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4 Models of Water Service Provision T his chapter describes various public-private arrangements for wa- ter service delivery and some of the experiences gained with shifts in ownership arrangements. Many core issues in debates regard- ing water services privatization relate to appropriate organizational struc- tures for delivering those services. For instance, are government agencies that operate in an open public forum the most appropriate body to deliver water services? Are water services more appropriately provided by pri- vate organizations that are subjected to full market forces? How can effi- cient and equitable organizations for water service delivery be created? How can a public agency ensure under either public or private operations that the water utility will not cut corners on long-term investments to enhance short-term profits, ignore important conservation programs in favor of increased revenue, or tolerate lower water quality in favor of improving the financial bottom line? As noted in Chapter 1, water services privatization takes many forms and there are many permutations involving ownership and operation. Most choices regarding privatization do not represent a simple dichotomy between public and private ownership. The decision to privatize various sections of the water utility is complex. Nonetheless, governments are more frequently considering this option and weighing its advantages and disadvantages. Political considerations represent a hurdle to water utility privatiza- tion in the United States. Local politicians fear losing control of a public 56
MODELS OF WATER SERVICE PROVISION 57 utility and the possible losses of their constituentsâ jobs. Long-standing relationships between local officials and water service suppliers are im- portant, as is job security and the role of labor unions in the operations of the nationâs water systems. But public officials must remain responsible for oversight and contract monitoring; for setting, monitoring, and en- forcing water-quality standards; for protecting ecosystems; and for bring- ing the public into the process in an open and transparent fashion. Whether a public or private operation provides water services, failure of the organization to fulfill a communityâs expectations will result in public protests to the local government. This issue is at the heart of the quandary for the public official: if a municipality decides to privatize, how can public officials ensure that, in case of failure, they can gain sufficient control of the operation to restore service? On the other hand, if a munici- pality decides to operate the facilities itself, how can the public official ensure that the publicâs money is being well spent? Private organizations do not necessarily operate efficiently, nor are they inherently more effi- cient than public organizations. By the same token, public organizations do not always deliver on their promises. The point is that neither public nor private organizations automatically entail âeffectiveness.â Well-run and poorly run organizations exist in both sectors. When an organization provides a public good or service such as wa- ter and wastewater services, there are often other, more subtle factors integral to the organizationâs purpose. For example, is the organization to deliver services to all members of the public, regardless of their ability to pay? Or is it to deliver those services strictly based upon customersâ abil- ity to pay? Does the community expect the organization to deliver the best service possible, regardless of cost? Or is the lowest acceptable level of service to be provided at the lowest possible cost? Is the operation expected to assist in other public purposes in times of emergencies (e.g., snow removal; recovery from tornado, hurricane, or earthquake dam- age)? Is the organization expected to help meet other social goals such as giving preference for supply contracts to local businesses, to disadvan- taged segments of the population, or to environmentally friendly firms? Public service delivery is often an important factor in decisions about where people choose to live. If a public utility also provides disaster response teams, grounds maintenance, and snow removal services, im- portant social objectives may be compromised with the restructuring of the public service. Ancillary services such as transport services or snow removal add to the price paid for the service, and if they are not perceived as adding value, consumers may not be willing to pay the additional price. Consumers tend to hold public services provided by governments to different standards than they do most privately provided services.
58 PRIVATIZATION OF WATER SERVICES IN THE UNITED STATES Public services tend to be monopolistic and are delivered at the same level to all public consumers, and the public collectively expects them to be of a reasonable quality and reliability. The challenge for public officials is that the public determines the measure of âreasonable quality and reli- abilityâ while the public may not widely agree on important measures of quality and reliability. FOUR STRATEGIES Public officials often select from four broad options for improving the delivery of public services: (1) improve current public operations, (2) con- tract the provision of all services to a private operation that will provide services largely in the same manner as the current public operations, (3) provide improved service through a public operation with a mixture of public and private services, and (4) divest public assets and transfer own- ership to a private firm. Strategy 1âImproving Current Public Operations Professional water utility organizations like the American Water Works Association have long recognized the need for public utilities to address organizational and management issues. Public utilities have ac- cordingly taken measures to improve performance through strategies di- rected at improving worker productivity, upgrading capital facilities, and streamlining procurement of goods and services. Each utility is unique in terms of the condition of its facilities, its organizational structure, and its management. Nevertheless, several initiatives can be utilized to enhance performance and reduce costs. Several progressive public water utilities have instituted management initiatives directed at improving organizational efficiency. These initia- tives focus on performance, procurement of goods and services, labor productivity, and organizational culture. Public organizations are often bound by rules and regulations that can make them unresponsive. Coupled with labor agreements, these barriers sometimes make it diffi- cult to realize improved efficiency. Local governments that want to elimi- nate the costs of such bureaucratic processes and procedures have two main options: (1) make the municipal bureaucracy more responsive to consumer needs and (2) organize the utility into a stand-alone entity such as an authority, in which case the entityâs board of directors would estab- lish personnel, fiscal, and other policy. An innovative example of a stand-alone entity is the Louisville Water Company in Kentucky, which serves the city of Louisville and surround-
MODELS OF WATER SERVICE PROVISION 59 ing communities. Authorized by special legislation of the Kentucky state legislature over 70 years ago, the utilityâs organizational structure is mod- eled after a typical private corporation, with a board of directors ap- pointed by the shareholders. The difference is that the sole shareholders are the city of Louisville and Jefferson County, which surrounds Louis- ville. In this arrangement, the utility operates at armâs length from the governments, freeing it from the usual bureaucratic hurdles, yet a board of directors selected by the governments protects the publicâs interests and public policy. Benchmarking and Performance Measurement Benchmarking refers to the process of comparing the performance of a utility or one or more of its processes or functions with the performance of similar utilities, processes, or functions. The technique ranges from informal comparisons of data to sophisticated econometric analyses, usu- ally statistically linking unit costs of water delivery to characteristics of the environment in which the utility is operating. The procedure has been experimented with extensively in the United Kingdom, where privatized utilities are under the regulatory control of the Office of Water Services (OFWAT). This office uses these comparisons in setting âprice capsâ for individual utilities, while allowing utilities that exhibit below-average unit costs larger price increases in relation to the rate of inflation (chapters 6 and 10 in Armstrong et al., 1994; ICR Byatt, 1997). There are several challenges in data collection and interpretation, such as difficulties in measuring output, in determining the components of unit cost, and in the use of book values of assets in computing long-run marginal cost. In this regard, the ability to collect cost and output data from similar utilities may be easier with public utilities because of disclosure requirements. In the private sector, much benchmarking information may be considered trade secrets, while public utilities usually openly share information and research efforts. Benchmarking efforts help public utilities share knowledge and ben- efit from the latest self-improvement techniques. They can provide an overall assessment of individual utility performance and, more power- fully, they can be utilized to evaluate the performance of components of the business, such as quality of service, quality of product, metering, operation and maintenance, worker productivity, and capital investment. Indeed, seeing how a utility or a utilityâs business process compares with other utilities creates a powerful incentive to improve performance.
60 PRIVATIZATION OF WATER SERVICES IN THE UNITED STATES BOX 4-1 Improving Water Utility Operations and Management in the Western United States: Experiences of the San Francisco Bay Area and Phoenix The East Bay Municipal Utility District (EBMUD) serves 1.2 million customers in Oakland, California, and recently utilized a âreengineeringâ program to help im- prove its water system maintenance practices. EBMUD auditors identified the need for a review of business practices in several areas: materials handling, purchasing, work management and scheduling, maintenance needs and setting priorities for repair, information systems, and preventive maintenance. The district decided to initially focus on all processes related to maintenance and issued a request for proposals for a business process review and suggestions for improving those pro- cesses. After selecting a proposal and evaluating the suggestions, EBMUD esti- mated that it could save at least $6.7 million per year (with an initial outlay of $1.2 million) in system technology improvements, and it could improve its organization- al climate. The Phoenix Water Services Department (PWSD) faces several challenges in meeting customer demands. Water service providers across the nation share many of Phoenixâs challenges: customer demands for high-quality/low-cost water, limited ability to affect future rate increases, regulatory concerns, aging infrastruc- ture, rapid population growth, and prospects of both regionalization and privatiza- tion. The city was especially concerned about the prospects of privatization and recognized that private sector firms held potential advantages over the public sec- tor in many areas. To help meet these demands and to help improve its performance, in 1995 the Phoenix Water Services Department began an internal review to see how it com- Organizational Improvement Organizational improvement, often referred to as âreengineeringâ or as âcapacity buildingâ1 in the water utility field, represents a set of meth- ods to change business processes and organizational climate. Business process reengineering has been defined as the fundamental rethinking and radical redesign of existing business processes in order to achieve improvements in performance measures such as cost, quality, service, and speed. Reengineering in the water utility sector generally begins with goal setting and an assessment process that includes evaluation of a range 1The term âreengineeringâ (or âcapacity buildingâ) is used to describe changes in water utility organizational performance. These changes borrow from concepts and methods from fields such as public administration and evaluation. Outside the water utility sector, efforts aimed at improving organizational performance are known by other terms such as âorgani- zational strengthening.â
MODELS OF WATER SERVICE PROVISION 61 pared with well-run public utilities. The utility was especially interested in union- management relations, and it established a Participating Association of Labor and Management (PALM) group to identify and focus on the key issues. PWSD then initiated a comprehensive reengineering plan that constituted the most ambitious internal change process in the utilityâs history. The program focused on several areas, including improved union-management relations, dispute resolution, and employee empowerment. The city enlisted indus- try consultant assistance and worked with several of its sister agencies within the city and with local unions. The city identified several clear goals in the process: develop empowered, self-directed teams; ensure that no employee would involun- tarily lose a job within the city; maintain or improve levels of customer service, product quality standards, and environmental protection; and become a âbest in classâ water utility, with cost-effective operations. The PALM group sought to move from a reactive maintenance mode to a planned maintenance strategy, to merge formerly separate operations and maintenance (O&M) staff into a combined O&M program, and to emphasize on-the-job training and cross-training (e.g., encourag- ing staff to develop multiple skills across the utility). Initial results have been impressive: $3.1 million saved in the first phase of reengineering, with additional savings of nearly $2 million. In 1999, PWSD estimat- ed savings of more than $10 million by the year 2000. PWSD also estimated that improvements in operations efficiencies allowed them to avoid hiring 72 additional staff. How does reengineering within a public organization compare with the pros- pects of privatization? According to PWSD director Michael Gritzuk, âPrivatization doesnât even begin to address the scope of what a reengineering project can ad- dressâ (AWWA, 1999). of business processes that include: work practices, information manage- ment and technology, procurement of goods and services, management systems, and organizational structure. Box 4-1 describes examples of reengineering in the San Francisco Bay area and in Phoenix, Arizona. These examples also highlight the importance of including labor to help improve organizational performance. In the East Bay Municipal Utility District (EBMUD) and Phoenix experiences, both labor and management were intimately involved in the evaluation, modification, and implemen- tation of consultant recommendations. Areas addressed included man- agement systems, work task redesign, team building, and strategic use of information technology. Both utilities had labor forces willing to allow workers to perform multiple jobs utilizing multiple skills in exchange for increased compensation. But improving an organizationâs overall performance includes more than merely changing its organizational chart. As evidenced in the EBMUD and Phoenix examples, successful change involves an overall
62 PRIVATIZATION OF WATER SERVICES IN THE UNITED STATES change in the way members of the organization perceive and carry out their work. In initiating useful changes, the organization must under- stand the nature of its âcore culture.â Just as societies and cultures exhibit different customs, traditions, and beliefs, organizations also develop unique cultures. The key to initiating successful change is to understand the key elements of an organizationâs core culture and how they impact utility characteristics such as strategy, leadership, and business processes. Financial Incentives Public water utility service professionals have long contended that utility revenues should be kept separate from other municipal revenues and should be directed solely toward the operation and maintenance of existing facilities and the development of new facilities. They advocate cost-based pricing, dedicated revenues, and long-term capital improve- ment planning and implementation. Many communities have blended water revenues with other government revenues, allowing revenues needed for upgraded capital facilities and/or enhanced operation and maintenance to be diverted to other government services. But this consti- tutes a lack of transparency and accountability. In some cases, such as in New York State, municipalities have found themselves unable to finance additional capital improvements because of constitutional limits on borrowing. As a result, capital improvements have been deferred, resulting in increased operation and maintenance costs and in greater difficulty achieving environmental and public health objec- tives. In New York City, legislation was passed that allows the city (mu- nicipalities) to form a water finance authority that could issue revenue- backed bonds. These funds were exempt from the stateâs constitutional debt limit and were issued at significantly lower interest rates than subse- quent city general obligation finances. Strategy 2âContracting All Public Service Operations to the Private Sector Increasing interest in the prospect of private sector involvement in the water and wastewater industries has led to the emergence of âpri- vatizers,â which include investor-owned utilities and other private inter- ests that seek an expanded role in water and wastewater services. Some privatizers will operate utilities only where they hold ownership of the utilitiesâ assets; these are often referred to as investor-owned utilities. However, most privatizers will enter into contractual arrangements with public or private water and wastewater utilities to operate facilities they do not own. Such arrangements are usually referred to as âcontract opera-
MODELS OF WATER SERVICE PROVISION 63 tions.â Some firms own and operate utilities while also providing contract operation services. Hundreds of U.S. water or wastewater systems are operated in this fashion. Most âprivatizersâ actively market their engi- neering and managerial expertise and, in some cases, also offer special financing arrangements to the contracting utility or municipality. The outsourcing of noncore services such as meter reading or provi- sion of supplies to specialists is common in both the private and public sector in the United States, as well as in many other nations. Outsourcing arrangements are intended to allow businesses to focus on their core areas by hiring specialists to perform ancillary work. Many U.S. cities and counties have outsourced the design, financing, construction, and opera- tion of many systems, including airports, hospitals, toll roads, and waste- to-energy refuse disposal systems. But outsourcing of services in the wa- ter and wastewater sector is of greater significance than in other sectors, as a larger percentage of water and wastewater services are currently operated by their public owners. Contracted duties in the water utility sector include design and construction, financing, and many services in- cluded in operation and maintenance of facilities, including laboratory services, vehicle maintenance, meter reading, and public relations. Governments usually outsource only a limited portion of their water utility operations to the private sector. According to a recent survey of 261 cities by the U.S. Conference of Mayors Urban Water Council (1997), mu- nicipally owned water systems operating under contract serve less than 10 percent of the population and municipally owned wastewater systems operating under contract serve less than 6 percent of the population. That survey also found that 40 percent of municipally owned wastewater fa- cilities have some private sector involvement other than engineering, while another 14 percent are considering it. The U.S. Conference of May- orsâ survey and a Water Industry Council survey (1999) indicated that the most frequently cited reason for outsourcing of water or wastewater treat- ment services was the expected reduction of operating costs. Environ- mental compliance and political ideology were also noted as factors that encouraged privatized operations (Box 4-2 describes the experience with water services privatization in Atlanta). American Commonwealth Management Services provides guidelines designed specifically for public utility commissions, other regulators, and grant and loan agencies (Schmidt, undated). These guidelines identify the conditions under which contract operation and maintenance services can best be used, as well as the variety of services available (including man- agement, planning, engineering, record-keeping, reporting, evaluation functions, etc.). The U.S. Environmental Protection Agency has also pre- pared a quiz (Box 4-3) for municipalities considering contracting opera- tions and maintenance for a wastewater facility (EPA, 1993).
64 PRIVATIZATION OF WATER SERVICES IN THE UNITED STATES BOX 4-2 Water Services Privatization in Atlanta On January 1, 1999, the United Water firm assumed operation of the city of Atlantaâs water system after nearly a two-year process of public debate, bid solic- itation, and selection. Under a 20-year agreement, United Water operates a 136 million gallon/day and a 56 million gallon/day water treatment plant along with approximately 2,400 miles of transmission and distribution water mains. They also provide the utilityâs water system maintenance, customer service, and billing and meter reading services. In the Atlanta area, United also operates three wastewater treatment plants in northern Fulton County (Campos et al., 1998). The 20-year water agreement provided for $21.4 million in annual compensa- tion to United Water in return for water services to 1.5 million residents. This repre- sented nearly a 50 percent reduction in operating costs when compared to operat- ing expenses of the municipally run utility in 1998. Although no independent studies have been completed to determine actual savings since United Water has taken over operations, United and city officials at the time of signing the agreement had projected $400 million in savings over the life of the agreement. The savings are expected to go into capital maintenance and replacement programs rather than reductions in water rates. United Water is the North American subsidiary of parent company Ondeo, a Paris, France based multinational conglomerate. In 2000, Ondeo had revenues of $8.5 million with operations in 130 countries. U.S. Internal Revenue Service Regulation 97-13 allows contract opera- tors with the financial strength to guarantee long-term performance an opportunity to lock in a municipally assured cash flow of up to, and sometimes exceeding, 20 years (see discussion in Chapter 3). This made it economically reasonable for a utility to operate at a loss for several years as long as it was reasonable to expect to recover that loss in the latter years of the contract. The long-term contract also made possible major infra- structure investment, 20 years being a sufficiently long time to fully de- preciate investment in equipment and collection and distribution sys- tems. The long-term contract has allowed contractors to offer municipal clients an âup-frontâ fee for the right to operate for 20 years. Of course, this fee (often called in the United States a âconcession feeâ) is factored into the annual charge to the client for system operation. Although con- tinuing to remain small relative to the total U.S. population served, fol- lowing IRS 97-13, the number of large cities contracting for their water and wastewater operations has increased. The award of a long-term con- tract typically does not depend on lowest price alone but rather on best valueâi.e., best combination of successful operating history, financial strength, technical expertise, and price. Nonetheless, most contracts are awarded to the company offering the lowest life-cycle cost.
MODELS OF WATER SERVICE PROVISION 65 BOX 4-3 Considering Private Operations and Maintenance: EPAâs Quiz for a Municipal Wastewater Utility If your answer to most of the following questions is âyes,â then you may want to seriously consider using contract operations and maintenance. â¢ Design problems? Has the plant had trouble meeting design specifications from the beginning? Have increasing design problems come to light as the plant has aged? Has staff had to jerry-rig solutions to design problems too often? Is the plant being run to design parameters? â¢ Excessive costs? Has the wastewater budget been increasing dispropor- tionately as the plant has aged? Are replacement costs high? Are the same items being replaced too frequently? â¢ Personnel problems? Is morale low? Is staff over-worked, but poorly uti- lized? Is staffing out of synch with work-load and shift requirements? Are there labor-management disputes? Is salary not commensurate with performance? Is staff hard to acquire and keep? â¢ Public-image issues? Do citizens complain about over-flow and backup problems? Odors? Appearance? Higher user charges? Water-quality problems? â¢ Operating inefficiencies? Do plant managers fail to take advantage of op- portunities for cost savings or economies of scale? Are certain operating units underused? Have chemical or energy costs risen excessively? â¢ Compliance difficulties? Has plant effluent frequently been in violation of standards? Has the plant experienced enforcement actions? Is compliance regu- larly marginal? Are periodic problems from industrial loads frustrating compliance? â¢ Training issues? Do plant managers fail to provide training in a consistent, effective manner? Is staff inadequately prepared to deal with sophisticated equip- ment? Are there too many specialists and not enough generalists on staff? Does the plant have above average safety problems or lost-time accidents? SOURCE: EPA (1993). In addition to national-level regulations, the International Organiza- tion for Standardization (ISO) has developed a set of international stan- dards for utility performance. Based in Switzerland, the ISO provides a basis for certifying enterprises based upon performance benchmarks. Cer- tification under ISO 9000 and ISO 14000 uses a standardized system for assessing company performance, particularly in terms of resource man- agement and environmental protection. The U.S. representative to the ISO is the American National Standards Institute (ANSI), whose member- ship includes more than 1,000 private and public members. ANSI admin- isters and coordinates a voluntary standardization and conformity assess- ment system in the United States, and provides formal national standards.
66 PRIVATIZATION OF WATER SERVICES IN THE UNITED STATES Compliance with ISO 9000 and 14000 has been included in water pri- vatization service contracts in the United States, and the familiarity of prospective contractors with ISO procedures has been part of evaluation criteria. A proposal by France to have the ISO set standards for contracts on water privatization around the world was approved in late 2001; as this report went to press, the ISO was establishing a committee to enact this proposal. Private firms may not be able to assume operations and willingly invest significant resources to fix a water utilityâs ills and also reduce prices. Private companies and their shareholders will not invest money in a local community without receiving reasonable returns on investment. Over the short term (5-10 years), private firms are most likely to effect changes in organizational structure and functioning, such as staff reduc- tions and supply cost savings that help achieve cost and service efficien- cies. The resulting savings may be sufficient to pay for needed capital investments and pay the needed return to the firmâs shareholders. Contractors accomplish operational benefits and savings in cost by being energy-efficient, purchasing-proficient, staffing and training ori- ented, economically positioned, technically deep process-control versed, automation-knowledgeable, and improvement-astute (PWF, 1994). In Farmington, New Mexico, for example, a 30 percent reduction in water system operating costs was attributed to consolidation of the mainte- nance groups of different facilities, the installation of management con- trol systems to save on power and chemicals, and the implementation of changes in physical facilities to promote more efficient utilization of the utility plant (Haarmeyer, 1992). On the other hand, it is possible that contractors might achieve cost savings by cutting staff, by not making necessary investments in operations and maintenance, and by reducing necessary long-term investments. When a public utilityâs operations are handed over to the private sector, the public agencyâs importance in running the agency does not diminish, but the way the agency performs its role changes dramatically. For the local government, it becomes a question of contract management versus traditional program management. When a contractor provides the operations, the local government organizationâs focus is on contract man- agement. The talents and skills needed for contract management are sig- nificantly different than the talents and skills needed for traditional op- erations management. The importance of reorganizing for contract management must be recognized. After all, if an agency could not capably manage itself, it probably would not be able to immediately change and effectively manage outside contractors (Scalar, 2000). Successful contract operation arrangements ultimately rely upon a good working relationship between the contractor and the public agency.
MODELS OF WATER SERVICE PROVISION 67 This relationship begins with a contract that clearly states the unified purpose of the function being turned over to the contractor, a well-de- fined understanding of customer preferences, and a description of the division of responsibilities between the contractor and the public agency. Each of these responsibilities requires specific performance measure- ments to assure that the contractor has performed up to expectations and is deserving of the prescribed compensation. Clear and measurable per- formance indicators are essential to answer questions such as âHow will we know if the private operating firm is meeting the terms of the con- tract?â Under a well-designed agreement, full-contract operations firms can help pay for the cost of some capital improvements, provide corrective and preventive maintenance, apply specialized knowledge and experi- ence, install computerized management systems, prepare regular reports, document and disclose costs and savings, implement sound management and staff motivation practices, and assume most utility-management headaches (EPA, 1993). Many contract firms prefer to operate under a contract of five years or more so that they can establish a track record with the client, prove their effectiveness, and spread their front-end costs over several years. Some contracts require that the contractor pay fines for violation of drinking water and effluent standards. Small and Rural Contract Operators The practice of contract operations has been common in the United States for small and/or rural communities including suburban or ex-ur- ban subdivisions and mobile home parks. Water or wastewater systems for such communities generally serve less than 3,300 households and busi- nesses. In the United States these systems make up 78 percent of all drink- ing water systems, with a majority of these small systems serving fewer than 500 people (EPA, 1999a; see also Chapter 1). For these small or re- mote communities, it has often been economical for a specialized contrac- tor to oversee water and/or wastewater system operations of several small communities, rather than to burden a community with a service that might require only a few hours per week of attention. Most contract operators in the country remain small, local âmom and popâ type businesses. Accord- ing to the EPA, there are approximately 46,000 small and remote water operations in the United States, but they constitute only 15 percent of the volume of water processed (EPA, 1999a). The percentage of these systems that are under contract operations is unknown, but the needs of these small operators and the manner in which these operators interact with their clients and communities differ markedly from large regional compa- nies or large multinational conglomerates.
68 PRIVATIZATION OF WATER SERVICES IN THE UNITED STATES The needs of firms that operate small and/or rural water utilities differ from those of the major multinational companies. Small utilities cannot take advantage of the economies of scale to the extent that larger utilities can. Small firms usually do not have access to specialized techni- cians that multinationals retain. The borrowing and bonding power of large firms is essential for competing for and operating large water and wastewater systems. Rural firms are often protected from competition by oft-renewed short-term contracts perpetuated by the long-term involve- ment of the firms with the community. Small and rural firms also are often too dispersed for multinational firms to be effective competitors, and contracts tend to be too small to be of interest to these large compa- nies. Contract operators headquartered near the site of operations may have a better understanding of local needs. A relationship may eventually develop between the facility owner and an efficient operator. An operator may have a competitive advantage by being headquartered near the site. The operator may have a detailed understanding of the needs of the facil- ity and the community it serves. In many cases, the contract operator is a former municipal employee stationed at that plant and certified to oper- ate it. The contract operator typically negotiates directly with the owner for the terms and conditions of the contract. Contract terms are usually between one and five years. The contract is typically renewed on a sole source basis for the same reasons it was initially consummated. If the relationship is mutually satisfactory, the level of trust and familiarity that can develop between a client and contractor can create a barrier to new entrants competing for the contract. There are occasions, however, when a contractor terminates a satisfactory partnership. The principals of a con- tract firm may retire, sell their business, or die. A larger contractor may offer such significant improvements that the community is induced to open the contract process to competition. Such competition from larger regional or national contract operators has occurred more frequently since the mid-1990s. In 1997, a National Research Council committee reported on small water systems (NRC, 1997). The report noted that water supply is gener- ally acceptable if a well with an ample supply of good-quality water is available. However, this is often not the case, in which event problems are likely to ensue. Improvement costs are high, and the original contractor may not be qualified to make the changes. Small communities that lack sufficient resources for water treatment and distribution can have diffi- culty meeting federal Safe Drinking Water Act standards. Systems serv- ing fewer than 500 people violate drinking water standards for microbes and chemicals more than twice as often as systems serving larger commu- nities (NRC, 1997). A key problem concerns small, private developers that
MODELS OF WATER SERVICE PROVISION 69 build a community distant from a city, where land costs are lower, and they put in their own water supply and wastewater treatment and dis- posal facilities. Getting approval is generally no problem as the technol- ogy is widely employed. The developer or a homeowners association generally owns the facilities, and they almost always contract out the operation and maintenance to private contractors. Wastewater problems are far more numerous. Package plants for these small communities are âoff-the-shelfâ but require competent opera- tion and maintenance. Their failures come to the attention of regulatory agencies only when a nuisance is created and complaints are made. In many cases, the facilities put out a poorly treated effluent that is not discerned because it reaches a point of disposal without creating a nui- sance. State regulators seldom have the resources to monitor the facilities. Private assistance can be helpful, but small, local private contractors are often not fully qualified, and the facilities are too small to warrant a large and competent contractorâs interest. Public or private regionalization (the assumption of the operations of multiple water or wastewater systems in a given area by a government agency or a private organization) is a viable strategy that has proven to be useful in both circumstances. For example, the Greater Cincinnati Water Works, a department of the city of Cincin- nati, Ohio, has actively pursued regionalization strategies by providing smaller utilities with technical and operational assistance, wholesale sup- ply of finished water, or a merger of operations into the larger utility when desired. Similarly, the American Water Works Service Company has pursued a specific strategy of purchasing or entering into contract operation agreements with groups of small utilities. These types of re- gional approaches, which can be accomplished by either public or private organizations, achieve economies of scale from common operations, as well as improved customer service through an organization with access to greater technical and operational skills. Strategy 3âCombining Public and Private Roles A third option for public utility officials considering improvements is a mixture of public and private services within the utility. This approach implies that the efficiencies that a private firm can achieve in the opera- tions of specific tasks of the public utility can be achieved at less cost to the consumer despite the need for shareholder return. The key with this option is a careful review of the utilityâs operations to determine which parts can more efficiently and effectively be provided by internal re- sources versus outside âprivateâ resources. In reality, a mixture of public and private services within a utility operation has been a common practice (albeit on a limited scale) for de-
70 PRIVATIZATION OF WATER SERVICES IN THE UNITED STATES cades. Many U.S. utilities have often used engineering firms to design, prepare bid specifications, and manage construction of new facilities. Some utilities contract with private firms to provide billing and meter reading services, and most utilities use private firms to perform special- ized maintenance tasks and laboratory services. However, with techno- logical improvements and extensive use of the Internet, utilities have been able to effectively merge public and private services and to use private firmsâ services to a larger extent. The EPA has long advocated the use of public-private contracts as a means of addressing the rising cost of complying with critical environ- mental regulations (EPA, 1990). The EPA believes these types of part- nerships will help reduce costs, speed project completion, guarantee performance, and preserve jobs (EPA, 1990). Some common types of part- nerships are summarized in Table 4-1. The EPA has documented some successful public-private partner- TABLE 4-1 Public-Private Contract Options Partnership Option Description Acquisition Public utility sells the facility to private contractor, resulting in private ownership and operation. Joint Venture Private contractor owns facility in conjunction with public utility. Build, Own, and Private contractor builds, owns, and operates the facility. Transfer (BOT) At the end of the specified period, such as 30 years, the facility may be transferred to the public utility for a nominal fee. Turnkey Facility Private contractor designs, constructs, and operates the facility. The public utility retains ownership and generally assumes the financing risk, while the private contractor assumes the performance risk for minimum levels of service and/or compliance. Full-Service Contract Public utility contracts with private contractor for a fee to operate and maintain the facility. The public utility owns the facility (although it may have been built by the private contractor). Contract Operations Private contractor operates and maintains the public utilityâs facilities over the long or short term. Contract Management Private contractor manages and supervises the public utilityâs personnel. Operations Assistance Private contractor provides transition management or program management to improve effectiveness of the public utilityâs operations.
MODELS OF WATER SERVICE PROVISION 71 ships, including projects in Mount Vernon, Illinois (construction and op- eration of a wastewater treatment plant); Scottsdale, Arizona (creative financing for drinking water supply); Dowingtown, Pennsylvania (re- gionalization for upgrading and expanding wastewater treatment facili- ties); and Kerrville, Texas (competitive negotiation for financing waste- water treatment facilities). Examples of other successful partnerships include the Western Carolina Sewer Authority (two-step competitive bid- ding for wastewater treatment plant construction and operation) and the Seattle, Washington, Tolt River treatment plant project. Two major pri- vatization initiatives in wastewater treatment (in the city of Indianapolis and the Miami Conservancy District in Ohio) are EPA demonstration projects that will be closely monitored and analyzed. In the year 2000, over 60 competitive government contracts were announced, totaling $113 million in annual revenues (PWF, 2001). A form of public-private partnerships that has recently gained a wider acceptance is the use of design-build or design-build-operate agreements between public agencies and private firms. In the construction of a capital asset, water utilities can enter into privatization agreements at three sepa- rate stages in the development of a capital facility: (1) prior to the design of the project, (2) after completing the preliminary design, and (3) after completing the final design, but prior to construction (Westerhoff, 1986). Each approach has unique advantages and disadvantages. For example, the first approach provides the private firm with the opportunity to con- struct a facility that it views as the most cost-efficient. The second ap- proach can facilitate joint development of the project, so that the interests of both parties are served. The third approach provides the water utility with maximum control over the design of the project before the private firm begins construction. Box 4-4 shows case studies of DBO projects in Seattle and New Jersey. Growing Interest in the Design-Build-Operate Model The design-build-operate model (DBO) of public-private water sys- tem partnerships has become popular with some contract operators and private water companies. In this model, one corporate entity, possibly composed of a partnership of several companies, has responsibility to design the water or wastewater facility or system and then build and operate it under contract for a period, typically between 15 and 25 years. The advantage of this system is that the designer is motivated to antici- pate operation problems and to design for the best overall performance over the contract period. Financing of the project may also be included as a contractor responsibility although the contracting community typically retains ownership.
72 PRIVATIZATION OF WATER SERVICES IN THE UNITED STATES BOX 4-4 Design-Build-Operate Projects in Seattle and New Jersey Seattle: One notable example of cost savings through the design-build-oper- ate model is Seattleâs 1997 procurement of a new 120 million-gallon-per-day water treatment plant following substantial completion of a conventional design. The es- timate for the construction and operation costs of the conventional design was $171 million over the 25-year maximum project life. The selected DBO proposal was for $101 million, providing savings of $70 million, which is 41 percent of the engineering estimate. The city is also proceeding with the Cedar Treatment project to treat 180 million gallons per day with provisions to treat 275 million gallons per day, at an estimated DBO savings of $50 million over the estimated cost of a conventional procurement process. The project enhances Seattle Public Utilitiesâ (SPU) existing multiple bar- rier approach to provide reliable public health protection and specifically provide treatment for Cryptosporidium, and it addresses the non-health-related taste and odor issues associated with the Lake Young reservoir on the Cedar supply. Capital Cost Total CEDAR (permitting, design, Operating Cost (25-year TREATMENT construction, (25-year present present value; PROJECT in millions $) value; in millions $) in millions $) SPUâs estimated cost $115.0 $49.0 164.0 for design, build, and construction of thefacility using a conventional design- bid-build contracting approach (in 2001 dollars) Amount negotiated with $78.0 $31.0 109.0 contractor Add estimated cost of $3.0 $1.30 4.3 SPU oversight The contractor that provides the proposal deemed most advantageous to the community must deliver a finished facility to the community on a certain date and at a guaranteed cost, and the facility must be able to pass an independent test of its performance. After passing an âacceptance test,â the facility is placed in service and is operated by the contractor. In this model, one entity bears full responsibility for all elements of the project from design through 15-25 years of operation. This differs from conven- tional municipal procurements, which typically have started with the non- competitive selection of a qualified engineering firm to design a new facility under a professional services agreement. Construction of the facil-
MODELS OF WATER SERVICE PROVISION 73 New Jersey: A similar but smaller project in Washington Borough, New Jersey demonstrated the differences between the conventional and the DBO model. (Mangravite, 1999). The initial engineering estimate for construction of this 3.6- million-gallon-per-day wastewater treatment plant was $11 million. Private firms offered a combined design-build-operate procurement as a means of reducing overall cost. The borough invited the firms to develop nonbinding conceptual pro- posals. The Borough and its consultants compared the conventional engineering- construction model of procurement to the design-build-operate model. The Bor- oughâs consultants prepared a Request for Proposal for each concept. On the same day, November 7, 1998, the Borough received cost proposals for a DBO project and construction bids for a conventional design. After comparing the costs and benefits, including time to completion and full life-cycle costs, the Borough voted to negotiate with two DBO firms. The DBO advantages were the shorter DBO construction period, a design cost of $370,000, 58.4 percent lower than the estimated cost of sole source conventional design fee, and lower construction costs. The proposed construction cost in the conventional model averaged $10.28 million, which was close to the $10 million estimate, about 10 percent below typical construction costs for a project of this nature. The construction price for the selec- ted DBO proposal, after subtracting cost of design and management, was $7.4 million. This is 16 percent lower than proposed in the conventional model for Wash- ington Borough and 25 percent lower than is typical for this type of project. SOURCE: Mangravite (1999). ity is then publicly bid, with the award going to the lowest bidder. After start-up, the municipality operates the facility. In a DBO procurement, the DBO firm is the construction manager. This is done to aggregate all de- sign and construction liability. It also eliminates change orders for all but uncontrollable circumstances. Another area where privatization can be used is in the development of joint water projects among two or more utilities (Hardten, 1984). The utilities can enter into an agreement with a private firm to develop source of supply, treatment facilities, and possibly distribution networks. By serv- ing more than one community, joint projects can help the utilities share
74 PRIVATIZATION OF WATER SERVICES IN THE UNITED STATES costs and realize economies of scale. Joint projects also facilitate regional water supply planning and environmental management of water re- sources. Lease Financing For utilities willing to delegate some elements of control, especially ownership, leasing has emerged as an alternative technique for financing equipment and facilities for water utilities. For investor-owned utilities, leasing is a means of reducing equipment costs and eliminating construc- tion expenditures. For publicly owned utilities, leasing is a form of pri- vatization, as well as a means of compensating for the reduced availabil- ity of federal and state government construction grants. Leasing can be complex, with tax consequences for the lessee (the water utility) and tax benefits for the lessor (the private firm providing the leased good or the lender). The simplest form of leasing is the direct lease (AWWA, 1986). A leveraged lease is a more complicated three-party lease in which the les- sor (the owner) acquires financing from a third party (the lender) for the bulk of the cost of the equipment or facility. A third form of leasing involves certificates of participation (AWWA, 1986). Leasing provides several advantages for the various parties involved. The primary advantage for the lessee (the water utility) is the capability to have equipment or facilities in place more quickly because of fewer ob- stacles than with conventional financing. In other words, private financ- ing results in less regulatory oversight, fewer delays in bringing the equip- ment or facilities on-line, and lower aggregate project costs. The leveraged lease has some unique advantages. For tax purposes, the lessor owns the equipment or facility and thus qualifies for federal tax benefits based on the total equipment or facility cost. The third-party lender receives inter- est payments that generally exceed those associated with comparable loans. The lessee receives the benefits of lower equipment and facility costs. By transferring a portion of the tax savings linked to equipment purchases and facility construction, the water utility can obtain external financing, thus saving water customers substantial capital costs. Lease financing has additional advantages (Crane, 1987). Leasing frees some funds for other purposes and reduces the risk of obsolescence asso- ciated with aging equipment. In a regulatory context, lease financing can be viewed as a technique for coping with rate shock (large increases in rates to generate sufficient cash to pay for expensive equipment or build- ing replacements), because it alters the capital recovery pattern for the investment. Lease financing permits expense treatment rather than rate- base treatment of the equipment or facility. With rate basing, investments in capital assets (buildings and equipment) begin with high front-end
MODELS OF WATER SERVICE PROVISION 75 costs that decline over time with depreciation. The large cash outlay at the time of purchase requires significant rate increases to raise the needed cash. With leasing, level payments are made indefinitely. Leasing can reduce initial revenue requirements and result in lower initial rates, al- though ratepayers actually may pay more for equipment or facilities in the long term. A similar example would be purchasing versus renting a home. In the purchase arrangement, the new homeowner usually pays a sizable upfront down payment on the purchase price and then makes monthly mortgage payments. Once the loan is repaid, the homeowner holds title to the asset and no longer has to make payments toward its purchase. On the other hand, the renter usually makes lower monthly payments for the use of the home and does not have to make a sizable up- front payment. But because the renter never owns the home, he or she will have to make payments indefinitely. Disadvantages to lease financing also exist. Leasing essentially shifts some costs from capital to operating expenditures, depending on how lease payments are accounted for. In all leasing arrangements, insurance costs can be substantial since the lessor will require that the lessee be fully insured. In a leveraged lease, transaction costs are substantial, given the number of parties involved and various tax and legal complexities. With certificates of participation, the use of purchase options requires that in- terest-rate protection be provided to the investors. Finally, lease financing means that the water utility cannot earn a rate of return on the leased asset. At the completion of the lease term, if the water utility does not want the facility, the lessor is left with an unwanted facility and the risk of being regulated by a regulatory commission. Changes in tax rates may result in lessors not receiving the anticipated tax savings. Lenders face the risk of defaults on payments of interest and principal. Problems with lease financing result primarily from each party having a different view of the arrangementâs advantages and disadvantages. The lender seeks a high return on borrowed funds; the lessor is concerned about the repay- ment of capital and tax benefits; and the lessee is concerned about the impact on costs, revenue requirements, and fulfilling the obligation to serve should something go wrong.2 Strategy 4âPrivate Ownership of Utility Assets Turning over ownership of utility assets to an investor-owned utility is the most extreme form of privatization, but there are situations where 2A bankruptcy by the lessor, for example, could force a sale of facilities, which may not be in the best interest of a utility or its customers.
76 PRIVATIZATION OF WATER SERVICES IN THE UNITED STATES this might be the best path to follow (Table 4-2 lists the major U.S. inves- tor-owned water utilities). There are several potential advantages of asset divestiture as a strat- egy (Beecher, 2000). Local government is released from direct responsibil- ity for managing and planning operations. Monitoring of responsible op- eration is typically assumed by a state regulatory agency. Divestiture may facilitate regionalization and the integrated operation of water and waste- water facilities. Operating practices, pricing of services, and financing are removed to a greater distance from local politics, while opportunities for fraud and nepotism may be reduced. The privately owned utility will TABLE 4-2 Larger Investor-Owned Water Utilities in the United States Total Water Operating Residential Delivered to Revenues Customer System (in billions Water Utilities (in millions $) Connections of gallons) Pennsylvania American 291 495,917 71 New Jersey American 244 300,755 52 California Water Services 203 339,278 109 Southern Californa (American States) 160 238,511 64 Philadelphia Suburban 151 280,779 40 Elizabethtown (Thames) 133 187,993 49 United New Jersey 124 160,651 38 San Jose Water Co. 116 191,461 51 St. Louis County 106 285,954 61 Indianapolis 94 237,332 51 Bridgeport Hydraulic (Kelda) 92 123,837 25 West Virginia American 78 141,674 19 Illinois American 74 131,255 32 Indiana American 73 152,004 28 California American 68 91,934 24 San Gabriel 53 76,649 28 Florida Water Services 53 129,996 N/A Middlesex Water Co. 41 51,300 17 Long Island (American) 35 68,271 11 Baton Rouge 34 127,700 21 Suburban Water Systems 32 63,959 17 Tennessee American 32 59,963 14 Virginia American 30 43,929 14 Northwest Indiana (American) 27 57,415 14 United Idaho 26 57,638 16 SOURCE: Adapted from NAWC (1999).
MODELS OF WATER SERVICE PROVISION 77 have greater freedom in dealing with the workforce and, through cross- training and other steps, could increase labor efficiency. Cities that sell their assets can use the proceeds for other municipal purposes. The investor-owned utility becomes a tax-paying corporate citi- zen. Importantly, asset sales place the utility under the purview of inde- pendent state economic regulators who often have a greater capacity for oversight than do local governments. Regulation removes the system from local political processes and provides a powerful system of accountability and performance incentives. Economic regulation requires less duplica- tion of expertise and management than does oversight of privatization contracts. The National Association of Water Companies commissioned a study of 29 water utility privatizations, which were motivated primarily by the large backlog of needed investments and partly by cash-flow concerns (NAWC, 1999). The projects resulted in operating cost savings ranging from 10 to 40 percent, and previously planned rate increases were avoided. The nine divestitures resulted in asset acquisition payments of $537 million, concession fees of $35 million, and facility investments of $55 millionâa substantial infusion of capital to the local communities involved. There can be disadvantages or risks that are unique to this form of privatization. The valuation of utility properties is difficult, while the resulting upfront payments constitute a one-time windfall. Reacquiring the assets may require the city to exercise powers of eminent domain and can be costly. The city would also need to reacquire expertise in manage- ment and operations. The financing and tax advantages of public owner- ship are lost, and rates may have to be increased to pay for the costs associated with financing, taxes, and profits, particularly if water has been underpriced relative to actual costs. Advocates of private ownership contend that efficiency gains help offset these costs. Economic regulation and cost-based ratemaking may not be considered desirable. The major barrier to asset transfer, however, is the perceived loss of control, a per- ception exacerbated by the consolidation and globalization of the inves- tor-owned water industry. ASSURING SUCCESSFUL CONTRACTS Local officials can implement a variety of safeguards to protect the interests of their communities and their citizens in the privatization pro- cess. When considering privatization, local government officials should perform a series of analyses to evaluate water system needs, review cur- rent technologies, assess vendor interest, compare risks and benefits, in- ventory financing alternatives, and appraise legal and regulatory consid-
78 PRIVATIZATION OF WATER SERVICES IN THE UNITED STATES erations (Raftelis Rate Survey, undated). Fortunately, information sources on how to contract for public services are fairly well developed. For ex- ample, public officials can draw on a wealth of information about com- petitive bidding processes. Certain safeguards are based on common sense, while others may require more technical capability. Contracts involving larger commu- nities can be complex, and the risks associated with failure can be very high. Yet for small communities, the potential risks are at least as signifi- cant because of constraints on local resources. There are also significant health and environmental considerations associated with community water supply, regardless of community size, because even a small mishap in a small community can have serious consequences. Ideally, privati- zation will enhance, not detract from, compliance with environmental and health standards. RISK MANAGEMENT Risk management is an essential part of any privatization agreement. Local government officials can ill afford to enter privatization agreements without a careful analysis of risks and a clear delineation of risk manage- ment methods (see example in Appendix C). Savings from privatization will not be realized if the privatization contract allocates costs and risks to the public entity and does not provide the contractor with adequate in- centives for efficient and effective performance (Holcombe, 1991). The enticement of profits without risk sharing and accountability will not serve community interests. According to the EPA, âpublic-private partnership agreements are designed to allocate risks among the parties in proportion to their abilities to bear risks, and to control factors associated with those risksâ (EPA, 1990). Privatization agreements are inherently large and complex because of the numerous parties involved and the range of issues that are covered (construction, operation, technologies, and finance). Professional assis- tance could prove useful to community leaders in structuring privatiza- tion agreements in order to ensure protection of community interests. CONTRACT OVERSIGHT AND EVALUATION Continual oversight is a key part of any privatization arrangement. Three key issues for local government officials to consider are the costs of monitoring, alternative monitoring techniques, and responsibility for monitoring (Rehfuss, 1990). Monitoring costs can be significant. Monitor- ing techniques include inspections, reports, complaints, and accountabil- ity and performance standards. Officials at different levels within the
MODELS OF WATER SERVICE PROVISION 79 governmental agency can perform monitoring, and an arrangement work- ing well in one organization for one type of contract may not work well under different circumstances. Some privatization advocates have suggested that the renewal of a contract is proof of success. But contracts may be renewed for a variety of reasons, including the tendency to maintain the status quo, limited alter- natives, and the economic and political cost of âundoingâ an agreement in place. Politicians usually invest some political capital in the decision to privatize and are generally reluctant to reverse the course. Evaluating successes and failures of water services privatization must reach beyond the single measure of contract renewal. A broader concern is whether privatization achieves desired outcomes and is truly âsuccessful.â These outcomes can be measured not only in terms of the provision of water services, but also in terms of economic, environmental, and social goals. Sound evaluation criteria can provide a framework for assessing whether privatization is living up to its promises. Evaluation criteria and methods of evaluation might include but are not limited to the following: â¢ economic efficiency, as measured in cost effectiveness and cost and benefit terms, as well as in rate impacts on customers; â¢ environmental quality, as measured in terms of compliance with federal and state water quality standards and indicators of environmental quality; â¢ customer satisfaction, as measured in opinion surveys, service per- formance, and complaint records; â¢ labor relations, as measured in worker safety, benefits, retention, and satisfaction; â¢ corporate citizenry, as measured in terms of the contractorâs pres- ence and relationships in the community; â¢ equity considerations, as measured in terms of the extension of water services to those less able to afford them; and â¢ transparency, as measured in terms of public access to meetings and contractual processes. Evaluation criteria are ideally established early in the process. Mecha- nisms for monitoring and data collection can subsequently be put in place. SUMMARY Public organizations should focus on improving their services to the public and in meeting customersâ expectations through responsible ex- penditure of public funds. The goal of providing water services to the public can be achieved by a public organization or a private organization
80 PRIVATIZATION OF WATER SERVICES IN THE UNITED STATES or by a combination of both. How a communityâs public officials choose to provide these services depends on community-specific circumstances. Organizations can be improved by focusing on identified deficiencies or by undertaking a more comprehensive strategic planning process that establishes goals and options and that optimizes the conduct of each op- erating function based on measured benefits and costs. With a commit- ment to systematic improvements, both public and private leadership can open a flow of innovation from middle managers and rank-and-file em- ployees so that all employees do their best work in the public interest. For any organization to reach its potential, it is essential for the top members to help the organization maintain a focus on its key objectives. The leader- ship must encourage an organization and its staff to take significant steps offered by innovative opportunities when warranted, without fear of re- prisal from failure.