PPPs and the water sector Plugging the infrastructure hole

March 2009 Deloitte Corporate Finance Infrastructure & Project Finance Roger Black

Introduction

In early 2007 Deloitte released its global research study of the experience with public-private partnerships (PPPs) across different sectors of social and economic infrastructure, including water, wastewater and waste Titled, Closing the infrastructure gap: the role of publicprivate partnerships, it provided a global overview of PPPs including: how, why and when PPPs should be considered as a delivery model; which countries have greatest experience with infrastructure and services delivery via PPPs; which sectors of infrastructure have seen greatest deployment of PPPs; and the circumstances under which different types of PPP delivery models have been used, and with what success. The follow up, Closing the infrastructure gap: Part II to be released Q1 2009 specifically focuses on aiding the public sector deal with the strategic and operational issues involved with private sector involvement in the delivery of infrastructure projects. Specific questions addressed in the research include: what are my choices in terms of the role of the private sector? how do I decide what role the private sector should play? what are the risks and considerations in selecting the role of the private sector? what is being done in other jurisdictions? what is the cost of involving the private sector? what might a deal structure look like for incorporating the private sector? The goal of the research is to provide a framework that helps public officials select the appropriate role or involvement for the private sector in infrastructure projects based on: risk qualification/assessment the costs associated with different delivery models the desirability of retaining control over the infrastructure. This paper draws from the findings of both Deloitte research papers, including leading examples from around the world, and applies the research to the provision of infrastructure and services in the water, wastewater and waste sectors.

PPPs in water 3

PPPs in the water sector globally: current status

In the developing world private participation in the water sector began to be hailed as a solution to chronic failures of coverage and services during the 1990s. Between 1990 and 2005 private investors committed over USD 50 billion to more than 380 water infrastructure projects in developing countries. The PPP experience in providing water and wastewater infrastructure in many ways replicated the PPP experience in other sectors of social and economic infrastructure. Contracts often reflected excessive optimism by both private investors and governments, and the socio-political difficulties of raising tariffs to levels covering costs were often underestimated. After a number of major water project contracts proved insufficiently robust to survive the financial crisis of the 1990s, several international operators lost much of their appetite for further investment in developing countries. While traditionally the sole province of state and local government, water and wastewater management has become a growing area for the application of PPPs globally. The drivers for this are many and vary from country to country, although in broad terms typically differ between the developed and the developing worlds, and the water-rich and the water-scarce. In the developed world early entrants into various types of PPPs included the Netherlands, a number of Canadian municipal governments and Ireland. in the Netherlands a 30 year concession - with a total contract value of 1.58 billion - was awarded by the Water Board of Delft land in 2002 for the design, construction, and operation of a new wastewater treatment plant, and the refurbishment and operation of an existing wastewater treatment plant in Canada, ageing water and wastewater systems requiring renewal expenditure of more than $28 billion prompted the municipalities of Moncton, Hamilton & Dartmouth to consider and develop PPP financing mechanisms to deliver water services in Ireland more than 100 water and wastewater PPP projects - most of them design-build (DB) - are either operational, or in construction and planning. More recently, continued necessity combined with the lessons and experience of earlier ventures is resulting in a maturing of the PPP market following the initial boom and subsequent contraction. Stakeholders, public and private, are growing more aware of both the benefits and risks involved, and are looking for contractual arrangements best suited to the nature of the inherent risks and the socio-political context. So, before dealing with the specific characteristics of water, wastewater and waste infrastructure including dams, pipelines, water grids, water treatment plants, water recycling plants, desalination plants, waste treatment/sewerage plants it is worth outlining the range of PPP options and the general learnings, to date, regarding the conditions which underpin PPP success.

Table 1: Water PPP projects by region and type (1991-2007) Region East Asia & Pacific Europe & Central Asia Latin America & the Caribbean Middle East & North Africa South Asia Sub-Saharan Africa Total No. of Projects 282 61 193 15 9 24 584
Source: World Bank Group, Private participation in infrastructure database

Concession 116 8 109 0 1 2 236

Divestiture 8 5 12 0 0 0 25

New Projects ie. DBO/BOO etc 146 7 42 6 4 2 207

Service & Management Contracts & Leases 12 41 30 9 4 20 116

Table 2: Water PPPs by subsector (1991-2007) Subsector Treatment plant Segment Potable water and sewerage treatment plant Potable water treatment plant Sewerage treatment plant Utility Sewerage collection Sewerage collection and treatment Water utility with sewerage Water utility without sewerage Project Count 12 120 163 1 9 215 64 584
Source: World Bank Group, Private participation in infrastructure database

PPPs in water 5

Models of PPP

Common forms of PPP where new infrastructure is required In general terms a PPP refers to a contractual agreement formed between a government agency and a private sector entity that allows for greater private sector participation in the delivery of public infrastructure projects. Compared with traditional procurement models, the private sector assumes a greater role in the planning, financing, design, construction, operation, and maintenance of public facilities. Some of the most common PPP models used for new projects include: Design-Build (DB)/Build-Transfer (BT): Under this model the public sector contracts with a private partner to design, and build, a facility in accordance with the requirements it sets. Upon completion the public sector assumes responsibility for operating and maintaining the facility Design-Build-Maintain (DBM): This model is similar to Design-Build except that the private proponent also maintains the facility. The public sector retains responsibility for operations Design-Build-Operate (DBO)/Build-TransferOperate (BTO): Under this model, the private sector designs and builds a facility. Upon completion, the title for the new facility is transferred to the public sector, while the private sector operates the facility for a specified period Design-Build-Operate-Maintain (DBOM)/BuildOperate-Transfer (BOT): This model combines the responsibilities of design-build procurements with the operations and maintenance of a facility for a specified period by a private sector partner. At the end of that period, the operation of the facility is transferred back to the public sector Build-Own-Operate-Transfer (BOOT): The public sector grants a franchise to a private partner to finance, design, build and operate a facility for a specific period of time. Ownership of the facility is transferred back to the public sector at the end of that period Build-Own-Operate (BOO): The public sector grants the right to finance, design, build, operate and maintain a project to a private entity, which retains ownership of the project. The private entity is not required to transfer the facility back to the public sector Design-Build-Finance-Operate/Maintain (DBFO, DBFM or DBFO/M): Under this model, the private sector designs, builds, finances, operates and/or maintains a new facility under a long-term lease. At the end of the lease term, the facility is transferred to the public sector. (NB In some countries, DBFO/M covers both BOO and BOOT).

Figure 1: the PPP continuum: degree of public sector responsibility New projects
Design-build Design-buildmaintain Design-buildoperate Design-buildoperatemaintain Design-own operatetransfer Design-ownoperate

Public responsibility

Private responsibility

Service contracts

Management contracts

Lease

Concession

Divestiture

Existing services and facilities

Source: The National Council for Public Private Partnerships

Common forms of PPP involving existing infrastructure In addition to delivering new infrastructure, PPPs can also be used for existing services and facilities. Models include: service contract: The public sector contracts with a private entity to provide services the public sector previously performed management contract: A management contract differs from a service contract in that the private entity is responsible for all aspects of operations and maintenance of the facility under contract lease: The public sector grants a private entity a leasehold interest in an asset. The private partner operates and maintains the asset in accordance with the terms of the lease concession: The public sector grants a private entity exclusive rights to operate and maintain an asset over a long period of time in accordance with set performance requirements. The public sector retains ownership of the original asset, while the private operator retains ownership over any improvements made during the concession period divestiture/privatisation: The public sector transfers an asset, either in part or in full, to the private sector. Generally it will include certain conditions with the sale of the asset to ensure that improvements are made and the community continues to be served. Figure 1 (opposite) identifies the differences in the levels of public and private sector responsibility involved in each of the models.

Recent developments in PPP models A number of variations of the PPP model have been developed in recent years in response to the challenges faced in specific situations and sectors. Alliancing. Under this model, the public and private sector agree to jointly design, develop, and finance the project. In some cases they also work together to build, maintain, and operate the facility. Bundling: Contracting with one partner to provide several small-scale PPP projects in order to reduce the length of the procurement process as well as transaction costs. Competitive Partnership: Several private partners are selected, in competition with each other, to deliver different aspects of a project. The contract allows the public sector to reallocate projects among partners at a later date, depending upon performance. The public partner can also use the cost and quality of other partners outputs as a benchmark for all partners. Incremental Partnership: The public sector contracts with a private partner, in which certain elements of the work can be called off, or stopped, if deemed unproductive. The public sector can commission work incrementally, and reserves the right to use alternative partners if suitable. Integrator: The public sector appoints a private sector partner, the integrator, to manage the project development. The integrator arranges the necessary delivery functions and is rewarded according to overall project outcomes wherever possible, with penalties for lateness, cost overruns, poor quality, and so on. The integrator has a less direct role in service provision and in some cases is barred from being involved in direct delivery at all. In other cases, the integrator is appointed to carry out the first phase of work, or specified works but is then barred from carrying out subsequent phases of work to remove the potential for conflict of interest between achieving best value for the public sector and maximising private returns through the supply chain. Joint Venture: A joint venture company is set up, a majority of which is owned by a private sector partner. The public sector selects a strategic partner through a competitive process that includes a bid to carry out the first phase of work. The typical contract is for 20 years. Subsequent phases are commissioned by the public sector partner, but carried out by the strategic partner using the first phase of work as a benchmark to determine the appropriateness of future costs. The United Kingdom has used a variant of this model, called local improvement finance trust (LIFT), for its hospital PPPs. PPPs in water 7

Lessons to date

Private Sector vs Public Sector The defence of PPPs generally is not the focus of this paper. While failures have been headline news and typically involved the failure of the private operator and the loss of investor capital rather than the failure to deliver the contracted infrastructure for public use numerous reports support the effectiveness and utility of PPPs. Whatever the drivers for involving the private sector in greater partnership in the provision of much needed infrastructure and services then and these can range from the nakedly political to the utterly financial the ideal PPP should combine the characteristic and arguably distinctively different skills of the public and private sectors to maximise the delivery of public good. In short, the regulatory and economic development expertise which is typically the preserve and expertise of the public sector, and the management, innovation, finance raising, budgeting and on-time and on budget delivery skills which, at best, are hallmarks of the private sector.

Lessons for the water sector from the global PPP experience Our research of the PPP experience globally - across all sectors of social and economic infrastructure - holds useful insights for the development and application of PPPs in Australia for water, wastewater and waste. PPPs have proven to be an effective infrastructure delivery tool under specific conditions! The key to success is the role of the public sector. Most commonly project failure has equated to the financial failure of the private operator. A significant part of designing an enduring market, and therefore private sector willingness to fund and undertake risk, entails improving public sector capacity to execute and manage sustainable partnerships. Poor PPP outcomes can be seen to have emanated from: poor setup. The success or failure of PPPs can often be traced back to the initial design of PPP policies, legislation, and guidance. A common mistake is placing so many restrictions and conditions and expectations of risk transfer on the private sector sponsor and agencies involved that a financially feasible deal becomes impossible to structure. Another is having unrealistic expectations of PPPs thinking that they provide free money or that theyre the solution to all problems lack of clarity about project objectives. Sponsors sometimes lack consensus about the purpose of, and expected outcomes for, the project. Public officials may then try to compensate for this failure by overspecifying inputs too much focus on the transaction. Public sector may mistakenly view PPPs merely as financing instruments when in fact they represent a very different way of working. This can lead to a poor operational focus and service outcomes inappropriate risk model applied to project. Much of what differentiates the various PPP models is the level and nature of risk shifted to the private sector. A common mistake is the attempt to transfer demand risk ie the amount of use the infrastructure will receive - to the private sector, even when the private contractor has no control over demand factors

 lack of internal capacity. Even when the public sector is supported by external advisers, many tasks cannot be outsourced, and often the agency does not have the skill sets internally to manage complex PPPs or the dedicated team required to address the time intensive upfront structuring needs failure to realise value for money. This failure occurs when the borrowing and tendering costs associated with PPPs are not sufficiently offset by efficiency gains or when government officials dont have a real understanding of how to test value for money inadequate planning. Without taking proper account of the market in the planning phase, the public sector may come out with more projects than bidders creating a non-competitive environment. On the flipside, too few projects can result in industry moving on to a more active jurisdiction.

Setting up successful PPPs A step-by-step guide to designing and implementing PPPs is beyond the scope of this paper (although further detail can be found in Closing the infrastructure gap Parts 1 & 2). However the lessons learned from water and other infrastructure projects delivered so far suggest several strategies for successful execution of these partnerships. First, the public sector needs a full life-cycle approach or framework that pays adequate attention to all phases of a PPP - from policy and planning, to the transaction phase, and then to managing the facility. The goal of such an approach is to avoid the problems of poor setup, lack of clarity about outcomes, inadequate internal capacity, lack of interest from the private sector, and an overly narrow focus on the transaction. Second, a strong understanding of the range of possible PPP models can help the public sector achieve the proper allocation of risk even in conditions of pronounced uncertainty about future needs. Proper risk allocation allows the public sector to better tailor PPP approaches to specific situations and infrastructure sectors.

PPPs in water 9

Taking a life-cycle approach

It is essential to get the financial terms of the PPP deal right. Equally critical however is getting stakeholder buyin, managing the change process, correctly allocating risk, developing the legislative and regulatory framework, and analysing the long-term effects of the project on the sector as a whole. This means developing a holistic view of the infrastructure projects entire life cycle from the very outset. A life-cycle view helps to get better buy in from all parties involved. It also provides a framework for evaluating whether the solution is the most appropriate for the public over time. Without such a holistic view, public officials will be unable to plan in advance for key considerations that if not properly accounted for can stymie efforts to move beyond the transaction stage. A life-cycle approach best ensures the interest of the government agency that retains ownership and ultimate responsibility for the asset throughout the life-cycle. While many experts emphasise the transaction phase of PPP transactions, the success of the project is actually heavily dependent on a sound policy and legal framework, effective risk allocation, a well-executed procurement process, strong project management, and close attention to the concession phase. A life-cycle perspective helps governments understand how decisions made during different phases will affect the long term success of the project. For example, the way a project is monitored will be determined largely by how much risk is transferred to the private sector during the transaction construction and concession phases. Figure 2 shows the three major phases in the lifecycle of an infrastructure project and the key tasks and activities involved in each stage.

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Figure 2: Project lifecycle and activities Policy and planning phase Transaction phase Construction and concession phase

Sequential activities for infrastructure delivery

1. Condition of infrastructure nancial situation 2. Legislation/regulation 3. Leadership: policy and project management 4. Planning: environmental assessments and project opportunities 5. Communications: internal and external with major stakeholder groups Establish objectives. The objectives a government establishes for the PPP project form the foundation for evaluating options and allows it to communicate a consistent message regarding the purpose of the program. Time spent fully exploring objectives and core values regarding the governments roles and responsibilities will avoid missteps later in the process. Evaluate alternative nancing structures. This evaluation should start with an understanding and analysis of the existing debt alternatives within the state. By preparing a range of nancial alternatives, the agency can articulate to its stakeholders what might be accomplished with traditional nancing and what innovative nancing structures are available and perhaps necessary for project feasibility. Communicate the benets. A strategic communications plan that explains the benets of the program can prevent the discourse from being dened by detractors and focus discussion on economic benets (such as congestion relief and improved movement of goods) as well as social benets such as faster and more reliable commute times). Build market interest. There should be an appropriate number of projects coming into the market at the right pace to ensure that constructors and facility management rms have the capacity and nancial ability to keep pace with the potential projects.

1. Transaction process 2. Shortlist qualied bidders 3. Risk transfer and value for money 4. Payment mechanism/performance 5. Request for proposal 6. Finalise project agreement 7. Preferred bidder selection and negotiations 8. Financial close

1. Transition to construction (e.g. design/build) 2. Construction and monitoring 3. Facility operation (contract and relationship management) 4. Evaluate whether promised benets materialised 5. Maintenance: hard and soft service provision 6. Asset hand back Monitor construction. Many entities believe that once they have entered into turnkey contracts with concessionaires their responsibility for construction monitoring and oversight has been transferred. The public will continue to hold the public sector accountable for the successful delivery of the project, however, so it is critical to establish sound monitoring programs throughout the construction phase without creating additional project risks. Monitor the concession. Under traditional procurement approaches, monitoring substantially ends at the completion of construction. In the case of a PPP procurement, the contract monitoring needs to be far more sophisticated because it is required to address a wide range of issues relating to nance, operations and maintenance over an extended period of time. Prepare staff. Most jurisdictions are used to undertaking these projects on their own. While PPPs may reduce the need for additional staff to do inhouse design and engineering work, current staff are required to provide project management and long-term oversight. Establish the concession governance model. Its important that effective project governance models are established and that skilled individuals are in place during both the construction and concession phase.

Key activities

Establish a realistic time frame. Project objectives, the budget, market interest, the amount of risk shifting, project size, and the structure of the deal all affect the timeline for the project delivery. Secure the best value for money. A fundamental objective in any project is to secure the best value for money. Creating comprehensive nancial models that allow you to evaluate value for money from both a qualitative and quantitative perspective is a critical component of this process. Establish performance standards. This often entails using penalties and rewards to achieve the desired behavior. Care must be taken with both rewards and penalties since they can drive unintended consequences. Setting performance standards will also help to develop the best payment approach for each project. Develop a draft project agreement. These agreements are included with the request for proposal (RFP) and help to identify issues bidders may have before the selection of the successful bidder. Establish construction governance. Large infrastructure construction projects should have effective governance and controls in place before the project begins in order to avoid cost overruns, scheduling delays and litigation.

PPPs in water 11

Choosing the right model

The following key questions should be asked prior to choosing the model: how confident are you now about the type of infrastructure and services that are needed over the next 10, 15, or 20 years? how likely is it that the needs of citizens in this area will change? how likely is significant policy change? how easy is it to specify what will be needed? in which sector is the PPP approach going to be employed? how confident are you in the supplier of the service and how much control do you wish to retain? can risks be transferred or would better outcomes be achieved through risk sharing? The level of certainty the public sector possesses about its infrastructure and service requirements should be a key determinant in the choice of model. This includes certainty about the external environment, including the policy environment, as well as the capacity of contract performance standards and realities and incentives to higher outputs. Figure 3 classifies certainty into three categories, being low, medium and high. A high level of certainty suggests that the public sector can shift substantial control and risk to the private sector (the best options are Private Developer Scheme, Design-Build-Finance-Operate/ Maintain, or Conventional Procurement). The integrator, joint venture, or competitive partnership models should be considered where certainty is more limited. The alliancing or incremental partnership models would be more appropriate when a low level of certainty exists. The decision tree in Figure 4 provides some guidance regarding the most appropriate model in particular circumstances. This list of models is by no means exhaustive; any decision to choose one model over another should always be derived from a robust appraisal of the options, based on the specific circumstances in which the project is being developed.

Figure 3: Certainty classifications

Certainty continuum

Low
The public sector is unsure about the infrastructure it needs (or even what is possible), let alone when or how it wishes to have it delivered.

Medium
The public sector knows the kind of infrastructure it needs, but is less certain about the timing and exact extent of work in wishes to undertake.

High
The public sector knows with condence either the condition of the assets and/or the future asset and service requirements at a detailed level.

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Figure 4: PPP model decision tree Selecting an appropriate model

Do assets have high residual value? Yes

Private developer scheme Design-build-nance operate/maintain Conventional procurement

No High

Is the project size signicant?

Yes

No

What is the level of certainty about the infrastructure?

Medium Are the elements of work heterogeneous? No

Yes

Integrator

Low

Can work easily, be separated into discrete elements?

Yes

Competitive partnership

No

Joint venture

Is the infrastructure large, indivisible, and complex?

No

Incremental partnership

Yes

Alliancing

PPPs in water 13

Implications for PPPs in the water sector

While it shares characteristics with some other sectors of social and economic infrastructure the water, wastewater and waste sector has some unique characteristics which need to be factored into consideration in terms of PPPs. Challenges Market Competition. There are a small number of market participants in the water sector. This is due to the high market concentration, and over-specification. Substantial procurement costs. High procurement costs and high uncertainty about the availability of technology require a contractual framework with shorter procurement times that fosters innovation. Uncertainty. The condition of assets in existing facilities may result in an increase in project costs. Scale. The size of the project may not allow for efficient use of private finance. Also, contracts involving water supply of less than 40 million m3 suffer from unrealised economies of scale. Conversely, when the level of water supply exceeds 400 million m3, the operation will suffer from diseconomies of scale. Politics. Water and wastewater are often seen as falling squarely under the public sector domain. Public employees may have deep concerns for their welfare under the new management. Table 3: Some current water PPPs by type Sydney Desalination Plant (value $1.76 billion) Bahrain, Tubli WWTP expansion (value $133 million) Egypt, New Cairo WWTP Egypt, Abu Rawash WWTP China, Harbin Qunli WWTP (value $56.8 million) China, Wenzhou Xipian, Zhejiang Province WWTP Mexico, Guadalajara, Agua Prieta WWTP (value $150 million) 250 megalitre/day 230,000m3 to 350,000m3 250,000m3 800,000m3 150,000m3 100,000m3 734,000m3 DBO DBO & 5 year operating contract BOO 20 years BOO 20 or 25 years DBOM 30 years DBOM 26 years DBOM Contract awarded 22/06/07 RFP issued 31/12/08 RFP issued 01/12/08 In progress Contract awarded 30/11/08 Contract awarded 20/11/08 RFP issued 01/11/08 Because of this, most water projects tend to be leases or operating contracts as they allow the private operator to concentrate on improving the utilitys operational efficiency and viability while leaving the public authority in charge of raising investment financing. Greenfield projects are still common in treatment plants however. Solutions Applying the analytical assessment of PPP models outlined in brief in the foregoing (and in more detail in Closing the infrastructure gap: parts 1 & 2) can help overcome some of the challenges in the water sector. For example, the public sector can reduce the length of the procurement process and attract companies with stronger financial and operational capacity by using a bundling approach. This saves procurement time and effort as the public sector is no longer required to contract with different private partners in delivering individual small-scale projects. A key challenge in this sector is that the consumer is generally not exposed to the full cost of water. Moving to full cost pricing of water utilities before moving to a PPP approach can help to avoid rate shocks that may derail the project.

Source: Global Water Intelligence, volume 9; issue 12, December 2008.

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Conclusion

PPPs are an effective way of delivering infrastructure projects, and draw upon the strengths of both the public and private sectors. There are a number of different PPP models that can be utilised for the different types of infrastructure required in the water, wastewater and waste sector. Whether it be; dams, pipelines, water grids, waste treatment plants, water recycling plants, desalination plants, or waste treatment/sewerage plants, sufficient planning and investigation should be undertaken to ensure the correct model is implemented. There is a strong precedent for water infrastructure projects being delivered via PPPs. Key learnings from previous projects must be taken on board and thinking creatively about the delivery model can aid in the successful procurement of this very much needed sector of infrastructure.

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Contact us Deloitte Riverside Centre Level 26, 123 Eagle Street Brisbane Qld 4001 Australia Tel: +61 (0) 7 3308 7000 Fax: +61 (0) 7 3308 7001 www.deloitte.com.au

Acknowledgment This document was derived from the author guidelines used for all AWA conferences and events. References Allen Consulting Group, November 2007, Performance of PPPs and traditional procurement in Australia. Booz & Company, 2008, Public-Private Partnerships: A New Catalyst for Economic Growth. Deloitte Touche Tohmatsu, 2006, Closing the Infrastructure Gap: The Role of PublicPrivate Partnerships. Global Water Intelligence, volume 9; issue 12, December 2008. Philippe Marin and Ada Karina Izaguirre, September 2006, Gridlines private participation in water. The World Bank & PPIAF, Private Participation in Infrastructure Database, http://ppi.worldbank.org/explore/ppi_exploreSector.aspx?sectorID=4

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