 2000, we rationed water in the south of the São Paulo Metropolitan Region, affecting approximately 3.5 million people, or 20% of the total population of this region. Under this rationing, water was made available to our customers for only two out of every three days. During this period of rationing, we also reduced our total water production by 8%.

From April 2001 through January 2002, we rationed water in the west of the São Paulo Metropolitan Region, affecting approximately 300,000 people, or less than 2% of the São Paulo Metropolitan Region. Under this rationing, water was made available to these 300,000 customers for only 40 out of every 72 hours. See "Item 3. Key Information-Risk Factors-Risks Related to Sabesp-Droughts may result in major shortages in our water supply, which may have a material adverse effect on our company”.

The year of 2003 was also marked by low levels of rainfall and drought. From October to December 2003 we rationed water on the western part of the São Paulo Metropolitan Region, served by the Alto Cotia System, affecting approximately 450.000 people, or 2% of the Region’s population. Under this rationing water was available to those customers for three days, followed by two days of rationing. During this period our total water production volume was reduced in 0.8%.

In the largest municipalities of the Interior Region, the principal source of water for Sabesp consists of surface water from nearby rivers. In the smaller municipalities of the Interior Region, we draw water primarily from wells. The Coastal Region is provided 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 the areas where we operate. In 2001, 2002 and 2003, 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, the installation of 751.5 thousand new water connections from 2000 through 2003 statewide, as well as the introduction of a new tariff structure which helped reduce average consumption and demand.

Water in the São Paulo Metropolitan Region is distributed through the Metropolitan Aqueduct System. The Metropolitan Aqueduct System is a network of aqueducts that covers most of the São Paulo Metropolitan Region, which allows for diversion of water from or to a particular region as demand varies, as required to properly supply a particular area of the network.

We are implementing as part of our capital expenditure program the Metropolitan Water Program, which involves substantial investments in reservoirs, water treatment facilities, water

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mains and the distribution network in the São Paulo Metropolitan Region to increase water production and to improve capacity of the Metropolitan Aqueduct System. The Metropolitan Water Program consists of a series of projects which will require approximately R$620 million in investments from 2004 through 2008 in the São Paulo Metropolitan Region.

Water Treatment

We treat all water at our water treatment facilities prior to placing it into our water distribution network. We operate over 193 treatment facilities, of which the 8 largest, located in the São Paulo Metropolitan Region, typically account for approximately 76% of all water supplied by Sabesp. 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.

We use conventional treatment processes in our water treatment facilities. For surface water, the treatment process involves several phases, including filtration and disinfection. Groundwater typically is of higher purity and usually requires only disinfection by chlorine treatment. All water treated by Sabesp also receives fluoridation treatment.

Water Distribution

Water is distributed by Sabesp through our own networks of water pipes and mains, ranging in size from 2.5 meters to 100 millimeters in diameter. As of December 31, 2003, our water network contained approximately 56,777 kilometers of water pipes and mains and 6.0 million water connections.

Approximately 95% of the water pipes in our water distribution network are made of cast iron or polyvinylchloride (PVC). Distribution pipes at customers’ residences typically are made from high-density polyethylene tubing. Our water mains are mostly made of steel, cast iron and concrete.

We distribute treated water through our networks of mains and service pipes that deliver water through pressurized systems. Storage tanks and pumping stations regulate the volume of water flowing through the networks to maintain adequate pressure and continuous water supply.

We have a program to install valves to regulate water pressure throughout the water mains to correspond to downstream consumption needs during each day. 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 intelligent valves are equipped with probes programmed to feed data to the valve to reduce or increase pressure to the water mains as water usage fluctuates. Through December 31, 2003, we had installed such valves at strategic points in the network, with 703 valves installed in the São Paulo Metropolitan Region and 256 in the Regional Systems. We plan to install additional 130 valves through 2005.

As of December 31, 2003, our water distribution pipes and mains included approximately:

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We have 313 storage tanks in the São Paulo Metropolitan Region with a total capacity of 1.8 million cubic meters, and 1,666 storage tanks in the Regional Systems. We have 192 treated water pumping stations in the São Paulo Metropolitan Region, including stations at treatment facilities, intermediate trunk transfer pumping stations and small booster stations serving local areas.

Water derived from our water sources is relatively non-corrosive to pipe materials. As a result, structural weakness and leakage arising from internal pipe corrosion have not been problems for Sabesp. Operational experience suggests that the decrease in flow capacity as a result of reduced water pressure due to pipe encrustation in the older cast iron pipes has been a problem for Sabesp in the São Paulo Metropolitan Region. In addition, fractures in the pipes making up the distribution network caused by heavy vehicular traffic loads in the streets of the São Paulo Metropolitan Region have been a further problem for Sabesp. Operational experience also suggests that there is a relatively low incidence of external corrosion of pipe materials in the Coastal Region as a whole. External factors contribute to brittle fractures which are triggered by heavy vehicular traffic loads. These fractures occur most frequently in smaller pipes and house connections.

We consider the condition of the water pipes and mains in the São Paulo Metropolitan Region generally to be adequate. Due to age, external factors such as traffic, the high population and commercial and industrial development, the condition of the water pipes and mains in the São Paulo Metropolitan Region is somewhat more susceptible to degradation than those in the Regional Systems. To counteract the effects of deterioration, we maintain a continuing program for maintenance of water pipes and mains intended to deal with anticipated fractures and clogs due to brittleness and encrustation, and maintain water quality.

Water mains that require maintenance are cleaned and relined. We are typically notified of water main fractures or breaks by the general population through a toll-free number maintained by Sabesp.

We expect that new customers will be responsible for covering part of the costs of connecting to our water distribution network. Our water connection policy is to pay for the cost of installation of up to 15 meters of pipe from our distribution network to the point of connection, with the remainder paid by the customer. Thereafter, the customer must cover the costs of connecting to the network from the customer’s residence, including costs of purchasing and installing the water meter and related labor costs. Industrial customers are responsible for the entire cost of connection. The installation of the water meter is performed by Sabesp, which also conducts periodical inspections and measurements. After completion of installation, the customer has a fiduciary duty to the network and the water meter.

Our Water Loss Reduction Program initiated in 1995 has two main objectives:

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We are taking measures to decrease physical losses by reducing response times to broken pipes and mains to less than 24 hours and by better monitoring of non-visible water mains fractures. We currently repair approximately 4,000 broken pipes and mains per month. Among other measures we have adopted to reduce physical water losses are:

Measures adopted to decrease non-physical water losses include:

Water Quality

We believe that we supply high quality treated water that is consistent with standards set in the United States and Europe. Under a current Health Ministry regulation in effect in Brazil, we have significant statutory obligations regarding the quality of treated water. These laws set certain standards that govern water quality.

Some of our water sources in the southern area of the São Paulo Metropolitan Region contain low quality water due to the effects of pollution and algae growth. Currently, we successfully treat this water to make it potable; however, during dry periods of the year, this water retains an unpleasant taste and odor in spite of the treatment. If restrictions on the use of water are imposed in the future and if advanced treatment standards are not implemented, water originating from this area may decrease in quality and our customers may use only limited amounts of, or refuse to pay for, this lower quality water.

We have 15 laboratories that monitor water quality and purity as required by standards set by Sabesp and as required by law, which employ approximately 200 technicians, biologists, engineers and chemists. Our laboratories perform an average of 130,000 analyses per month. 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. Five of our laboratories have obtained ISO 9002 certification and two have obtained ISO-17025 certification.

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In addition, we have implemented the “Real Time Water Quality Monitoring System for the São Paulo Metropolitan Region”. Under this system, the water of some reservoirs located in the São Paulo Metropolitan Region is tested by 12 probes equipped with six sensors each attached to buoys which are set at different depths. This equipment permits Sabesp to make up to 9,000 analyses per probe per month. At the end of 2002, we temporarily stopped performing these analyses when the contract relating to them expired. After conducting a public bid, we have engaged another company to perform the analyses as from December 2003.

Water Source Program

From time to time, we face significant problems with algae growth, as it causes water to have an unpleasant taste and odor. In order to minimize this problem, we have implemented additional treatment processes such as absorption by powdered activated carbon and oxidation by potassium permanganate. We believe that all the chemicals used are safe for human consumption, but the algae problem creates significant additional costs because of the higher volumes of chemicals used to treat the raw water.

Algae growth tends to occur mainly in the Guarapiranga Reservoir, but it has also been frequently detected in the reservoirs that compose the Rio Grande and Alto Tietê systems. Algae growth in the Guarapiranga and Rio Grande reservoirs are basically due to the discharge of untreated sewage from squatters living adjacent to the reservoirs in violation of laws intended to protect the watershed. In the Alto Tietê system the algae growth is mainly caused by effluents from the agricultural use of the drained areas.

To mitigate the pollution problem in the Guarapiranga and Rio Grande reservoirs, we are planning to participate on the Programa Mananciais (or “Water Source Program”) together with other organizations engaged on the promotion of urban development and social inclusion. In this program Sabesp will be responsible for the expansion of sewage systems, pre-treatment of streams and development more sophisticated treatment facilities.

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 which is 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 of sewage through our sewage systems and for its subsequent disposal with or without prior treatment. On December 31, 2003, we collected 81% and 73% of all the sewage produced in the municipalities in which we operate in the São Paulo Metropolitan Region and the Regional Systems, respectively, accounting for 78% of all the sewage produced in the municipalities in which we operate in the State of São Paulo.

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Sewage System

The primary function of our sewage system is to collect, convey and treat sewage. As of December 31, 2003, we were responsible for the operation and maintenance of approximately 35,759 kilometers of sewer lines, trunk lines, interceptors and outflows, of which approximately 17,659 kilometers are located in the São Paulo Metropolitan Region, and 18,100 kilometers are located in the Regional Systems.

Our sewage system is comprised of a number of systems built at different times and constructed primarily from clay pipes and, more recently, PVC tubing. Sewer lines larger than 0.5 meters in diameter are primarily made of concrete. Our sewer 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 sewer lines made of cast iron.

Industrial sewage can vary in nature and concentration of contaminants. The standards for disposal of industrial effluents are set by Article 19A of State Decree No. 8,468 of September 8, 1976, as amended, and broadly correspond to the standards for such disposal set by the U.S. Environmental Protection Agency. The basic premise of these standards is that industrial effluents interfere with the natural biological process occurring at sewage treatment facilities and, therefore, such effluents must be treated so that the final effluent meets the parameters set forth in State Decree No. 8,468. This decree requires industries that produce industrial sewage to pre-treat such sewage so that levels of certain parameters, such as pH, temperature, sediments, grease, oil and metals are reduced to environmentally sound levels prior to release into our sewer lines. To ensure compliance with Article 19A, we periodically analyze sewage produced by each industrial customer to check whether the customer has complied with the requirements of the decree.

Effluents from our sludge treatment facilities (Estações de Tratamento de Esgotos — ETEs) shall comply with flow and quality standards established by Federal and State regulations. Flow standards are related to the composition of effluents before being discharged into water bodies, while quality standards measure the condition of the water bodies after the dilution of effluents. Both flow and quality standards will vary according to the expected use of the relevant water body: the more important the use of the water body, the more stringent the standards applicable.

We consider the condition of the sewer lines in the São Paulo Metropolitan Region generally to be adequate. Due to greater volume of sewage collected and to higher population and commercial and industrial development, the condition of the sewer lines in the São Paulo Metropolitan Region is somewhat worse than that of the Regional Systems. To counteract the effects of deterioration, we maintain a continuing program for the maintenance of sewage lines intended to deal with anticipated fractures arising from obstructions caused by system overloads.

In the Regional Systems the structural condition of our sewer lines is considered generally to be good given the peculiarities of each of its areas. Unlike the São Paulo Metropolitan Region, the Interior Region does not generally suffer obstructions caused by sewage system overload. The Coastal Region however experiences obstructions in its sewer lines primarily due to infiltration of sand, especially during the rainy season in the summer months. In addition, the number of sewage connections in the Coastal Region is significantly lower than in the other regions

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serviced by Sabesp, with only 49% of all residences in the Coastal Region currently connected to our sewage network.

New sewage connections are made on substantially the same basis as connections to water lines. We assume the cost of installation for the first fifteen meters of sewer lines from the sewage network to residential and commercial customers’ sewage connections. Industrial customers are responsible for the entire cost of extension and connection to the sewage network.

Sewage Treatment and Disposal

For 2003 approximately 60% and 65% of the sewage collected by Sabesp in the São Paulo Metropolitan Region and the Regional Systems respectively, or 61% of the sewage collected by Sabesp 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 finite capacity. Flows in excess of such capacity are discharged directly, untreated, to inland waters and the Atlantic Ocean. Currently we operate 428 sewage treatment facilities and eight ocean outfalls.

The purpose of sewage treatment is to reduce the polluting impact of the incoming sewage in order to comply with State Decree No. 8,468, of which stipulates maximum concentrations of certain substances prior to discharge into the environment. Although the flow and composition of sewage arriving at sewage treatment facilities varies, on average more than 98% of its content is water. Our sewage treatment relies essentially on physical separation processes and on natural biological processes to break down organic matter and reduce the amount of harmful organisms and chemicals.

The primary treatment process is the principal separation process for suspended solid material present in untreated sewage. The sewage is passed into sedimentation tanks. Solid matter settles to the bottom of the tanks, is removed as sludge and is then passed to the sludge treatment process. The sewage remaining after this sedimentation process is either given activated sludge treatment or may be discharged to receiving waters.

The activated sludge treatment process, the principal method for secondary treatment of sewage used by Sabesp, relies on natural bacterial action to break down the organic matter in sewage and, where required, to remove ammonia. In the activated sludge treatment process, the sewage from primary treatment is passed into aeration tanks which are continuously replenished with recirculated activated sludge. The mixture in the tanks is agitated and aerated enabling the micro-organisms in the activated sludge to digest organic material contained in the incoming sewage. The effluent and activated sludge mixture produced by this process flows over to the final sedimentation stage.

We operate 40 activated sludge treatment facilities, each of which also contains a primary treatment facility. The five largest activated sludge treatment facilities located in the São Paulo Metropolitan Region have treatment capacity of approximately 18 cubic meters of sewage per second.

Sewage treatment in the Regional Systems will vary according to the particularities of each area. In the Interior Region treatment consists largely of aeration ponds where the organic matter is aerobically digested and the treated sewage is discharged to receiving waters. There

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are 347 secondary treatment facilities in the Interior Region which have treatment capacity of approximately 7.5 cubic meters of sewage per second.

The majority of sewage collected in the Coastal Region receives secondary treatment and disinfection and is then discharged into rivers and into the Atlantic Ocean. We have 64 sewage treatment facilities in the Coastal Region.

Our trunk lines are currently not sufficiently extensive to transport all sewage collected by Sabesp to our treatment facilities. As a result, a portion of the sewage collected by Sabesp is released untreated into receiving waters, resulting in high levels of pollution in such bodies of water. Our capital expenditure plan includes projects to increase the amount of sewage that we treat. See “Government Regulation — Sewage Requirements” below.

Sludge Disposal

Sludge removed from the primary and secondary treatment processes typically contains water and a very small proportion of solids. We use filter presses, belt presses and centrifugation machines to extract the water from the sludge. In 2003, we produced approximately 44,611 tons of sludge-dry base, of which 39,226 tons were discharged into landfills and the remainder was used for agricultural purposes. In addition, we are testing new technologies for sludge disposal as fertilizer in forest projects, fuel development and concrete manufacturing.

Customers

General

We currently operate water and sewage systems for 368 of the 645 municipalities in the State of São Paulo. The following table provides information regarding volumes of water and sewage invoiced, by customer category, for the periods presented.

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In addition to serving residential, commercial, industrial and governmental customers in municipalities in which we hold concessions, we currently make bulk sales of water to 6 municipalities having a total estimated population of 3.1 million.

Tariffs

Although we have the power to set our tariffs for water and sewage services, we traditionally have consulted the Governor of the State of São Paulo prior to setting new tariff rates. For example, we did not increase tariffs in 2000 due to a State policy for the year of not increasing tariff rates for some public carriers, such as public transportation and water supply services.

The most recently implemented tariff regulations allow Sabesp to more aggressively set tariffs and to more realistically cover the operational costs of water and sewage systems. In addition, the new tariff regulations allow us to calculate the water and sewage service tariffs in order to better adequate the tariff value to the peculiarities of each service, the diversity of the regions covered and the social and economical condition of the end user.

We established a new tariff schedule, effective May 2002, for commercial and industrial customers that (1) consume at least 5,000 cubic meters of water per month and (2) enter into demand agreements with Sabesp for at least one-year terms.

On August 29, 2003 we developed and implemented a new readjustment formula for our tariffs to better reflect cost evolution. According to this new formula the cost components of the Tariffs Readjustment Index (IRT) is separated in two parts (“A” and “B”), where Part “A” encompasses all costs related to: electricity; water and sewage treatment materials; federal, state and local taxes; and the financial compensation due to use of water resources. The readjustment of Part A will be based on the price variation observed in its components during the preceding 12-month period.

Part “B” of the cost is composed by all other costs and expenses and is adjusted according to IPCA - Índice de Preços ao Consumidor Amplo (an inflation measurement index based on final consumer price, published periodically by IBGE).

We establish separate tariff schedules for our services in each of the São Paulo Metropolitan, Interior and Coastal Regions. Each tariff schedule incorporates cross-subsidies pursuant to which certain customers, in effect, subsidize the provision of water and sewage services to other customers. Customers with high monthly water consumption rates pay higher tariffs than our costs of providing such 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 and Coastal Regions.

We divide tariffs into two categories: residential and non-residential. The residential category is sub-divided into basic residential, social and favela (shantytown). The latter two sub-categories were instituted to assist lower-income customers by providing lower tariffs for consumption. The non-residential category consists of:

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Sewage charges in each region are fixed as a function of the monthly water charges. In the São Paulo Metropolitan Region and the Coastal Region, the sewage tariffs equal the water tariffs. In the Interior Region, sewage tariffs are approximately 20% lower than water tariffs. Bulk water rates are established separately for each municipality served. We also make available sewage treatment services to those municipalities, although no formal agreement for the provision of these services has been signed as of the date of this document. In addition, various industrial customers pay an additional sewage charge, depending on the characteristics of the sewage they produce.

Tariffs have historically been adjusted once a year and for at least 12 months during the months of June or July. However, we did not increase tariffs in 2000 due to the State policy described above. We raised tariffs in June 2001, in August 2002 and in August 2003. The following table sets forth the water and sewage services tariffs by customer category charged during the years stated in the São Paulo Metropolitan Region, which accounted for approximately 76% of our operating revenues in 2003.

Annual Water and Sewage Tariffs for the São Paulo Metropolitan Region

Commercial/Not-for-profit entities

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The average annual tariffs charged by Sabesp at the Interior and Coastal Regions for the provision of water and sewage collection during 2003 were 37% and 22% below the tariffs charged at the São Paulo Metropolitan Region, respectively.

See “Government Regulation-Tariff Regulation” below for additional information regarding our tariffs.

Billing Procedures

The procedure for billing and payment of our water and sewage services is basically the same for each customer category. 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 losses resulting from faulty water meters. Sewage billing is included as part of the water bill and is based on the water meter reading.

We deliver all water and sewage bills by hand to our customers, mainly through independent contractors who are also responsible for reading water meters.

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 Sabesp and service fees of between R$0.40 and R$1.19 per transaction are charged for collection and remittance of these payments.

Customers must pay their water and sewage bills by the due date for payment if they wish to avoid paying a fine. We generally charge a penalty fee and interest on late bill payments. However, we do not assess a penalty fee or interest in respect of governmental customers. In 2001, 2002 and 2003 we received, respectively, payment of 91.5%, 94.5% and 90.9% of the amount billed to our retail customers, and 96.0%, 94.6% and 93.8% of the amount billed to those customers other than state governmental entities, within 30 days after the due date. Almost all of the amount not paid within 30 days is owed by state governmental customers. With respect to bulk sales, in 2003 we received payment of 55.4% of the amount billed within 30 days.

In the São Paulo Metropolitan Region we monitor water meter readings by use of hand-held computers. 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

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water consumption usage at each metered location and prepares bills based on actual meter readings. We outsourced this billing system to third party contractors that employ and train their own meter readers whose training we supervise. We are currently implementing water meter reading by hand-held computers in some municipalities that we serve in the Regional Systems.

Electricity Consumption

The use of electricity is material to our operations, and as a result we are one of the largest users of electricity in the State of São Paulo. We obtain electricity primarily from Eletropaulo Metropolitana Eletricidade de São Paulo S.A., Elektro Eletricidade e Serviços S.A., Bandeirante Energia S.A. and CPFL-Companhia Paulista de Força e Luz pursuant to long-term contracts. Each of these companies has been privatized by the State of São Paulo. To date, we have not experienced any major disruptions in electricity supply. Any significant disruption of electricity to Sabesp could have a material adverse effect on our business, financial condition, results of operations or prospects. Furthermore, fluctuations in electricity voltage supplied to Sabesp have in the past, and may in the future, cause major damage to our water and sewage systems.

In May 2001, the Brazilian government announced measures aimed at an average reduction of 20% in electricity consumption in a number of regions of Brazil, including areas in which we operate. However, companies that render “essential services”, such as companies like Sabesp that render water and sewage services, were not subject to these measures other than with respect to their administrative buildings, which were required to reduce electricity consumption by 35%. As a result of higher levels of rainfall, as of March 2002 the Brazilian government eliminated all electricity consumption restrictions.

Capital Expenditure Program

From 1998 through 2003, our capital expenditure program included capital expenditures totaling R$4.2 billion in the aggregate, primarily to build up our infrastructure. We have budgeted capital expenditures totaling approximately R$4.3 billion in the aggregate during the period 2004 through 2008. There can be no assurance that the amount budgeted will be available to spend during this time period.

Currently, our capital expenditure program is designed to improve and expand our water and sewage system and to increase and protect water sources in order to meet the growing demand for water and sewage services in the State of São Paulo. It has three specific targets in the municipalities we serve:

The following is a brief description of each of the principal projects in our capital expenditure program.

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Metropolitan Water Project

Demand for our water services has grown steadily over the years in the São Paulo Metropolitan Region and has exceeded at times the capacities of our water systems there. As a result, prior to September 1998, certain of our customers in this Region received water only on certain days of the week. We refer to this as “rotation”. In order to remedy this situation, we implemented the Metropolitan Water Project to improve regular water supply to the entire São Paulo Metropolitan Region. The Metropolitan Water Project increased production capacity from approximately 59.7 cubic meters of water per second in 1994 to approximately 67.7 cubic meters of water per second at the end of 2003. Through implementation of this project, we eliminated widespread rotation in September 1998.

The project involved construction of new water abstraction facilities and increasing the capacity of existing treatment facilities, development of new reservoirs in the São Paulo Metropolitan Region and water mains to interconnect the systems within the Region, and the construction, renovation and enlarging of 30 water storage tanks to store treated water in order to meet higher demand during peak periods. In addition, in order to relieve pressure on reservoirs, such as the Guarapiranga Reservoir and some reservoirs of the Alto Tietê System, where we have over-exploited water supplies, we built water mains from the Billings Reservoir into the Guarapiranga Reservoir and from the Tietê River into the reservoirs of the Alto Tietê System. Portions of this project were financed by the World Bank and Caixa Econômica Federal as well as from Sabesp’s own resources. We have spent approximately R$700 million on the Metropolitan Water Project. Regarding the remainder of the Metropolitan Water Project, we have budgeted for additional capital expenditures of approximately R$620 million from 2004 through 2008.

Tietê Project

The Tietê River crosses the São Paulo Metropolitan Region and receives most of the Region’s run-off and wastewater. The Tietê Project is designed to reduce pollution of the River Tietê by constructing sewage collection lines along the banks of the River Tietê and its tributaries. These lines collect raw sewage and deliver it to our sewage treatment facilities. In connection with the first phase of the Tietê Project, in June 1998, we completed construction of three additional sewage treatment plants. Currently, raw sewage is delivered to our secondary treatment facilities along the River Tietê and the River Tamanduatei before treated sewage is discharged into those rivers. We plan to build additional collection lines to direct more raw sewage to our treatment facilities.

In addition, we completed the construction of the main sewage collection pipes on the banks of the River Pinheiros, the Pinheiros Leopoldina Interceptor, which cost approximately US$36.0 million and increases the amount of sewage treated in existing sewage treatment plants. The Caixa Econômica Federal has provided financing to complete construction of the Pinheiros Leopoldina Interceptor.

The first phase of the Tietê Project commenced in 1992, was suspended in 1994 due to lack of funding, resumed in 1995, and was completed in December of 1998. We now provide secondary treatment to 60% of the sewage collected in the São Paulo Metropolitan Region. The five principal sewage treatment plants 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 10.3 cubic meters of sewage per second.

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We made capital expenditures with respect to the first phase of the Tietê Project of US$900.0 million. Of that amount, US$450.0 million was financed by the Inter-American Development Bank and US$450.0 million was funded by Sabesp. On December 31, 2003, we owed US$343.8 million to the Inter-American Development Bank regarding this financing agreement.

In July 2000, we commenced work on the second phase of the Tietê Project to reduce pollution affecting the River Tietê and the work is still ongoing. The main objectives of this second phase is to increase the number of sewage connections in the São Paulo Metropolitan Region so that 90% of the population in the region will be connected to our sewage system, and to treat 70% of the sewage collected by Sabesp in the region. For this second phase we have budgeted for additional capital expenditures of approximately US$400.0 million from 2000 through 2005, US$200.0 million of which will be financed by the Inter-American Development Bank. We have also entered into a loan agreement and an on-lending agreement with BNDES for R$60 million and R$180 million, respectively, to finance this second phase. Through December 31, 2003, we have spent US$112.6 million on this phase of the Tietê Project.

Regional Systems Investment Programs

We currently have a number of projects in progress and planned for the Regional Systems, including projects relating to abstraction of water and collection and treatment of sewage. We spent approximately R$337.5 million, R$321.8 million and R$195.0 million on such projects in 2001, 2002 and 2003, respectively, and we have budgeted for additional capital expenditures of approximately R$1.3 billion in the period from 2004 through 2008.

As part of our Coastal Region Investment Program, we are currently negotiating with the Japan Bank for International Cooperation to help finance our Environmental Recovery Program for the Santos Metropolitan Region. The main goals of this program are to improve and expand our water and sewage systems in the municipalities making up the Santos Metropolitan Region.

Guarapiranga Project

The Guarapiranga Reservoir (the “Reservoir”), the second largest reservoir serving the São Paulo Metropolitan Region, has been polluted by the inhabitants of favelas located in the area surrounding the Reservoir in violation of current laws intended to protect water resources. This population releases untreated sewage into the Reservoir. In addition, the untreated sewage introduced by our own sewage collection system into rivers that feed the Reservoir has contributed to the pollution of the Reservoir.

The recovery of the Reservoir involved the expansion of the wastewater collection network, sewage treatment facilities and solid waste collection, as well as monitoring, environmental education and watershed restoration. Today, part of the inhabitants of the favelas is served by sewage system, and most of the sewage collected is either sent to our treatment facilities, either intercepted and diverted to other areas. Additional measures to reduce pollution of water bodies include the use of wetland treatment and flotation technologies and the reversal of highly polluted small tributaries that lead into the Reservoir. This project cost approximately US$329.8 million through December 31, 2001, of which US$119.0 million was financed by the World Bank, US$81.3 million by the State of São Paulo, US$45.7 million by Sabesp and US$83.8 million by the City of São Paulo. The first stage of this project finished in December, 2000 but engendered a follow-up project called “Programa Mananciais” that is in preparation.

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It involves an estimated investment of US$342 million in all the hydrographic basins that produce water for the São Paulo Metropolitan Region.

We will be responsible for approximately US$116 million of the total Program budget. The implementation of this program is estimated to occur during 2005 - 2010, with the support of the World Bank.

Competition

We do not face any competition in the municipalities in which we provide water and sewage services, and we believe that in those municipalities we have an exclusive right to provide such services. We do not serve, either directly or on a bulk basis, 272 municipalities in the State of São Paulo that operate their own water and sewage systems and that collectively have a population of approximately 11.9 million, or 30% of the population of the State. In addition, private water companies provide three municipalities with water and sewage services pursuant to concessions from such municipalities.

Under current Brazilian law, a municipality may terminate a concession at any time prior to its contractual expiration date for any “good public reason”, although we have the right to continue providing services until the municipality has paid all indemnification payments due to Sabesp. Termination of a concession must be initiated by the mayor and approved by the municipal chamber of representatives by means of a law approved by a majority of the municipal representatives. The municipality itself or another concessionaire could then replace Sabesp and would then be in competition with Sabesp. The loss of concessions could have a material adverse effect on our business, results of operations, financial condition or prospects and on our competitive position in the State of São Paulo, depending on the geographic area covered and the population served. Although we believe we generally have good relationships with the municipalities served and are in the process of developing closer relationships, we cannot assure you that such relationships will continue to be satisfactory or that municipalities will not seek to rescind their concessions to Sabesp.

We face some competition with respect to the supply of water to industrial customers. Several large industrial customers located in municipalities served by Sabesp use their own wells to supply themselves with water. However, we do not experience any competition with respect to the sewage collection services we provide to industrial customers.

Government Regulation

In Brazil, water and sewage services are rendered by a broad variety of companies, most of which are state-owned companies, controlled either by the states or the municipalities. Under Brazilian law, the operation of water and sewage systems are considered to be of public interest because the capacity to provide drinking water and collect sewage influences public health, ensuring drinking water capacity and production requires the rational use of water resources, and our operations produce environmentally hazardous substances which must be properly disposed. Accordingly, we are subject to extensive Brazilian federal, state and, in certain respects, local laws and regulations governing, among other things:

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General

Pursuant to Article 23 of the Brazilian Constitution, water and sewage services are the common responsibility of the Brazilian government, the states and the municipalities.

Article 216 of the State Constitution provides that, by law, the State of São Paulo 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 the formation of Sabesp to plan, provide and operate water and sewage services in the State of São Paulo and also acknowledged the autonomy of the municipalities.

Pursuant to Article 175 of the Brazilian Constitution, the furnishing 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 furnish these services directly or through a concession granted to a third party.

Pending Legislation

Proposed legislation, the Lei do Saneamento Básico (Sanitation Law), which has been under discussion in the Federal House of Representatives, would introduce the creation of a legal framework to govern water and sewage services. Under the proposed legislation, the organization of water and sewage services would take into consideration the existing water basins as well as the network structures of municipalities, and the National Water Agency would be responsible for the regulation of the provision of water and sewage services. In addition, it is expected that the proposed legislation, if and when approved, will define the party responsible for granting concessions for water and sewage services within the metropolitan regions, including the São Paulo Metropolitan Region.

The legislature of the State of São Paulo is also considering adopting a law which would establish a State regulatory agency responsible for regulating and controlling public sanitation services in the State. This proposed agency would be part of the Energy, Water Resources and Sanitation Secretariat of the State of São Paulo.

The State legislature of the State of São Paulo is also debating new legislation that would establish procedures for the collection of fees related to the use of water.

We cannot assure you when or if any of the legislation described above will be adopted, the final form of these laws if they are approved, or how this legislation would affect our business.

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Concessions

Concessions for water and sewage services are evidenced by contracts between the federal, state or municipal government, as the case may be, and a concession under which the concessionaire is granted the right to supply these services in a particular municipality or region. Our concessions usually have a contractual term of not longer than 30 years, although a number of our concessions are of unlimited duration. However, our concessions generally may be terminated at any time if certain quality and safety standards are not met or if there is a default under the concession contract. A substantial portion of our concessions is automatically renewable unless notice of rescission is received by the non-rescinding party at least six months prior to the expiration date of the concession. A municipality that elects to take control of its water and sewage services must either provide such services itself, auction the concession to potential concessionaires through a competitive public bidding process, or enter into agreements with a public entity directly. The State Constitution provides that, if we are replaced as the concessionaire by any municipality, the municipality must reimburse Sabesp for the unamortized economic value of its investments. See “Concessions” above for a further description of our concessions.

Federal legislation enacted in 1995, and subsequently amended, governs the granting of concessions in Brazil. The Federal Concessions Law regulates the granting of concessions by federal, state and municipal governments. In addition, the Federal Public Bidding Law sets forth the bidding procedures related to the granting of concessions. At the São Paulo State level, the State Concessions Law corresponds to the Federal Concessions Law, and the State Public Bidding Law corresponds to the Federal Public Bidding Law. In the event of any conflict between federal and state law, federal law prevails.

Concessions Laws

The Federal Concessions Law and the State Concessions Law require that a concession granted by a public entity be based on a public bidding process. The Federal Public Bidding Law provides, however, that the public bidding process can be waived in certain circumstances, including in the case of services to be rendered by a public entity created for such specific purposes prior to the enactment of that law, provided that the prices for such services are compatible with those prevailing in the market. In addition, a provision of the Brazilian Constitution provides for waivers of the public bidding requirement in similar situations. Based on this provision, we were granted concessions by municipalities after enactment of the Brazilian Constitution without a public bidding process, although under current law we may be required to bid to acquire new concessions. We did not have any of our concessions canceled or revoked following promulgation of the Federal Concessions Law. The requirements of the Federal and State Concessions Laws will, however, govern the grant of new concessions to Sabesp in the future. In February 1998, the Attorney General of the State of São Paulo, in response to a request made by Sabesp, delivered an opinion that any municipality of the State of São Paulo may grant to Sabesp a concession to operate such municipality’s water and sewage services without having to resort to a public bidding process. In April 1998, a State court issued a judgment substantially to the same effect. There can be no assurance that the Brazilian courts will continue to interpret the concessions laws to allow municipalities to grant concessions without a public bidding process.

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The City of São Paulo legislature approved Law No. 13,670, of November 25, 2003, which regulates article 148 and the sole paragraph of article 149 of the Organic Law of the Municipality of São Paulo, concerning water supply and sewage public services, establishes the Municipal Regulation System of Water Supply and Sewage Public Services, creates the Regulatory Authority for Water and Sewage Services of São Paulo, addresses its organization and operation and establishes the Municipal Sanitation Plan. Pursuant to this Law, the Mayor of the City of São Paulo has authority to grant and monitor formal concessions for water and sewage services in the Municipality of São Paulo. Following the enactment of Law No 13,670, the Governor of the State of São Paulo has filed a legal action alleging that the Law is unconstitutional. As a result, the enforcement of Law No. 13,670 has been suspended and the merits of such lawsuit have not yet been judged. The provisions of the State Concessions Law parallel the provisions of the Federal Concessions Law.

Public Bidding Procedures

Pursuant to the Federal Public Bidding Law, the public bid process commences with publication by the granting authority in the federal, state or municipal official gazette, as the case may be, and another leading Brazilian newspaper, of an announcement that it 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:

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 provisions of the State Public Bidding Law parallel the provisions of the Federal Public Bidding Law.

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The federal and state bidding laws will apply to Sabesp in the event that we seek to secure new concessions. Moreover, these bidding laws currently apply to Sabesp with respect to obtaining goods and services from third parties for, among other things, our business operations or in connection with our capital expenditure program, in each case subject to certain exceptions.

Water Usage

In July 2000, the National Water Agency, a federal agency under the Ministry of the Environment, was established in order to develop the National System for Water Resources Management. Under proposed legislation, the National Water Agency would be responsible for the coordination of the regulatory aspects involved in the rendering of water and sewage services. See “Pending Legislation” above.

Under existing law, Federal Governmental agencies are authorized to collect fees from persons that either abstract water from, or dump sewage into, water resources controlled by these agencies. In most cases, the fees have yet to be established by implementing regulations. However, for one specific water basin (the Rio Paraíba do Sul water basin), recent legislation was enacted requiring Sabesp to pay the Federal Government or an agency in respect of the use of water, and Sabesp started making payments in this respect on March 2003.

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

Under state law, implementation of any project that involves the use of surface or underground water requires prior authorization or licensing of the competent government authority.

Pursuant to an executive order of the Governor of the State of São Paulo, the Departamento de Águas e Energia Elétrica (Department of Water and Energy) of the State of São Paulo has as its objectives establishing (1) a policy for the use of water resources with a view to developing the water business of the State of São Paulo, and (2) plans, studies and projects related to the integral use of water resources, directly or by means of agreements with third parties. The

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Department of Water and Energy has established the standards which regulate abstraction of water from water resources in the State of São Paulo.

State law provides the basis for the fees charged by governmental water agencies in the State of São Paulo for the extraction of water from the State of São Paulo’s water resources controlled by such agencies. Although governmental water agencies in the State of São Paulo currently do not charge fees for any of the water which Sabesp extracts, there can be no assurance that such fees will not be charged in the future. See “Item 3. Key Information—Risk Factors—Risks Relating to Our Business— We may become subject to substantial water- and sewage-related charges imposed by governmental water agencies of the State of São Paulo and of the Federal Government” for more information.

Water Quality

An ordinance issued by the Ministério da Saúde (Ministry of Health) of the Brazilian government sets forth the standards of potability of all water for human consumption in Brazil. This ordinance is modelled on the U.S. Safe Drinking Water Act and regulations promulgated by the U.S. Environmental Protection Agency thereunder. The Secretaria de Estado da Saúde (Secretariat of Health) of the State of São Paulo has also set minimum standards for the potability of water for human consumption which are more restrictive than the national rules.

We analyze test samples at our laboratories to determine compliance with Ordinance No. 518, of March 25, 2004 and state law using “Standard Methods” (181^st. Edition) procedures established by the American Water Works Association.

Sewage Requirements

State law sets forth regulations regarding pollution and protection of the environment in the State of São Paulo. The standards for disposal of industrial effluents set forth in this law broadly correspond to the standards for such disposal set by the U.S. Environmental Protection Agency. State law generally prohibits the discharge of pollutants into water, air or land in the State of São Paulo.

State law provides that, in areas in which there exists 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 certain characteristics, which allow such effluents to be treated by our treatment facilities and discharged in an environmentally safe manner. Effluents which exceed such characteristics are prohibited from being discharged into the public sewage system. State law requires industries that produce industrial sewage to pre-treat such sewage so that maximum levels of certain parameters, such as pH, temperature, sediment, grease, oil and metals, are reduced to environmentally sound levels prior to release into our sewer lines.

Companhia de Tecnologia de Saneamento Ambiental—CETESB (Environmental Sanitation Technology Company, or CETESB), a mixed capital company controlled by the Secretariat of the Environment of the State of São Paulo, is authorized under state law to monitor discharges of pollutants into public waters and to enforce the requirements of state law. CETESB has the power to grant consents to entities which are discharging pollutants into receiving waters. Although we have not received formal authorization from CETESB to discharge untreated

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sewage into waters, we continue to discharge such sewage with the knowledge of, and after having made disclosure to, CETESB. Our capital expenditure program includes the Tietê Project, which is designed to reduce the discharge of untreated sewage into the River Tietê, a major river in the São Paulo Metropolitan Region. CETESB participates in the development of this project. There can be no assurance that we will not be required in the future to obtain specific consents or authorizations for discharges of untreated sewage.

The disposal of sludge must also meet the requirements of state law. CETESB also regulates the discharge of effluents into bodies of water under state law and must approve all of our treatment facilities.

State law also provides the basis for fees to be charged for discharging effluents into the State of São Paulo’s water resources. Although neither the State of São Paulo nor its agencies currently assesses fees for such discharges, we cannot assure you that such fees will not be charged in the future.

Some municipalities of the State of São Paulo have enacted municipal laws requiring Sabesp to charge a fixed fee, and not a tariff, for sewage services being provided. To date, we have not acknowledged the enforcement of any such laws.

Tariff Regulation

The tariffs set by Sabesp for its services are subject to federal and State regulation to some extent.

In 1991, involvement of the Brazilian government in the establishment of tariff rates for the provision of water and sewage services ended pursuant to a federal executive order dated September 5, 1991. In addition, on December 16, 1996, the Governor of the State of São Paulo issued a decree which approved the existing tariff system and allowed Sabesp to continue to set its own tariffs. We have set our tariffs based on the general objectives of maintaining our financial condition and preserving “social equity” in terms of the provision of water and sewage services to the population. Furthermore, this decree directs Sabesp to apply the following criteria in determining its tariffs:

The costs associated with the exploitation of water resources, depreciation, provision for bad debts, amortization of expenses and adequate remuneration for investments also may be considered by Sabesp in determining tariffs. We usually submit new tariffs to the Governor of

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the State of São Paulo for approval, although we are not required by law to do so. We have recently implemented a new readjustment formula designed to better reflect costs. See “Customers-Tariffs” above.

We currently maintain three different tariff schedules, depending upon whether a customer is located in the São Paulo Metropolitan Region, the Interior Region or the Coastal Region. There are four levels of volume consumed for each category of customer. Customers are billed on a monthly basis. We are also authorized to enter into individual contracts with certain customers, such as municipalities, to sell water or sewage services on a bulk basis.

Tariffs must be published in the Diário Oficial do Estado de São Paulo (Official Gazette of the State of São Paulo).

We are subject to a federal law which, in the case of water and sewage services provided pursuant to certain concessions, effectively prohibits tariffs that would produce a return on assets in excess of 12% per annum. Return on assets is calculated using operating income (before financial and certain other expenses) measured against operational assets (property, plant and equipment and certain other assets), based upon our financial statements prepared in accordance with the Corporate Law Method. We continue to be subject to the above return on assets limitation in adjusting tariffs because substantially all of our concessions were granted during the period in which these rate regulations were in effect. We are not, however, subject to such limitations in setting tariffs under our newer concessions or for the City of São Paulo and other municipalities in which we operate without formal concessions. The above return on assets limitation does not apply to renewals of existing concessions. In any event, our tariffs have been set in the past, and continue to be set, at levels well below the return on assets limitation discussed above.

Governmental Restrictions on Incurrence of Debt

On June 30, 1998 the Central Bank issued a resolution amending certain conditions that must be observed with respect to the external credit operations (i.e., foreign currency borrowings) of states, the Federal District, municipalities and their respective autarquias (agencies), foundations and non-financial companies, including Sabesp. This resolution provides, among other things, that, with certain exceptions for the importation of goods and services,

The Central Bank resolution further provides that the requirements described above do not apply to financing transactions involving multilateral or official organizations such as the World Bank, the InterAmerican Development Bank or the Japan Bank for International Cooperation. The Central Bank circular implementing this resolution provides, among other things, that the

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account referred to in the first bullet point above must be an escrow account opened in a federal financial institution, which is to hold such funds until released for the purpose of refinancing outstanding obligations of the issuer. The circular further provides that the escrow 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 external credit transactions are also subject to the approval of the National Treasury Secretariat and the Central Bank, which, after reviewing the financial terms and conditions of the transaction, 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 commercial market for foreign exchange.

Finally, our external credit transactions are also subject to the prior approval of the Secretariat of Finance of the State of São Paulo.

Lending Limits of Brazilian Financial Institutions

The National Monetary Council resolutions limit the amount that Brazilian financial institutions may lend to public sector companies, such as Sabesp. Financing of projects which are put up for international bid are excluded from these limits.

Conselho Estadual de Saneamento—Conesan

State law regulates the provision of sanitation services and establishes rules for the planning of sanitation-related public works in the State of São Paulo. The State plan for public sanitation services must integrate institutional, technological, financial and administrative resources to ensure that a healthy environment is created for inhabitants of the State of São Paulo. The State plan must also assist in developing and organizing the sanitation sector in the State.

Pursuant to State law, the State of São Paulo’s sanitation policy is implemented by the Sistema Estadual de Saneamento (State Sanitation System). The Fundo Estadual de Saneamento (the State Sanitation Fund) collects funds and manages resources to fund the programs approved in the sanitation plan.

The Conselho Estadual de Saneamento (State Sanitation Council) must approve proposals related to the sanitation plan and prepare an annual report regarding environmental health issues confronting the State. The State Sanitation Council establishes protocols for the development of investment programs approved by the State Sanitation System and resolves disputes related to the State Sanitation System’s implementation of the sanitation plan.

Property, plant and equipment

Our principal properties consist of reservoirs, water treatment facilities, water distribution networks consisting of water pipes, water mains, water connections and water meters, sewage treatment facilities, and sewage collection networks consisting of sewer lines and sewage connections. At December 31, 2003, we owned 193 water treatment facilities and approximately 56,777 kilometers of water pipes and mains, as well as 428 sewage treatment

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facilities and approximately 35,759 kilometers of sewer lines, and trunk lines, interceptors and outfalls.

We own our headquarters building and other major administrative buildings. We have pledged some of our properties, including our headquarters and some of our other administrative buildings and water storage tanks, as collateral to the Brazilian Federal Government in connection with certain long term financing transactions we have entered into with the World Bank and the Inter-American Development Bank that the Brazilian Federal Government has guaranteed.

At December 31, 2003, the total net book value of our property, plant and equipment was R$14,063.2 million.

All of our material properties are located in the State of São Paulo.

Environmental Matters

Our water and sewage operations are subject to stringent Brazilian federal, state and local laws and regulations relating to the protection of the environment as described under “Government Regulation” above.

In the State of São Paulo, CETESB (Environmental Sanitation Technology Company) is responsible for pollution control pursuant to State Law No. 997 of May 31, 1976.

In particular, the construction and operation of water and sewage treatment facilities, as well as the release of effluents and final disposal of the sludge generated as a result of the water and sewage treatment process, must comply with environmental standards established by State environmental laws, in particular, by State Decree No. 8,468 of September 8, 1976, as amended.

Non-compliance with environmental laws and regulations can lead to the imposition of criminal and administrative penalties, in addition to civil liability which may arise as a result of environmental damages. Pursuant to Brazilian Federal Law No. 9,605 of February 12, 1998, individuals (including but not limited to the directors, officers and managers of legal entities) may be penalized with imprisonment or other restrictions on personal rights for violations of environmental rules and regulations, and legal entities may be penalized with fines, restrictions on rights, including, among other things, rights to be granted tax benefits and to enter into contracts with public entities, and mandatory rendering of services in the public benefit. At the administrative level, penalties range from warnings and fines to partial or total suspension of corporate activities, and may also include the forfeiture of, or restriction on, tax incentives, and the cancellation or interruption of participation in credit facilities granted by government banks, as well as a prohibition on contracting with entities of the public sector.

Since 1995, we have maintained a division responsible for developing environmental impact studies and programs. We believe that we are in material compliance with all relevant environmental laws and regulations.

Our procedure for constructing and operating water and sewage facilities involves the mandatory compliance with environmental legal requirements. Firstly, for those projects which have a significant environmental impact, studies are prepared by outside experts who make recommendations on measures designed to minimize the environmental consequences of a

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project. The environmental impact report is then submitted to governmental authorities for analysis and approval. Once the environmental impact assessment is approved, the project goes through a three-stage licensing process, which includes licenses:

In order to obtain the environmental licensing of those undertakings that have a significant environmental impact or as result of an environmental impact assessment, environmental agencies may impose on Sabesp an obligation to establish a nature conservation area. In order to fulfill such obligation, we are required by environmental regulations to spend not less than 0.5% of the total cost of the relevant undertaking for that purpose. We also have a policy of implementing programs to encourage water conservation in order to minimize the environmental impact of our ongoing operations.

Although our environmental compliance costs have not been substantial to date, we believe these costs will increase as water and sewage treatment capacity increases. The amount and timing of future expenditures required to comply therewith could substantially increase from current levels.

Insurance

We maintain insurance covering, among other things, fire or other damage to our property, office buildings and third-party liability. We currently obtain our insurance policies through public bids involving major Brazilian and international insurance companies in Brazil. At December 31, 2003, we had paid a total aggregate amount of R$6.6 million in premiums, covering approximately R$971.9 million. 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. In addition, we do not have insurance coverage for liabilities arising from water contamination or other problems involving our water supply to customers. We believe that we maintain insurance at levels customary in Brazil for the type of business in which we are engaged.

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ITEM 5. OPERATING AND FINANCIAL REVIEW AND PROSPECTS

The following management’s discussion and analysis of financial condition and results of operations should be read in conjunction with our audited financial statements included in this annual report. This annual report contains forward-looking statements that involve risks and uncertainties. Our actual results may differ materially from those discussed in the forward-looking statements as a result of various factors, including, without limitation, those set forth in “Item 3. Key Information—Risk Factors”.

The financial statements in this annual report have been prepared in accordance with the Corporate Law Method, which differs in certain significant respects from U.S. GAAP. We have included a discussion below of the material differences between the Corporate Law Method and U.S. GAAP related to each critical accounting policy in our audited financial statements. For additional information regarding other differences between the Corporate Law Method and US GAAP, please see Note 25 to our audited financial statements

In the following discussion, references to increases or decreases in any year are made by comparison with the corresponding prior year, except as the context otherwise indicates.

Overview

We operate public water and sewage systems in the State of São Paulo, including in the City of São Paulo, Brazil’s largest city, and in more than one-half of the other municipalities in the State. We also make bulk sales of water to six additional municipalities in which we do not operate water systems.

The São Paulo Metropolitan Region, which includes the City of São Paulo, is our most important service territory. With a population of approximately 18.7 million, the São Paulo Metropolitan Region accounted for approximately 75.8% and 75.9% of our operating revenues in 2002 and 2003, respectively. Approximately 72.7% and 72.9% of the property, plant and equipment reflected on our balance sheet at December 31, 2002 and 2003, respectively, is located in this Region. The demand for our water and sewage services has grown steadily over the years, particularly in the São Paulo Metropolitan Region. As a result of a prolonged drought during 2002 up to 2003, the risk of not fully meeting demands for water supply in this region increased. However, these risks have been manageable. In an effort to respond to the demand in the São Paulo Metropolitan Region and because the Region represents the principal opportunity to increase our net operating revenues, we have dedicated a major portion of our capital expenditure program to expand the water and sewage systems and to increase and protect water sources in this Region. Our capital expenditure program is our most significant liquidity and capital resource requirement.

We experienced major operational and financial problems beginning in the mid-1980s, culminating in 1994. In 1994, we had some difficulty in meeting all of our debt and other obligations. Because we did not have the resources to make necessary capital expenditures to maintain our water and sewage systems, we experienced frequent breakdowns in our water distribution systems such that the weakened condition of these systems exacerbated water shortages and threatened, in some cases, water supplies. See “Item 4. Information on the Company — History”.

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Our results of operations and financial condition are highly dependent upon our ability to set and collect adequate tariffs for our water and sewage services. Although we generally have broad power to establish tariffs within our service territories, this power is, in practice, subject to limits due to, among other factors, the following:

Tariffs have often failed to keep up with inflation during periods of high inflation in the past. During the past few years, we generally have been able to raise tariffs in line with increases in cost of services rendered and operating expenses and to support our liquidity and capital resource requirements. We were able to increase our tariffs in mid-1998, which primarily accounted for an increase of approximately 6.9% in net operating revenues in that year, and again in mid-1999, which primarily accounted for an increase of approximately 4.3% in net operating revenues in that year. These tariff increases in 1999 exceeded inflation levels. In 2000, we did not raise tariffs due to the State policy for that year of not increasing tariffs for many public services. In June 2001, however, we increased our average tariff by approximately 13.1%, which was broadly in line with prevailing inflation rates in Brazil since mid-1999 as measured by the consumer price index, and in August 2002, we increased our tariffs by approximately 8.2%. In August 2003, we increased our tariffs by approximately 18.9%. Tariffs have historically been adjusted once a year during June, July or August. The following table sets forth, for the periods indicated, the percentage increase of our tariffs, as compared to three inflation indices:

Sources: Central Bank, Fundação Getúlio Vargas and Fundação Instituto de Pesquisas Econômicas.

We believe that our last tariff increases and the continuing implementation of our strategy have, to date, enhanced our business operations and financial performance and should provide the

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basis for our long-term operational and financial development, although we cannot provide you with any assurances in this regard. See “Item 4. Information on the Company—Strategy”. Any failure to establish or maintain tariffs commensurate with our liquidity and capital resource requirements could have an adverse effect on our results of operations and financial condition.

Overview of Brazilian Economic Conditions

At the end of 1997, in the aftermath of a financial crisis in Asia, Brazil experienced the beginning of an economic crisis brought about by capital flight, pressure on the Brazilian currency and increased interest rates. Before the economy could fully recover from the crisis, Russia devalued its currency in August 1998, and the Brazilian economy deteriorated further as a result of renewed capital flight.

The Brazilian government’s measures to mitigate the crisis were unsuccessful, and continued pressure on the currency led the government to devalue the real in January of 1999. The real was devalued by 31.7% against the U.S. dollar during the first half of 1999, and by 32.4% for the year as a whole. The Central Bank raised base interest rates to approximately 45% in March 1999. The base interest rate is the benchmark interest rate payable to holders of securities issued by the Federal Government and traded at the Sistema Especial de Liquidação e Custódia—SELIC (Special System for Settlement and Custody).

The second half of 1999 brought some improvement in Brazil’s economic situation. Base interest rates decreased to approximately 19% in December 1999, and the real devalued by 1.1% against the U.S. dollar during the second half of 1999, compared to 31.7% during the first half of the year. Inflation for the year as measured by the Índice Geral de Preços de Mercado (the General Price Index—Market, or IGP-M) was 20.1%.

The year 2000 saw additional improvement in the economy. The gross domestic product grew 4.2% during the year and the value of the real remained relatively stable. Inflation fell to 10.0% in 2000, as measured by the IGP-M. The Central Bank gradually reduced base interest rates to 17.5% at June 30, 2000 and further reduced them to 16.5% at December 31, 2000 and to 15.25% at January 17, 2001.

The growth of the Brazilian economy slowed in 2001, as the effects of the ongoing economic crisis in Argentina and lower levels of economic growth in the United States economy led to declines in investment and consumption in Brazil as well as in other emerging markets. The economic situation was exacerbated by the energy shortage and the resulting measures taken by the Brazilian government to reduce the consumption of electricity.

In 2002, several negative economic factors continued to adversely affect consumer confidence levels in Brazil. Prior to and subsequent to the presidential elections in November 2002, there was substantial uncertainty relating to Brazil’s own political and economic future. Other negative economic factors in 2002 included the continued economic and political uncertainties in Argentina and in Venezuela, concerns over the impact of the conflict in the Persian Gulf and its effects on the price of petroleum products and the global economic slowdown. The sharp devaluation of the real in the second half of 2002 heightened concerns over a possible return to high inflation. The monetary authorities under both the former and new presidential administrations acted quickly to increase interest rates through the end of the year, which severely restricted credit available in the economy and consequently growth. General price

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inflation (IGP-M) increased to 25.3% in 2002, the annual base interest rates at year-end were 25.0% and the gross national product grew by an estimated 1.5%.

The real depreciated by 15.7% against the U.S. dollar during 2001, as the real/U.S. dollar exchange rate fell from 1.9554 reais per U.S. dollar at December 31, 2000 to 2.3204 reais at December 31, 2001, and 34.3% during 2002 as the real/U.S. dollar exchange rate fell to 3.5333 reais at December 31, 2002. At the same time, the Central Bank increased the base interest rate in 2001 from 15.25% at January 17, 2001, to 19.0% at December 19, 2001 and to 25.0% at December 18, 2002. The Central Bank increased the base interest rate to 25.5% on January 22, 2003 and to 26.5% on February 19, 2003.

During 2003, the real appreciated 22.3% as the real/U.S. dollar exchange rate fell to 2.8892 reais at December 31, 2003.

The Central Bank increased the base interest rate to 25.5% on January 22, 2003 and to 26.5% on February 19, 2003 and decreased it to 16.5% on January 21, 2004, to 16.25% on March 17, 2004 and to 16.0% on April 14, 2004.

The following table shows Brazilian inflation as measured by the IGP-M and IPC-FIPE, devaluation (appreciation) of the real against the U.S. dollar and the period-end exchange rates and average exchange rates for the periods indicated:

Sources: Fundação Getúlio Vargas and the Central Bank.

During the four-month period ended April 30, 2004, the real depreciated 1.9% against the U.S. dollar from R$2.8892 at December 31, 2003 to R$2.9447 at April 30, 2004.

Our results of operations and financial condition are significantly affected by Brazilian economic conditions, particularly by exchange rate movements, inflation rates and interest rate levels.

We had total foreign currency-denominated indebtedness of R$3,012.7 million at December 31, 2003, and we anticipate that we may incur substantial foreign currency-denominated indebtedness in the future. In the event of further significant devaluations of the real in relation to the U.S. dollar or other currencies, the cost of servicing our foreign currency-denominated obligations would increase as measured in reais, particularly as our tariff and other revenues are

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based solely in reais. In addition, any significant devaluation of the real will increase our financial expenses as a result of foreign exchange losses that we must record. For example, the 34.3% devaluation of the real in 2002 increased our financial expenses and negatively affected our overall results of operations for that year. The 32.4% devaluation of the real in 1999 was the primary factor in our net loss for that year.

Inflation affects our financial performance by increasing our costs of services rendered and operating expenses. In addition, all of our real-denominated debt is indexed to take into account the effects of inflation. Most of our real-denominated debt provides for inflation-based increases in the respective principal amounts of that debt, which increases are determined by reference to the Taxa Referencial-TR (daily government interest rate) plus an agreed margin. We cannot assure you that we will be able, in future periods, to increase tariffs to address, in full or in part, the effects of inflation.

Interest rate levels in Brazil are closely linked to exchange rate movements and inflation rates. High domestic interest rates result in increases in our financial expenses and also negatively affect our ability to obtain financing, on a cost-effective basis, in domestic capital and lending markets. As a result, we may continue to require substantial amounts of foreign currency-denominated debt in order to satisfy our liquidity and capital resource requirements, which increases our exposure to exchange rate movements as discussed above.

Effects of Drought and Electrical Energy Crisis

Much of Brazil experienced a prolonged and severe drought during 2000 and 2001. The São Paulo Metropolitan Region, in particular, faced its worst drought in 65 years. As a result, from mid-June to mid-September in 2000, we rationed water in the south of the São Paulo Metropolitan Region, affecting approximately 3.5 million people, or 20% of the total population of this Region. Under this rationing, water was made available to our customers for only two out of every three days. During this period of rationing, we also reduced our total water production by 8%. From April 2001 through January 2002, we rationed water in the west of the São Paulo Metropolitan Region, affecting approximately 300,000 people. Under this rationing, water was made available to these 300,000 customers for only 40 out of every 78 hours. The year of 2003 was also marked by low levels of rainfall and drought. From October to December 2003 we rationed water on the western part of the São Paulo Metropolitan Region, served by the Alto Cotia System, affecting approximately 450.000 people, or 2% of the Region’s population. Under this rationing water was available to those customers for three days, followed by two days of rationing. During this period our total water production volume was reduced in 0.8%. As a result of the drought, our revenues declined as our volume of water billed decreased, and our costs increased because of required expenditures to protect and develop water sources and to preserve water quality. Any recurrence of drought for a lengthy period could cause us to again ration water and thereby have a negative effect on our results of operations and financial condition.

Brazil experienced a severe shortage of capacity to generate and transmit electrical power during 2001 and through March 2002, primarily due to the drought affecting the country, which reduced hydroelectric power generation, as well as to a lack of investment in power generation. Because our operations require a significant consumption of electrical energy, a substantial shortage of electrical energy could result in an interruption of our services. In addition, as a

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result of this energy crisis and the increased surcharges for electricity, our customers reduced their use of washing machines, dishwashers and water generally, which affected demand for water services and, consequently, our revenues.

Interest on Shareholders’ Equity

Brazilian corporations are permitted to distribute dividends in the form of a tax-deductible notional interest expense on shareholders’ equity in accordance with Law No. 9, 249, dated December 26, 1995, as amended. The rate at which tax-deductible interest may be paid is limited to the product of the average Taxa de Juros de Longo Prazo-TJLP (a long-term interest rate published by the Brazilian government) and shareholders’ equity during the relevant period and cannot exceed the greater of:

Distribution of interest on our shareholders’ equity is a tax-deductible expense, for both income tax and social contribution purposes. The amount paid to shareholders as interest on shareholders’ equity, net of any withholding tax, may be included as part of any mandatory dividend. We are required to pay a mandatory dividend of not less than 25% of our net income, subject to some exceptions and adjustments.

In 1998, 2000 and 2001, we paid our shareholders interest on shareholders’ equity in lieu of dividends. We did not pay interest on shareholders’ equity or dividends in 1999, as we were not required to pay a mandatory dividend in light of our net loss in that year. In 2002, we announced that we would pay our shareholders interest on shareholders’ equity in June 2003. In April, May and November 2003, and January 2004, we announced that we would pay our shareholders interest on shareholders’ equity within 60 days after our 2004 annual shareholders’ meeting. In February 2004, we announced that we would pay our shareholders interest on shareholders’ equity within 60 days after our 2005 annual shareholders’ meeting.

Interest on shareholders’ equity is recorded as part of, but is immediately reversed under, the financial expenses line item in our statement of operations. See note 18 to our audited financial statements. The tax deduction relating to distributions of interest on shareholders’ equity is reflected under the income tax and social contribution line items in our statement of operations. This tax benefit consequently contributes positively to net income (loss) in our statement of operations.

Critical Accounting Policies

Critical accounting policies are those that are both (1) important to the portrayal of our financial condition and results of operations and (2) require management’s most difficult, subjective or complex judgments, often as a result of the need to make estimates about the effect of matters that are inherently uncertain. As the number of variables and assumptions affecting the possible future resolution of the uncertainties increase, those judgments become even more subjective and complex. In order to provide an understanding about how our management forms its judgments about future events, including the variables and assumptions underlying the

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estimates, and the sensitivity of those judgments to different circumstances, we have identified the critical accounting policies discussed below.

Our management discussion and analysis of financial condition and results of operations are based upon our primary financial statements, which have been prepared in accordance with the Corporate Law Method and which differ in significant respects from U.S. GAAP. In addition, we have included a discussion on material differences between the Corporate Law Method and U.S. GAAP related to each critical accounting policy in our audited financial statements.

Allowance for doubtful accounts

We maintain an allowance for doubtful accounts in an amount we consider sufficient to cover any probable losses on realization of our accounts receivable from our customers. The accounting policy adopted by Sabesp for establishing the allowance for doubtful accounts includes:

Provisions to the allowance for doubtful accounts are included in selling expenses, net of recoveries. The net charge to this allowance was R$37.6 million in 2003, R$162.9 million in 2002 and R$153.8 million in 2001.

Our methodology for determining the allowance for doubtful accounts receivable requires significant estimates, considering a number of factors including historical collection experience, current economic trends, estimates of forecast write-offs, the aging of the accounts receivable portfolio and other factors. While we believe that the estimates we use are reasonable, actual results could differ from those estimates.

In addition, we have substantial assets consisting of amounts owed by the State. These amounts consist primarily of accounts receivable for services, reimbursement for pensions paid and amounts due under our December 2001 and March 2004 agreement with the State. We do not reserve against any of these amounts owed by the State due to the following factors:

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As of December 31, 2003, the amounts owed to us by the State consisted of R$164.2 million in accounts receivable related to the provision of services (net of R$401.7 million of amounts applied in respect of dividends payable to the State) and R$491.0 million in reimbursement for pensions paid on behalf of the State government, and we expect that these amounts will continue to increase in the future.

If the State does not pay the amounts it owes to us, our cash flows, results of operations and financial condition will be impacted.

For U.S. GAAP purposes, the amounts receivable from the State Government for pensions paid is not recorded as accounts receivable, but rather is included as part of our estimated pension and other postretirements obligations. Only amounts effectively reimbursed by the State are presented as additional paid-in capital. No additional differences have been identified between accounting policies for accounts receivable and allowance for doubtful accounts under the Corporate Law Method and U.S. GAAP.

Indemnities receivable

Indemnities receivable is a long-term asset representing amounts receivable from the municipalities of Diadema and Mauá as indemnification for the unilateral withdrawal by those authorities of our water and sewage service concessions. At December 31, 2003, this asset amounted to R$148.8 million.

Under our concession agreements we invested in the construction of water and sewage systems in these municipalities to meet our concession service commitments. Upon the unilateral termination of the Diadema and Mauá concessions, our assets were impounded by the municipal authorities, which took on the responsibility of providing water and sewage services in these areas. At that time, we reclassified our property, plant and equipment balances relating to the impounded assets to long-term assets (indemnities receivable) and recorded impairment charges to reduce the carrying value of the assets to the estimated recoverable amounts for which we had contractually agreed as fair compensation with the relevant authorities.

Our rights to the recovery of these amounts are being disputed by the municipalities and no amounts have been received to date. Based on the advice of legal counsel, we continue to believe that we have the right to receive such amounts and we continue to monitor the status of the legal proceedings. However, the ultimate amounts to be received, if any, will most likely be subject to a final court decision. As such, actual amounts received could differ from those recorded.

No differences have been identified between accounting policies on compensation for concession termination adopted under the Corporate Law Method and U.S. GAAP.

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Property, plant and equipment

Valuation of long-lived assets

We review long-lived assets, primarily buildings, water and sewage system assets and acquired concession assets to be held and used in our business, for the purpose of determining and measuring impairment on a recurring basis or when events or changes in circumstances indicate that the carrying value of an asset or group of assets may not be recoverable. Under the Corporate Law Method, we evaluate possible impairment by determining whether projected future operating income is sufficient to absorb the depreciation or amortization of long-lived assets, within the context of the balance sheet as a whole.

Studies supporting the write-offs for obsolescence and abandonment of projects are conducted by our engineering department in the accounting period of the write-offs based on undiscounted cash flow projections, and approved by our Board of Directors. We monitor the carrying value of our property, plant and equipment on an on-going basis and adjust the net book value to assure future projected operations will be sufficient to recover the carrying value of the assets. Depreciation is provided using the straight-line method based on the estimated useful lives of the underlying assets. When possible, depreciation rates are adjusted to take account of changes in estimated prospective depreciable lives as assets are replaced.

U.S. GAAP Statement of Financial Accounting Standards, or SFAS, No. 144, “Accounting for the Impairment of Long-lived Assets”, requires companies to periodically evaluate the carrying value of long-lived assets to be held and used, and for long-lived assets to be disposed of, when events and circumstances warrant such a review. Companies are required to identify the smallest unit, or group, of assets at which cash flows generated by the group can be measured. The projected undiscounted cash flows from each such asset group is compared to its carrying value. For those assets for which the projected cash flows are not sufficient to recover the carrying values, a loss is recognized to the extent that the carrying value exceeds the fair market value of the assets.

In evaluating impairment of our long-lived assets, we make significant assumptions and estimates regarding matters that are inherently uncertain, including projections of future operating income and cash flows, future growth rates, and the remaining useful lives of the assets, among others. In addition, projections are computed over an extended period of time, which subjects those assumptions and estimates to an even larger degree of uncertainty. While we believe that the estimates we use are reasonable, the use of different assumptions could materially affect our valuations.

No adjustments have been included in the reconciliation from the Corporate Law Method to U.S. GAAP to take account of differences between the measurement criteria, because no impairment provisions were required based on our analysis of cash flows. Losses on the write-off of property, plant and equipment arose primarily from adjustments upon withdrawal of concession assets, construction-in-progress projects which were deemed no longer to be economically feasible and obsolescence write-offs.

Depreciation of property, plant and equipment

Depreciation of our property, plant and equipment, primarily buildings, water and sewage service assets and concession assets acquired, is provided using the straight-line method based on the estimated useful lives of the underlying assets, which generally do not exceed the contractual terms of our concession agreements.

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While we believe that our estimates of current remaining estimated lives is reasonable, the use of different assumptions and estimates and changes in future circumstances, could affect the remaining useful lives of our asset, which could have a significant impact on our results of operations in the future.

Loss contingencies

We are a party to a number of legal proceedings involving significant monetary claims. These legal proceedings include, among others, tax, labour, condemnation and other proceedings. We accrue for probable losses resulting from these claims and proceedings when we determine that the likelihood that a loss has occurred is probable and the amount of such loss can be reasonably estimated. As such, we are required to make judgments regarding future events for which we often seek the advice of legal counsel. As a result of the significant judgment required in assessing and estimating these loss contingencies, actual losses realised in future periods could differ significantly from our estimates.

No differences have been identified between accounting policies on loss contingencies adopted under the Corporate Law Method and U.S.GAAP.

Pension plans

Plan G1

We sponsor a funded defined-benefit pension and benefits fund (“Plan G1”), which is operated and administered by SABESPREV—Fundação SABESP de Seguridade Social.

Under the Corporate Law Method, prior to January 1, 2002, we recorded pension expense on an accrual basis based on our contributions to the plan. Effective January 1, 2002, in accordance with the issuance of a new accounting standard, we began accounting for our actuarial obligation under Plan G1. As permitted under this standard, we are amortizing the transition obligation related to the actuarial value of our obligation at the date of adoption of the new standard over a period of five years, which is recorded in our statements of operations as an extraordinary item, net of the related tax impacts. During 2003, pension costs charged to income totaled R$88.8 million, of which R$35.1 million (net of tax effects totaling R$18.1 million) was presented as “extraordinary item net of income tax and social contribution”. The remaining R$53.7 million was charged to cost of services rendered, general and administrative expenses and selling expenses.

Under U.S. GAAP, we had already adopted the provisions of SFAS No. 87, “Employers’ Accounting for Pensions” prior to 2002, which requires that we recognize an actuarial liability for pension benefits under Plan G1. While the actuarial assumptions used for US GAAP are the same as those used in determining the actuarial liability under the Corporate Law Method, pension costs and obligations under U.S. GAAP and the Corporate Law Method are not the same, mainly due to differences related to the first year of application, the amortization of the initial transition obligation, amortization periods for other actuarial gains and losses, and actuarial calculation methods, among others.

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Plan G0

Pursuant to a law enacted by the State Government, some of its employees who provided service to Sabesp prior to May 1974 and retired as employees of Sabesp acquired a legal right to receive supplemental pension payments (which rights are referred to as “Plan G0”). These amounts are paid by us on behalf of the State and are claimed as reimbursement from the State. As such, no pension expense related to Plan G0 is recorded and no future obligations are recorded under the Corporate Law Method.

Consistent with the guidance in SEC Staff Accounting Bulletin Topic 5-T (“SAB No. 5-T”), under US GAAP, we recognize the costs and obligations associated with Plan G0 supplemental pension benefits on a “push-down basis,” as the Company is the recipient of the benefits of the employee service for which the supplemental pension benefits are made. The Plan G0 benefit obligation and expenses are accounted for in accordance with SFAS No. 87. Eventual amounts received as reimbursement from the State Government, if any, are treated as additional paid-in-capital. As such, Plan G0 is considered unfunded for purposes of US GAAP.

Assumptions

Accounting for these pension benefits under the Corporate Law Method and US GAAP, requires an extensive use of assumptions, including those related to the inflation adjusted discount rate, expected return on plan assets, the expected rate of future compensation increases received by our employees, mortality rates, and turnover. We review each assumption annually, with the assistance of our actuarial consultant who provides guidance in establishing the assumptions. The assumptions are selected to represent the weighted average expected experience over time and may differ in any one year from actual experience due to changes in the capital markets and the overall economy, regulatory events, judicial rulings, and higher or lower actual rates of withdrawal, turnover or mortality within the population of our employee participants. While we believe that our assumptions used are appropriate, differences in actual experience or changes in assumptions could affect the amount of pension expense that we recognize.

The present value of our pension obligations was based on a discount rate of 12.32%, 15.56% and 10.50% for 2003, 2002 and 2001, respectively. Our pension obligation and expense increases as the discount rate is reduced.

Our expected return on plan assets for Plan G1 is determined by evaluating the asset class return expectations with our advisors, as well as actual, long-term historical results of our asset returns. For 2003, we used an expected rate of return on assets assumption of 12,06%, which is expected to remain the same for 2004. The expected return on assets assumption is based on a targeted allocation of investments in accordance with the investment strategies of the plans. We believe that actual long-term asset allocation on average will approximate this targeted allocation.

Certain Transactions with Controlling Shareholder

Reimbursement due from State Government

Reimbursement due from the State Government for pensions paid represent supplementary pensions (Plan G0) and leave benefits (sabbatical paid leave) that we pay, on behalf of the State Government, to former employees of the State-owned companies which merged to form Sabesp. These amounts are reimbursed to us by the State Government, as primary obligor. However,

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these amounts have been outstanding for a long period. As described under “-Accounts receivable and allowance for doubtful accounts” above, we account for these as long term assets, and we do not reserve against such accounts receivable as we expect to recover these amounts and loss is not considered probable. For U.S. GAAP purposes, these accounts receivable amounts are charged to income when paid, and recognized on a push-down basis as mentioned above. Reimbursements received are recognised as additional paid-in capital.

Accounts receivable from the State Government for water and sewage service provided

Certain accounts receivable from the State Government for water and sewage services provided to State-owned entities have been overdue for a long period. As described under “-Accounts receivable and allowance for doubtful accounts” above, we account for these as long term assets, and we do not reserve against such accounts receivable as we fully expect to recover these amounts and loss is not considered probable.

Use of certain assets owned by the State Government

We currently use certain reservoirs in the Alto Tietê System and the Billings and Guarapiranga reservoirs which are owned indirectly by the State Government. We currently do not pay any fees with respect to the use of these reservoirs. However, we are responsible for maintaining and meeting the operating costs of these reservoirs. If these facilities had not been made available for our use, we would have had to obtain water from more distant sources, which would be more costly. The State does not incur operating costs on our behalf.

The arrangement not to pay any fees to the State of São Paulo for the use of certain reservoirs of the Alto Tietê System is addressed by a number of formal agreements first entered into on March 31, 1992 and on April 24, 1997 and later amended on March 16, 2000 and on November 21, 2001. As part of the arrangement, we agreed to fund 100% of the estimated costs of the 1992 agreement (equal to R$27.8 million) and 75% of the 1997 agreement (equal to R$63.4 million) which was already disbursed, and the Government of the State of São Paulo, through the State Department of Water and Energy, agreed to fund approximately 25% of the estimated costs of the 1997 agreement (equal to R$21.1 million), to construct ducts, tunnels and other facilities to interconnect the Tietê River with the Biritiba and Jundiaí reservoirs and other bodies of water in exchange for our use of the reservoirs during a 30-year period. The amendments to the 1997 agreement increased our obligations under such agreement by R$5.9 million.

We have the right to draw water and release emissions in the reservoirs in the Alto Tietê system during a 30-year period which began in 1997. We capitalize our expenditures on the facilities we construct. The project subject to the 1992 agreement was concluded and the assets entered operations in 1994. The project subject to the 1997 contract became operational in 2002 and is being depreciated on a straight-line basis through 2027.

The arrangement for use of the Billings and Guarapiranga reservoirs is provided for through a grant issued by the State Department of Water and Energy. Sabesp has a right to use these reservoirs so long as Sabesp remains responsible for maintaining and meeting their operating costs.

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Recent Developments

Changes to Tax Law

In December 2002, Brazilian tax law was amended to change PASEP (Programa de Formação do Patrimônio do Servidor Público) to reduce the effect of double taxation, and to tax added value by allowing to record PASEP payments as credits to be compensated against future amounts. Our cost of services and selling, general and administrative expenses from 2003 onward thus show PASEP credits as offsetting amounts. However, any PASEP payments made by Sabesp in relation to salaries and benefits cannot be recorded as credits.

São Bernardo do Campo

On December 19, 2003, we agreed to purchase the water and sewage assets of the municipality of São Bernardo do Campo, thus obtaining the right to provide water and sewage services in that municipality, which had previously been one of our bulk sale customers. The economic value of the transaction was R$415.5 million, which was recorded as an intangible asset. The municipality owed us receivables in the amount of R$265.4 million when subjected to monetary adjustment, and this amount was recorded as a recovery against allowances for doubtful accounts. The R$150.0 million balance is being paid in cash, in instalments through November 2004.

Voluntary Redundancy Plan

In 2003 we initiated a voluntary redundancy plan in order to reduce headcount. Salary and related costs with respect to cost of services rendered, selling expenses and general administrative expenses have all decreased as a result of this plan.

Results of Operations

The following table sets forth, for the periods indicated, certain items in our statement of operations, each expressed as a percentage of net operating revenue:

2003 Compared to 2002

Net Operating Revenue

Net operating revenue for 2003 increased by R$342.8 million, or 9.1%, to R$4,109.9 million from R$3,767.1 million for 2002.

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Water net operating revenue from delivery of water, bulk water sales and services such as connections to water services increased by R$182.3 million, or 8.2%, to R$2,403.5 million from R$2,221.2 million for 2002. This increase was primarily due to an average increase of 18.95% in tariffs, which came into effect on August 29, 2003, together with the continuing effect of an average tariff increase of 8.2% in August 2002. The volume of water distributed in 2003 decreased by 0.3%.

Sewage net operating revenue increased by R$160.4 million, or 10.4%, to R$1,706.3 million from R$1,545.9 million for 2002. This increase was due primarily to an increase in tariffs, as sewage tariffs are set by reference to water tariffs, together with a 0.4% increase in volume.

Cost of Services Rendered

Cost of services rendered for 2003 increased by R$231.8 million, or 12.8%, to R$2,046.8 million from R$1,815.0 million for 2002. As a percentage of net operating revenue, costs of services rendered increased to 49.8% for 2003 from 48.2% in 2002. The increase in cost of services was primarily due to the following factors:

Cost of services in 2003 were offset by PASEP tax credits in the amount of R$20.3 million, as discussed above and by a decrease of R$4.8 million, or 2.3%, in the costs of third-party services, mainly for technical maintenance services.

Gross Profit

As a result of the above factors, gross profit for 2003 increased by R$110.9 million, or 5.7%, to R$2,063.1 million from R$1,952.2 million for 2002. As a percentage of net operating revenue, gross profit decreased to 50.2% for 2003 from 51.8% for 2002.

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Selling Expenses

Selling expenses for 2003 decreased by R$87.8 million, or 22.8%, to R$297.3 million from R$385.1 million for 2002. As a percentage of net operating revenue, selling expense decreased to 7.2% for 2003 from 10.2% for 2002.

The decrease in selling expenses was primarily due to the following factors:

These decreases were offset by the following:

General and Administrative Expenses

General and administrative expenses for 2003 increased by R$27.7 million, or 12.3%, to R$253.7 million from R$226.0 million for 2002. As a percentage of net operating revenue, general and administrative expenses increased to 6.2% for 2003 from 6.0% for 2002. The increase in general and administrative expenses primarily reflected:

These increases were offset by:

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Financial Expenses, Net

Net financial expenses consist principally of interest on our indebtedness, foreign exchange losses in respect of indebtedness and inflation-based indexation charges relating to indebtedness, offset partially by interest income on cash and time deposits and inflation-based indexation accruals mainly relating to agreements entered into with some customers to settle overdue accounts receivable.

Net financial expenses for 2003 decreased by R$1,929.8 million, or 84.8%, to R$346.5 million from R$2,276.3 million for 2002. As a percentage of net operating revenue, net financial expenses decreased to 8.4% for 2003 from 60.4% for 2002.

The absolute and relative decreases in net financial expenses were primarily due to a foreign exchange gain in 2003 as compared to 2002, reflecting the effects on our foreign currency-denominated debt of the significant recovery of the real against the U.S. dollar in 2003. Foreign exchange gain was R$540.6 million for 2003 as compared to the foreign exchange loss of R$1,345.3 million in 2002.

Interest and other charges on real- and foreign-currency loans and financings for 2003 increased by R$46.2 million, or 6.2%, to R$785.0 million from R$738.9 million for 2002. This increase was principally due to:

At December 31, 2003, all of our real-denominated debt was floating rate debt and indexed to take into account the effects of inflation.

Interest income for 2003 increased by R$1.0 million, or 1.4%, to R$70.0 million from R$69.0 million for 2002. This increase was primarily due to increase in interest earned from cash and time deposits.

In addition, indexation accruals relating to overdue accounts receivable increased by R$163.2 million to R$241.4 million for 2003 as compared to R$78.2 million for 2002. This increase was principally due to (i) a renegotiation of existing agreements with some customers to pay overdue accounts receivable over time based on inflation-based indexation arrangements, (ii) recognition of R$75.0 million resulting from the monetary variation on accounts receivables from the municipality of São Bernardo do Campo, recorded in connection with the purchase agreement and (iii) the recognition of R$58.5 million resulting from monetary variation recorded on amounts due from the State in connection with the settlement agreement reached with the State Government.

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Operating Profit (Loss)

As a result of the above factors (including, in particular, foreign exchange gains) operating income for 2003 totaled R$1,165.5 million as compared to the operating loss of R$935.3 million for 2002.

Non-Operating Income (Expenses), Net

Net non-operating expenses for 2003 increased by R$51.0 million, or 1,490.4%, to R$54.5 million in 2003 from R$3.4 million for 2002. The non-operating expenses were primarily due to R$61.7 million in dispositions and write-offs of obsolete and other non-productive fixed assets in 2003 as compared to R$16.5 million in dispositions and write-offs in 2002.

The decrease in non-operating income of R$8.5 million, or 49.4%, to R$8.7 million in 2003, from R$17.2 million in non-operating income in 2002, was primarily due to decreases in donations of property, plant and equipment received in 2003 and to decreases income from the provision of technical assistance to municipalities where we do not provide water and sewage services.

Income Tax and Social Contribution

Income tax and social contribution for 2003 increased by R$566.0 million, or 175.0%, to an expense of R$242.6 million from benefit of R$323.3 million for 2002.

Although for 2003 we had pre-tax income, we had an income tax benefit which was directly related to the interest on shareholders’ equity paid or accrued within that year which was not charged to pre-tax income as it is treated in a manner similar to a dividend but generates a tax deductible expense. That benefit amounted to R$171.4 million, representing approximately 15.4% of the R$1,111.1 million pre-tax income in 2003. See “-Interest on Shareholders’ Equity.”

Although for 2002 we had pre-tax loss, we had an income tax benefit which was directly related to the interest on shareholders’ equity paid and or accrued within that year which was not charged to pre-tax income as it is treated in a manner similar to a dividend but generates a tax deductible expense.

For both 2003 and 2002, the statutory composite tax rate was 34%.

Extraordinary Item

In accordance with the requirements of the Brazilian securities commission, under CVM Deliberation No. 371/2000, we have elected to recognize the actuarial liability calculated at December 31, 2001 with respect to our defined benefits pension plan (Plan G1) on a straight-line basis against earnings over the five years ending December 31, 2006.

As permitted, the expense is presented as an extraordinary item of R$35.1 million (net of tax effects of R$18.1 million).

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Net Income (Loss)

As a result of the above factors, we had net income for 2003 of R$833.3 million, compared to a net loss of R$650.5 million for 2002.

2002 Compared to 2001

Net Operating Revenue

Net operating revenue for 2002 increased by R$332.4 million, or 9.7%, to R$3,767.1 million from R$3,434.8 million for 2001.

Water net operating revenue increased by R$179.0 million, or 8.8%, to R$2,221.2 million from R$2,042.3 million for 2001. This increase was primarily due to an average increase of 8.2% in tariffs, effective on August 1, 2002. The increase in water net operating revenue was also due to an increase of 4.2% in volume of water distributed, primarily relating to the return of customer consumption to regular levels following the end of the Brazilian energy consumption restrictions in March 2002.

Sewage net operating revenue increased by R$153.4 million, or 11.0%, to R$1,545.9 million from R$1,392.5 million for 2001. This increase was due primarily to increases in revenues from water services, because our sewage charges are generally fixed as a function of the monthly water charges. See “Item 4. Information on the Company-Tariffs”.

Cost of Services Rendered

Cost of services rendered for 2002 increased by R$224.5 million, or 14.1%, to R$1,815.0 million from R$1,590.4 million for 2001. As a percentage of net operating revenue, costs of services rendered increased to 48.2% for 2002 from 46.3% in 2001. The increase in cost of services was primarily due to the following factors:

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Gross Profit

As a result of the above factors, gross profit for 2002 increased by R$107.8 million, or 5.8%, to R$1,952.2 million from R$1,844.3 million for 2001. As a percentage of net operating revenue, gross profit decreased to 51.8% for 2002 from 53.7% for 2001.

Selling Expenses

Selling expenses for 2002 increased by R$52.5 million, or 15.8%, to R$385.1 million from R$332.6 million for 2001. As a percentage of net operating revenue, selling expense increased to 10.2% for 2002 from 9.7% for 2001.

The increase in selling expenses was primarily due to the following factors:

General and Administrative Expenses

General and administrative expenses for 2002 increased by R$22.9 million, or 11.3%, to R$226.0 million from R$203.1 million for 2001. As a percentage of net operating revenue, general and administrative expenses increased to 6.0% for 2002 from 5.9% for 2001. The increase in general and administrative expenses primarily reflected:

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Financial Expenses, Net

Net financial expenses consist principally of interest on our indebtedness, foreign exchange losses in respect of indebtedness and inflation-based indexation charges relating to indebtedness, offset partially by interest income on cash and time deposits and inflation-based indexation accruals mainly relating to agreements entered into with some customers to settle overdue accounts receivable.

Net financial expenses for 2002 increased by R$1,171.1 million, or 106.0%, to R$2,276.3 million from R$1,105.2 million for 2001. As a percentage of net operating revenue, net financial expenses increased to 60.4% for 2002 from 32.2% for 2001.

The absolute and relative increases in net financial expenses were primarily due to a higher foreign exchange loss in 2002 as compared to 2001, reflecting the effects on our foreign currency-denominated debt of the significant devaluation of the real against the U.S. dollar in 2002. Foreign exchange loss increased to R$1,345.3 million for 2002 as compared to the foreign exchange loss of R$387.0 million in 2001.

Interest and other charges on real- and foreign-currency loans and financings for 2002 increased by R$123.0 million, or 20.0%, to R$738.1 million from R$615.1 million for 2001. This increase was principally due to:

At December 31, 2002, all of our real-denominated debt was floating rate debt and indexed to take into account the effects of inflation.

Interest income for 2002 increased by R$8.7 million, or 14.4%, to R$69.0 million from R$60.3 million for 2001. This increase was primarily due to higher average balances of cash and time deposits.

In addition, indexation accruals relating to overdue accounts receivable increased by R$34.8 million to R$78.2 million for 2002 as compared to R$43.4 million for 2001. This increase was principally due to a renegotiation of existing agreements with some customers to pay overdue accounts receivable over time based on inflation-based indexation arrangements.

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Operating Profit (Loss)

As a result of the above factors (including, in particular, foreign exchange losses), the operating loss for 2002 totaled R$935.3 million as compared to the operating profit of R$203.4 million for 2001.

Non-Operating Income (Expenses), Net

Net non-operating expenses for 2002 decreased by R$73.5 million, or 95.6%, to R$3.4 million from R$76.9 million for 2001. The non-operating expenses were primarily due to a R$16.5 million net loss on dispositions and write-offs of obsolete and other non-productive fixed assets in 2002 as compared to a net loss of R$84.9 million in 2001.

The decrease in net non-operating expenses was partially the result of an increase of R$5.4 million, or 43.8%, to R$17.2 million in 2002, from R$11.8 million in non-operating income in 2001. This increase, in turn, was primarily due to increases in donations of property, plant and equipment and income from the provision of technical assistance to municipalities where we do not provide water and sewage services.

Income Tax and Social Contribution

Income tax and social contribution benefit for 2002 increased by R$233.6 million, or 260.4%, to R$323.3 million from R$89.7 million for 2001.

Although for 2001 we had pre-tax income, we had an income tax benefit which was directly related to the interest on shareholders’ equity paid and or accrued within that year which was not charged to pre-tax income as it is treated in a manner similar to a dividend but generates a tax deductible expense. Such benefit amounted to R$166.5 million, representing approximately 131.6% of the R$126.5 million pre-tax income in 2001.

For 2002, although the tax effect arising from interest on shareholder’s equity decreased to R$36.8 million, the pre-tax loss amounting to R$938.7 million was the primary reason for the R$233.6 million increase in income tax and social contribution benefit for the year. See “Interest on Shareholders’ Equity” above.

For both 2002 and 2001, the statutory composite tax rate was 34%.

Extraordinary Item

In accordance with the requirements of the Brazilian securities commission, under CVM Deliberation No. 371/2000, we have elected to recognize the actuarial liability calculated at December 31, 2001 with respect to our defined benefits pension plan (Plan G1) on a straight-line basis against earnings over the five years ending December 31, 2006.

Under this CVM Deliberation, the expense recognition is presented as an extraordinary item of R$35.1 million (net of tax effects of R$18.1 million).

Net Income (Loss)

As a result of the above factors, we had a net loss for 2002 of R$650.5 million, compared to net income of R$216.2 million for 2001.

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Liquidity and Capital Resources

Our principal liquidity and capital resources requirements include the following:

Our primary sources of liquidity and capital resources consist of the following:

We believe that we have sufficient sources of liquidity and capital to meet our anticipated debt-service, capital expenditure and other requirements for the next few years, although we cannot assure you in this regard.

We generate substantial funds from our operations. We generated cash provided by operating activities of R$1,657.0 million in 2001, R$1,764.8 million in 2002, and R$1,655.3 million in 2003. We had net income of R$216.2 million in 2001, a net loss of R$650.5 million in 2002, and net income of R$833.3 million in 2003.

We have not immediately realized cash from a significant portion of our accounts receivable, primarily accounts receivable owed by the State of São Paulo and certain municipal governments. We do not reflect these accounts receivable in net cash provided by operating activities until cash is actually received by us.

We signed a protocol of understanding in September 1997 with the State of São Paulo which provides for the settlement of unpaid accounts receivable for water and sewage services due from the State using dividends payable by us to the State as one of our shareholders. We have in the past applied dividends in the form of interest on shareholders’ equity due to the State of São Paulo to settle a corresponding amount of unpaid accounts receivable. During 2003, our Board of Directors declared dividends, in the form of interest on shareholders’ equity, in an aggregate amount of R$504.1 million to be paid in June 2004. Accordingly, at December 31, 2003 the State of São Paulo was entitled to receive R$360.7 million to be offset against unpaid accounts receivable.

On April 29, 2002, our Board of Directors declared dividends, in the form of interest on shareholders’ equity, in an aggregate amount of R$108.2 million, to be paid in June 2003 to shareholders of record as of June 17, 2002. We expect the State to apply the entire amount of

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this declared dividend payable to the State, or R$77.4 million, to Sabesp in respect of current and future accounts receivable owed to us by the State or its controlled entities.

On April 24, 2003, our Board of Directors declared dividends, in the form of interest on shareholders’ equity, in an aggregate amount of R$40.2 million, to be paid within 60 days after our 2004 annual shareholders’ meeting to shareholders of record as of May 8, 2003. On May 29, 2003, our Board of Directors declared dividends, in the form of interest on shareholders’ equity, in an aggregate amount of R$118.2 million, to be paid within 60 days after our 2004 annual shareholders’ meeting to shareholders of record as of June 16, 2003. On November 20, 2003 and January 8, 2004, our Board of Directors approved the payment of dividends, in the form of interest on shareholders’ equity, in the amount of, respectively, R$154.9 million and R$190.8 million, to be paid within 60 days after our 2004 annual shareholders’ meeting to shareholders of record as of December 15, 2003 and January 19, 2004. On February 26, 2004, our Board of Directors approved the payment of dividends, in the form of interest on shareholders’ equity, in the amount of R$39.3 million, to be paid within 60 days after our 2005 shareholders’ meeting to shareholders of record as of March 15, 2004. We currently are unable to determine the amount, if any, of its portion of these declared dividends that the State will apply to current and future accounts receivable owed to us by the State or its controlled entities.

In December 2001, we entered into an agreement with the State Government under which the State, among other things, agreed to transfer the reservoirs in the Alto Tietê System in exchange for the cancellation of a portion of accounts receivable then due from the State and reimbursement then due from the State Government for pensions paid by us. The transfer of assets contemplated by this agreement will be a non-cash transaction.

Under the December 2001 agreement, in July and August 2002, a State-owned construction company, on behalf of the State, and an independent appraisal firm, on behalf of Sabesp, presented their valuation reports relating to the reservoirs. The appraisals contained in these reports were in the amounts of R$335.8 million and R$341.2 million, respectively. Under the December 2001 agreement, the arithmetic average of these appraisals will be deemed to be the fair value of the reservoirs. Since we have made investments in these reservoirs, the arithmetic average of the appraisals submitted to our Board of Directors, R$300.9 million, was net of a percentage corresponding to these investments. Our Board of Directors approved the valuation reports and they will be submitted for approval to an extraordinary general meeting of shareholders. However, we cannot assure you as to when a final determination as to the fair value of these reservoirs will be made, when the transfer of the reservoirs will occur or when cancellation of accounts receivable will take place.

The December 2001 agreement also provided that the legal advisors of the State Finance Secretariat would carry out specific analyses, which have commenced, to ensure agreement among the parties as to the methodology employed in determining the amount of reimbursement for pension benefits owed to Sabesp by the State. The commencement of payments with respect to pension amounts owed to Sabesp by the State has been postponed until these analyses are completed, the appraisal report is approved and the credit assignments relating to the transfer of the reservoirs described above are formalized. Under the December 2001 agreement, the original first payment was to be made in July 2002. We cannot assure you as to when agreement among the parties will be reached or when the State will commence making payments in respect of these pension amounts.

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On March 22, 2004, the State of São Paulo and Sabesp executed the First Amendment to the December 2001 agreement. Under this amendment the State of São Paulo acknowledges a debt before Sabesp of R$581.8 million, related to unpaid accounts receivable from the State until February 29, 2004, and Sabesp acknowledges the aggregate amount of R$518.7 million due to the State of São Paulo as dividends in the form of interest on shareholder’s equity.

Accordingly, Sabesp and the State agreed to set-off each other’s credit up to the limit of R$360.7 million in seven equal and consecutives monthly installments from June to December 2004. The remaining amount of R$221.1 million of the State’s consolidated debt shall be paid on 60 consecutives installments of R$3.7 million starting on May 30, 2004. Such installments will be indexed according to the IPCA on a monthly basis starting March 2004, plus an interest rate of 0.5% per month, except for the first twelve installments, which shall be paid at the nominal amount without any indexation or interest applied, the aggregate amount of which being R$44.2 million.

We anticipate that net cash provided by operating activities will continue to be the single largest source of liquidity and capital resources in future years and financial periods.

At December 31, 2003, our domestic debt of approximately R$4,251.6 million consisted primarily of real-denominated loans from federal and State Government-owned banks (in particular, Banco do Brasil S.A. and Caixa Econômica Federal), and debentures issued in March 1999, June 2001 and April 2002. At December 31, 2003, our foreign currency-denominated debt of approximately R$3,012.7 million consisted principally of US$449.2 million in loans from the Inter-American Development Bank and US$29.8 million in loans from the World Bank, US$275 million aggregate principal amount of 10% Notes Due 2005 sold in the international capital markets in July 1997, US$225 million aggregate principal amount of 12% Notes due 2008 sold in the international capital markets in June 2003 and an aggregate of US$40.0 million in syndicated loans. See note 10 to our audited financial statements.

At December 31, 2003, we had approximately R$6,267.3 million in long-term debt outstanding (excluding the current portion of long-term debt), of which approximately R$2,729.4 million consisted of foreign currency-denominated long-term debt. Substantially all of the foreign currency-denominated debt was denominated in U.S. dollars or baskets of foreign currencies. We anticipate that we may incur substantial amounts of foreign currency-denominated indebtedness in the future, among other things, to refinance a portion of our more expensive real-denominated indebtedness, to refinance our foreign currency-denominated debt and to finance our capital expenditure program. In the event of a significant devaluation of the real in relation to the U.S. dollar or other currencies, the cost of servicing our foreign currency-denominated debt and other obligations could be adversely affected, particularly as our tariff and other revenues are based solely in reais.

We had outstanding short-term debt of approximately R$997.0 million at December 31, 2003, representing the current portion of our long-term debt. At December 31, 2003, approximately R$283.3 million of this short-term debt was denominated in foreign currencies.

Our outstanding long-term debt at December 31, 2003 included approximately R$997.0 million due during 2004, approximately R$1,437.9 million due during 2005, approximately R$622.1 million due during 2006, approximately R$531.7 million due during 2007, approximately R$1,014.3 million due during 2008 and approximately R$2,661.3 million due during 2009 or

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thereafter. We believe that we can service this maturity schedule through a combination of funds generated by operations, the net proceeds of new issuances of debt securities in the Brazilian and international capital markets and additional borrowings from domestic and foreign lenders. Our borrowings are not affected by seasonality. For information concerning the current interest rates borne by our outstanding indebtedness, see note 10 to our audited financial statements.

All of our real-denominated debt is indexed to take into account the effects of inflation. Most of our real-denominated debt provides for inflation-based increases in the respective principal amounts of that debt, which increases are determined by reference to the Taxa Referencial-TR (daily government interest rate) plus an agreed margin.

We are subject to covenants under agreements evidencing or governing our outstanding indebtedness, including those set forth in a loan agreement with the Inter-American Development Bank, the indenture relating to the 10% Notes Due 2005, the 12% Notes Due 2008 and the loan agreements relating to the syndicated loans. Each of these agreements contains, among other provisions, limitations on our ability to incur debt. The indenture relating to the 10% Notes Due 2005 and the 12% Notes Due 2008 are the most stringent of these debt agreements. Both of these indentures prohibit, subject to some exceptions, the incurrence of additional debt in the event that (1) the ratio of Indebtedness to Adjusted Capitalization (as defined therein) is greater than 0.42x or (2) the Debt Service Coverage Ratio (as defined therein) is less than 2.50x. These ratios are calculated using financial statements prepared under the constant currency method (which is an accounting methodology that differs from the Corporate Law Method and that incorporates inflation accounting no longer commonly used in Brazil). We do not believe that these covenants will impose constraints on our ability to finance our capital expenditure program or, more generally, to develop our business and enhance our financial performance. As of December 31, 2003, our ratio of Indebtedness to Adjusted Capitalization was 0.29x and our Debt Service Coverage Ratio was 2.61x, in each case as calculated in accordance with the above-mentioned indentures.

We are currently in compliance with covenants contained in the agreements evidencing or governing all of our outstanding indebtedness. We previously were not in compliance with some operational and financial covenants, including a covenant relating to the age of overdue accounts receivable, contained in one loan agreement with the World Bank. We obtained waivers in respect of such covenant through year-end 1998, when these covenants ceased to apply to us.

We have a number of agreements with the Caixa Econômica Federal to provide us with an aggregate of approximately R$550.2 million in financing for our capital expenditure program, of which we had drawn R$522.7 million as of December 31, 2003. We have pledged amounts in certain bank accounts into which customers pay their water and sewage bills as collateral for these loans. We are entitled to draw upon these facilities during the next few years. While we also anticipate that Caixa Econômica Federal will provide additional financing for our capital expenditure program, we have not entered into definitive documentation for these financing facilities. Accordingly, we cannot assure you that these facilities will be available to meet a portion of our financing requirements.

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In August 2000 we entered into an agreement with the Inter-American Development Bank for US$200.0 million in loans to be funded through 2005 to finance portions of our capital expenditure program. Under this agreement, we are loaned funds to match our capital expenditures. At December 31, 2003, US$51.8 million had been drawn down and was outstanding under this agreement. In addition, in August 2002 we entered into a loan agreement and an onlending agreement with BNDES in the amounts of R$60.0 million and R$180.0 million, respectively, to finance portions of our capital expenditure program. Under the onlending agreement, funds are loaned by BNDES to the agents parties to the agreement, which, in turn, lend us the funds. These two agreements are collateralized by part of our revenues from water and sewage services. At December 31, 2003, we had drawn down R$102.2 million under these two agreements.

We are currently negotiating with the Japan Bank for International Cooperation, BNDES and Caixa Econômica Federal for additional loans to finance portions of our capital expenditure program.

Our borrowings from multilateral institutions, such as the World Bank, the Inter-American Development Bank and the Japan Bank for International Cooperation, have in the past been, and in the future are likely to be, guaranteed by the Government of the State of São Paulo or the Federal Government. We do not pay fees for these guarantees. We do not have any contractual or other right to continue receiving guarantees of the State or the Federal Government. If we could no longer obtain these guarantees, we would lose access to funding from these sources, which are generally on favourable terms.

Brazilian regulations provide that a state-owned company, such as Sabesp, must, subject to some exceptions, use the proceeds of “external credit operations” (i.e., foreign currency borrowings) to refinance outstanding financial obligations. Until so used, these proceeds must be deposited as directed by the Central Bank. The deposit requirement does not apply in the case of import financing and financing transactions involving multilateral and official organizations, such as the World Bank and the Inter-American Development Bank.

Our cash disbursements for purchases of property, plant and equipment under our capital expenditure program totaled approximately R$641.3 million in 2003, as compared with approximately R$586.0 million in 2002 and R$694.6 million in 2001. Our capital expenditure program will require total expenditures of approximately R$4.3 billion in the period from 2004 through 2008, including approximately R$883.0 million in 2004 and R$880.0 million in 2005.

We have been making State-mandated special retirement and pension payments to certain former employees who were employed by our predecessor entities prior to May 1974. These special payments totaled R$87.1 million in 2003, R$77.6 million in 2002 and R$72.8 million in 2001. The State of São Paulo is required to reimburse us for such amounts, but has generally not been paying us on a current basis. The State of São Paulo’s obligation to us for these amounts is recorded under reimbursement due from State Government for pensions paid on the balance sheet and totaled R$170.4 million at December 31, 2003. In 2002, these receivables totaled R$83.2 million and were classified as current assets. They were reclassified to non-current assets in our 2003 financial statements. The special payments to former employees made by us are not reflected in our statement of operations, but nonetheless represent a significant component of our liquidity requirements. Although we have had discussions with

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the State of São Paulo regarding more timely reimbursement for the special payments to former employees, including the negotiation of the December 2001 agreement described above, we cannot assure you as to when or whether such payments will be made by the State. We may continue to be held responsible for these special payments to former employees, even if the State of São Paulo stops reimbursing us with respect to these payments.

We did not make payments in respect of certain Brazilian federal income tax and social contribution liabilities during the period from 1991 to mid-1996 mainly because we were contesting certain assessments by the federal tax authorities and, in the case of 1993 and 1994, because we did not have sufficient funds to meet all of our then existing liquidity and capital resources requirements. Under the REFIS tax recovery program, we entered into an agreement with the Brazilian tax authorities regarding these tax obligations and have agreed to make payments on them in monthly installments ending in 2005. We are also required to pay interest on the unpaid balance of this tax liability. However, in July 2003, we included the amounts due under the REFIS program in another program called PAES, which is an alternative payment plan for taxes owed. In accordance with this settlement agreement, we are paying amounts due, of approximately R$317.0 million, in 120 monthly installments, from July 2003. See “Item 8. Financial Information-Legal Proceedings-Tax Proceedings” and note 12 to our audited financial statements. Payments in respect of this aggregate tax liability continue to constitute a liquidity and capital resource requirement which must be satisfied.

We may conduct primary offerings of our equity securities in the future to generate proceeds for use by us to satisfy a portion of our liquidity and capital resource requirements. However, we cannot predict whether the State of São Paulo, as our controlling shareholder, will authorize equity offerings by us or whether any such offerings in the future will constitute a significant source of funds for us. We anticipate that the State of São Paulo, which is required by applicable law to hold the majority of our common shares, will continue to retain substantial ownership and control of our company.

Off-Balance Sheet Arrangements

We do not have any material off-balance sheet arrangements.

Contractual Obligations and Commercial Commitments

The following table summarizes Sabesp’s significant contractual obligations and commercial commitments that affect its liquidity: