PPPUE: Tools for pro-poor municipal PPP: Mod 11/2-Selecting Options

11.1 What are the objectives?

11.2 What are the key processes involved?

11.3 Who is involved?

11.4 What are the key steps?

11.5 What are the key issues?

11.6 What are the key issues relating to options for pro-poor PPPs?

Module 11: Selecting Options

11.2. What are the key processes involved?

Generally, the processes involved in selecting PPP options can be presented by the following procedures:

1. Defining organisational options
2. Developing a partnership framework
3. Identifying the main PPP options
4. Feasibility management

1. Defining organisational options

The organisational framework of the partnership is an important step in the decision-making process. In order to establish an organisational framework, the municipality needs to consider what type of framework will help it meet its objectives and respond to the specific opportunities and constraints of its situation.

Municipalities are encouraged to compare different organisational arrangements to see how best to reach their objectives. The operational models include those listed below:

a. Direct contractual model.
The private sector is contracted directly to the municipality.

b. Utility model.
The municipality creates an independent utility to separate responsibility for the service. The municipality has an agreement with the utility and the utility has a management contract with a private operator. This organisational framework creates a series of contractual relationships at the higher level, supplemented by subsidiary contracts for service delivery.

c. Joint venture model.
The public and private actors assume co-ownership of the system assets and co-responsibility for the delivery of services. The public and private sector partners can either form a new company or share ownership of an existing company. Joint venture creates a new entity to implement various types of project structures.

d. Community-contracting model.
The municipality delegates its role to the community. In some situations, the municipality does not have a contractual relationship with the community; however, through a structured programme of change, the community establishes contractual relationships with the private sector. Significant community capacity development may be required to ensure this organisational framework is sustainable.

e. Bundling
refers to the aggregation of components or functions to create a larger scope of work. For instance, a municipality may approach its neighbours to determine whether there are significant benefits in them presenting their problems as a part of a consolidated package. This might include arrangements where municipalities group together: to attract the private sector; to introduce economies of scale not possible in smaller municipalities; or to share high transaction costs.

f. Unbundling
refers to the desegregation of components within a service sector. An “unbundled” sector may enable a range of service delivery options to be adopted and may be politically helpful in introducing a private sector approach. Breaking a service sector down into a number of parts may enable municipalities to keep control of controversial functions or it may allow them to involve a range of actors and build on existing local assets.

2. Developing a partnership framework

Once the municipality has agreed an organisational arrangement, it needs to decide upon a general strategy and select a contractual option, developing a partnership framework in the process.

The key elements of the partnership should be defined, discussed and agreed. This will include taking into consideration aspects already analysed, namely:

– clarifying realistic objectives;
– defining the basic principles of the partnership;
– establishing the programme of change;
– defining the scope and functions of the arrangement;
– identifying the key partners, their roles and relationships;
– defining the levels of service, and how the poor will be targeted;
– identifying the potential financing mechanisms;
– establishing the legal and regulatory framework; and
– identifying the major risks

3. Identifying main PPP options

After the municipality has defined the organisational option and a strategy for developing a partnership, the next step can be taken to identify the contractual option; this in turn can formalise organisational option.
The major options for PPP can be defined clearly in terms of how they allocate responsibility for functions such as: asset ownership; the level of responsibility and autonomy delegated to the private sector; the required capital investment; regulation; the duration of the contract; and the contractual relationship with the consumer.

At one end of the spectrum is the option of a fully public sector, where the government is responsible for all stages of service delivery. At the other end of the spectrum there is the option when the government delegates full responsibility for the service to the private sector, retaining only its roles as enabler and regulator. Between these, there is a plethora of other available options. The selection of a particular one depends on the results of a thorough analysis, described later it this Tool.

Different countries have adopted different contractual options for Public-Private Partnerships. In practice, these arrangements are often hybrids or a combination of the basic options:

• Service and management contracts;
• Lease;
• Concession;
• Build-Operate-Transfer (BOO) arrangements; or a
• Complete transfer of ownership through divestiture [see alsoTool 11-1].

A. Service contracts

Service contracts are simple contracts awarded to private companies for particular tasks, such as installing or reading meters, monitoring losses, repairing pipes or collecting accounts. They don’t normally last long – say, six months to two years. The responsibility for coordinating these tasks remains with the public utility managers. Service contracts will not remedy a situation where the utility is poorly managed and costs are not recovered.

B. Management contracts

A management contract is a more comprehensive form of service contract, under which the public authority appoints a private contractor to manage all or part of its operations.
The simplest management contract is the payment of a fixed fee in exchange for performing managerial tasks. More complex contracts will set payment based on meeting performance targets. Government has to decide whether the extra regulatory costs of setting and monitoring these targets will promote appropriate levels of efficiency.

Management contracts are not a good option if government wants to raise finance for new investment. The company takes on little or no commercial risk, so there is hardly any incentive to reduce costs or improve services.
However, management contracts are useful options in preparing for PPP where:

– the regulatory framework needs to be upgraded;
– tariffs are too low and government needs time to develop a system of subsidies;
– stakeholders have not yet agreed to long-term involvement of the private sector; or
– the country has no record or experience of public-private partnerships.

C. Lease contracts

Under a lease contract, a service utility leases the full operation and maintenance of its facilities within an agreed geographic area to a private operator for a period of time.Because the lessor effectively buys the rights to the income stream from the utility's operations (minus the lease payment), it assumes much of the commercial risk of the operations. Under a well-structured contract the lessor's profitability will depend on how much it can reduce costs (while still meeting the quality standards in the lease contract), so it has incentives to improve operating efficiency.

Government retains the responsibility for financing and planning investment. So if major new investments are needed, the government must raise the finance and coordinate its investment program with the operator's operational and commercial program.A company may not be willing to take on a lease, unless government makes adequate investment. A lease arrangement puts a regulatory burden on government, almost equivalent to that for concessions. Leases are most appropriate where there is scope for big gains in operating efficiency but only limited need or scope for new investments.

D. BOT contracts

Under Build-Operate-Transfer (BOT) or build-own-operate-transfer (BOOT) schemes the private sector typically designs, constructs and operates facilities, and provides services to municipal or government-owned service utilities. In contrast with lease contracts, BOT-type contracts allocate much more of the commercial risk for specific projects to private parties rather than governments.

BOT contracts are similar to concessions, except that the company invests in building the utility and operates it over an agreed period, often decades. The government, or distribution utility, pays the contractor for the service provided (water or electricity, for instance) at a rate, which covers the building and operating costs, plus a reasonable rate of return. The utility must pay for all the water or electricity produced, even if not all that water or electricity is used. This places demand risk on the distribution utility or government.

E. Concession contracts

Concession contracts combine elements of operation leases for existing assets and BOT contracts for greenfields. Under concession contracts, a private operator is given a contractual right to use existing infrastructure assets to supply customers and to finance and manage all capital extensions and upgrades to the existing services supplied. This tends to result in concession contracts being of longer duration than lease contracts to enable the operator to recover its capital and financing costs. Typically, under a concession agreement, the constructor and operators also are given the right to supply retail services direct to customers.

A concession gives the private partner responsibility for investment, as well as operation and maintenance of the utility. Assets remain with the government. The full assets, including any built by the private partner, go back to the government when the concession ends, usually after 25–30 years. The private bidder who intends to operate the utility and meet investment targets by charging the lowest tariff, usually wins the concession.

A concession is an attractive option if large investments are needed to extend and improve services. However, government will have a complex role in administering the arrangement. Quality of regulation is essential in such arrangements in order to balance profits earned by the concessionaire with lower prices and better services for the customer.

F. Divestiture

A full divestiture, like a concession, gives the private sector full responsibility for operations, maintenance and investment. However, unlike a concession, a divestiture transfers ownership of the assets to the private sector. This leaves the government responsible solely for regulation. The company now has the full responsibility for managing its assets. The regulator will require the private water company to report how its assets are being serviced.

Divestiture can take place through a sale of assets, sale of shares or management buy-out. Divestiture is likely to work best in an environment where financial services are extremely well established and stable. To date, divestiture has only taken place in England and Wales, although private water companies have been working in the United States for many years.

4. Feasibility management

The choice of the most viable PPP option for a particular country/ municipality at a particular point in time will depend on a number of factors. These include, but are not limited to:

◊ government and the community support, or the lack of such support, for private sector involvement;

◊ the nature of the problem at hand – lack of investment funds, lack of expertise, low cost recovery mechanisms, low quality of the service provision, weak poverty reduction policy and so on; and

◊ existing municipal and private sector capacity in terms of human resources, organisational development and regulatory framework.

Feasibility management should provide clear information concerning all existing and expected factors, which may support or oppose the implementation of the PPP options.

Feasibility management of all PPP options requires:

◊ analysis of a government commitment and community support for a certain option;

◊ a well-researched and negotiated legal contract;

◊ a strong regulatory and institutional environment; and

◊ analysis of the state of the utility, existing regulation, financial viability and risks.

However, it should be borne in mind that the quality of the written contract will play an important part in the ultimate success or failure of all possible PPP options. A good quality contract will, among other things, encompass an appropriate allocation of risks.