Private Participation Contracts for Water Section

Development of public owner-private operator contracts in the water sector is largely a reflection of the extent of private sector participation. International literature on the subject generally describes the various forms of these Private Sector Participation Contracts (“PSP contracts”) as (1) Service contracts; (2) Management contracts; (3) Leasing contracts; (4) BOT type contracts; (5) Concessions; and (6) Divestiture under license (BOO) arrangements.

An article entitled: Guidelines for Performance-Based Contracts between Municipalities and Water Utilities in Eastern Europe, Caucasus and Central Asia (EECCA) provides a very good summary of these contracts. Excerpts from this article are provided below:

In a service contract the private contractor provides agreed services to the public authority under the public authority’s general control and supervision. Service contracts are a potentially beneficial form of PSP where there is strong political or community opposition to wider involvement of the private sector and if there is opposition to water tariff increases which are generally required for many of the other forms of PSP (e.g., lease contract).

A management contract is a more comprehensive form of service contract, under which the public authority appoints a private contractor to manage all or part of its operations. Under such contracts, the bulk of the commercial risk and all the capital and investment risks remain with the government. These contracts are useful if the core objective is to increase a utility’s technical efficiency for performance of specific tasks. If management contracts include clauses which link the contract payments to utility performance, they come closer to the lease and concession arrangements [footnote]. Like service contracts, management contracts can lead to improvements in service for those customers who are connected to the network but they provide little potential for improved access by those potential customers who are not connected to the network. Management contracts are a potentially beneficial form of PSP when there is strong political or public reluctance to water tariff rises or there is concern about handing over more control to the private sector. Management contracts may also be the preferred approach if potential private sector investors consider that the risks associated with a higher level of private involvement are currently too high. If this course is followed, the government can seek to address some of the risk factors over the duration of the contract. For example, the government may implement changes in tariff and regulatory structures to facilitate a greater preparedness for private sector risk taking in the future.

Under a lease contract, a water utility leases the full operation and maintenance of its facilities within an agreed geographic area to a private operator for a period of time, say, ten years. The contract grants the operator the right to invoice and collect charges from customers within that area. The public utility would own the assets and remain responsible for major extensions and upgrades. The operator would be consulted on all major works, especially when the continuity of service is involved, and may participate in tender evaluation or submit its own tender.

Under a best practice lease contract, the private operator would take the full commercial risk on all operations within its lease area, with its remuneration directly linked to the charges it collects from customers. From these charges, it would pay the public utility a rental fee intended to cover the public utility’s capital costs in extending or upgrading the facilities.

Under a lease contract, the operator is usually required to finance the renewal of plant and equipment. At the termination of the contract, the government would compensate the operator for the works it had financed that had not yet been fully amortized.

The management of such works (preparation, procurement, and supervision) would be the operator’s full responsibility. Best practice lease contracts have built-in incentives that encourage the private operators to:

• Update customer files and implement efficient collection procedures to improve the collection ratio from customers (including government agencies);
• Implement an aggressive commercial policy aimed at servicing more customers to increase the revenue base;
• Reduce operating costs to maximize profits;
• Carry out regular maintenance to increase the reliability of plant and equipment and postpone their renewal; and
• Make decisions, not only on day-to-day management issues, but also on improvement of the facilities for which the operator is responsible.

Build-own-operate-transfer (BOOT, a.k.a. BOT or ROT) schemes are an adaptation of leasing contracts specifically designed for investments in water infrastructure which require extensive rehabilitation. Under these arrangements, the private sector typically designs, constructs and operates facilities, and provides services to municipal or government owned water utilities. Generally, any existing underlying assets are leased for a limited period, often 15 to 30 years. Contracts should be designed to allocate risks between the private operator and the public utility, preferably according to capacity to manage and minimize risk.

In contrast with lease contracts, BOT type contracts allocate much more of the commercial risk for specific projects to private parties rather than governments. They can also provide a relatively quick method for mobilizing project based non-recourse finance for new capital investment in developing countries, particularly where capital markets are poorly developed.

BOTs are generally production or bulk supply focused. Such bulk supply investments cannot deal with the major problems of high unaccounted-for-losses in water distribution systems. Nor do they allow private operators to seek out new customers and expand their operations where it is commercially viable. In general, BOTs are not likely to remedy a utility’s faulty (leaking) distribution system or its poor collection processes.

BOT schemes, because they do not involve management of distribution systems down to the household or business meter, are easier to implement than more comprehensive private sector models such as retail concessions, which require more extensive negotiation of contracts. In economies with poorly defined regulatory and legal structures and emerging capital markets, BOT schemes can be implemented relatively quickly and provide a building block for subsequent PSP in the rest of the distribution system.

Effective implementation of BOT/ROT type contracts requires careful attention to the design of tender documents and can involve a relatively lengthy bidding process. Experience with some BOTs shows that they have achieved some savings in capital construction costs and facilitated more rapid investment in infrastructure. However, they can also have a downside in that they can be an expensive way of substituting private debt for public debt, if there is an expensive take-or-pay contract for sale of bulk water to the retail utility.

Many BOTs have failed to deliver optimal outcomes for government or consumers. This is because the government’s agency responsible for negotiating allowed too much of the risk to remain with government – especially where (foreign exchange) guarantees on commercial risks are provided or where take or pay contracts are signed. On the other hand, private operators will not submit bids for BOTs if they feel that the government has attempted to transfer too much risk to the private sector.

Concession contracts combine elements of operation leases for existing assets and BOT contracts for major rehabilitation investments. Under concession contracts, a private operator is given a contractual right to use existing infrastructure assets to supply customers.
However, the concession contract also includes obligations to finance extensions and upgrades to the existing water supply. This tends to result in concession contracts being of longer duration than lease contracts to enable the operator to recover its capital and financing costs.

Management of all capital extensions and upgrades, as well as normal maintenance, is often entirely the responsibility of the operator. Procurement, in particular, could follow acceptable commercial practices that are often different from those required of public agencies.

In comparison to single project BOT type schemes, concessions leave greater flexibility in the hands of the operator in determining the nature and timing of the investments they make to achieve contractual supply obligations. Typically, under a concession agreement, the constructor and operators also are given
the right to supply retail services direct to customers.

For some water supply networks, for example those spanning an entire state or large city, it may also be possible to have a number of concessions operating at the one time. This would have the potential advantage of enabling government to compare the performance of concessionaires, to assess the price and quality of their services, and to evaluate the adequacy of investment programs for meeting community needs. There may also be potential to allow some level of competition between concessionaires, say, for large commercial customers using third party access arrangements.
The rights to provide services under concession arrangements can be awarded through a process of competitive tendering for the concession contract or through direct negotiation. An advantage of competitive bidding for concession contracts is that it limits the scope for monopoly pricing, and thereby avoids the requirement for heavy-handed industry regulation. However, there can be trade-offs when the competitive bidding process determines the successful tender with reference to the lowest supply price to consumers. This is because low prices are not always conducive to efficient demand management of the water resource. If the competitive bidding process involves a range of quantitative variables, such as reductions in unaccounted-for-water or increased use of meters, the selection process becomes more complicated as these qualitative variables are likely to differ between bids.

Thorough preparation and negotiation of scopes of works are required for all concessions to prevent experienced concessionaires extracting advantageous terms. Again, as in BOT contracts, care must be taken not to transfer too much risk to the private sector or they will not bid. In all cases, the regulatory framework for the concession will be important in determining its success.

PSP in infrastructure can also be achieved through the direct sale of infrastructure assets to the private sector. Private ownership of assets may be achieved through either 100 percent private ownership or JVs with public sector corporations. In either case, government retains the regulatory role.

Divestiture can be by way of sale of assets, sale of shares or management buy-out. Like divestiture, BOO contracts require removal of constraints to private sector entry in the water sector and the introduction of
competitive market structures or regulation by government.

In a full divestiture or BOO arrangement, the private sector has full responsibility for operations, maintenance, and investment in a utility. In contrast to a concession, these arrangements transfer assets to the private sector. In a concession, the government continues to own the utility’s assets and is therefore responsible for ensuring that the assets are used efficiently and, in particular, returned to the government in the appropriate condition at the end of the
concession period. Furthermore, the government needs to ensure customers are protected from poor service and monopolistic pricing.

Under divestiture or BOO, it should be the private company’s concern to operate, design and maintain the asset base. The government, on the other hand, would concern itself with the regulation of the water utility, which commonly involves a license to operate a water supply system.

Although the private company has ownership of the water supply assets, these arrangements do not necessarily mean permanence. Typically, the government only allows the right to supply water under an operating license. This license can include a clause that permits its revocation or a not to renew clause. Thus, certain experts claim that the difference between a traditional fixed term concession and indefinite divestiture with a license may not be as significant as it might first appear.

Footnote: Guislain, Pierre (1997), The Privatization Challenge: A Strategic, Legal and Institutional Analysis of International Experience Washington DC: The World Bank.