United States: Critical Issues For Water And Wasterwater Concessions

Although traditionally the province of state and municipal authorities, a variety of forces have converged lately to create tremendous opportunities for private companies seeking to participate in the ownership and operation of water and wastewater facilities throughout the world, including the United States. Among these forces are:

• a worldwide tightening of potable and wastewater regulatory regimes, often leading to new (and costly) capital improvements;
• a general desire to shrink government budgets by outsourcing to the more nimble and well-financed private sector certain tasks that were previously undertaken by governments;
• a recognition that the private sector is better able to organise, fund and administer research and development in certain areas; and
• a growing acceptance of so-called public/private partnerships, whereby the private sector supports or assumes tasks previously reserved for public entities.

In the US, for example, several major water and wastewater concessions have been let in the last 12 months. First, there was United Water Services’ 10-year, $350m contract to operate and manage Milwaukee’s sewer system. Right on the heels of the Milwaukee contract, a joint venture of United Water Services and its parent Suez Lyonnaise des Eaux signed a 20-year contract to operate and manage Atlanta’s water system. More recently, the City of Birmingham. Alabama, put its water system up for bid (but eventually postponed that mandate for political reasons after two rounds of bidding).

The competitive nature and short time frame under which these contracts were negotiated (the Milwaukee contract was signed less than 10 months after the issuing of the request for qualifications) demonstrates that the privatisation of water and wastewater facilities requires numerous complex issues to be negotiated quickly and under extreme competitive pressure. This article will provide an overview of several critical issues to consider when drafting or negotiating contracts whereby a government entity offers an operating concession or management agreement to a private company.

In privatising water and wastewater facilities, the key contract among the several agreements typically entered into between the host government and the operator is the concession or management agreement. This may also be styled as a water or wastewater sale or purchase agreement. Whatever the technical form of the agreement, careful attention must be paid to accurately and clearly describing the respective rights and obligations of both parties. This can be especially important in overseas jurisdictions, where local laws, business customs, cultural expectations, and language barriers may all conspire to create disputes and misunderstandings at a later date, which could have been alleviated by detailed drafting. Moreover, even when the intent of the parties is to outsource to the private operator as many tasks as possible, inevitably some tasks must remain for the host government.

For example, the concession contract may require the government to procure certain licences and maintain and renew permits and easements necessary for the operation of a given facility, especially if legal ownership of the facility is to remain in the name of the government. Similarly, the concession contract may require the government to provide access to heavy equipment, bulk purchased chemicals, and specialised repair facilities that it has in its possession and which are especially suited to the running of the plant(s) in question. By giving the operator access to such items, the operator’s costs should be reduced, lowering the cost of the concession. Likewise, in expansion concessions, the concession contract may require the government to use its eminent domain powers to assist the operator in land acquisitions, to speed up and reduce the cost of buildouts.

Careful drafting of the government’s obligations is also critical for the smooth transition of the facility from the government to the operator. The concession contract should contain provisions requiring the government to transfer outright title to, or appropriate access to, various items and materials necessary for the successful operation of the system, including billing and maintenance records, testing data, weather data, regulatory files, manufacturer’s warranties, guarantees and guidelines relating to the system, and similar items. The concession contract should also contain a provision requiring the government to provide reasonable access to the entire system as well as adjacent properties to the extent such access is necessary for the operation of the system.

Potential liability for regulatory violations and negligent employee conduct make the operation of water and wastewater facilities an inherently risky enterprise. Any agreement must carefully address the allocation of risks between the government and the operator. With potential liability almost unlimited, the operator will strive to place clear limits on its exposure for fines and civil liability. Clearly, the text of the concession agreement will be critical in this regard, but legal counsel should also investigate local law concepts such as strict liability (i.e., liability without fault) to be sure that local laws do not undercut a negotiated deal.

Insurance is another obvious firewall in this area, to the extent that it can be obtained to provide cover for the risk in question. The operator’s ability to limit its exposure in this area is often directly related to the role it is playing and the degree to which it is in total or partial control of the construction or operation of a system. For example, it will be difficult for an operator to limit liability for latent or design defects if the concession contract is a "build, operate and own" agreement. On the other hand, limitation for design and latent defects would be a more reasonable request in an "operate, manage and maintain" concession contract.

In further limiting its potential liability the operator will want to assume liability for only those parts of the system it controls. Thus, the concession contract should clearly define which parts of the system are under the control and responsibility of the operator. In some circumstances, the parties may need to establish specific testing points for monitoring the system. For example, if the product of an operator’s system merges with that of another operator or a government controlled part of the system, the concession contract should specify that the operator’s product be tested at the point at which it exits that part of the system last controlled by the operator.

Because there may be difficulties in evaluating the status and condition of the existing water system as well as developing accurate forecasts of future demand due to population growth or industrial development, the operator will often insist that there be no requirement that it supply or procure more water than is supplied into or available from the system. At the same time, prudent governments will want to enlist the operator’s expertise in locating and sourcing alternative, emergency water sources should local supplies prove inadequate for temporary or longer periods.

In any concession contract, the fee structure will be one of the first points to negotiate. Concession contracts may provide for a variety of ways to compensate the operator, ranging from fixed monthly payments untied to the system’s performance, to the other extreme whereby the bulk of the operator’s compensation is performance driven.

Besides commercial concerns, fee arrangements in concession contracts may also be driven by more extraneous factors, such as tax laws. For example, in the US, municipal water systems financed with state and federal funds often need to structure operator payment provisions to accord with certain rules limiting how much profit a private company can make operating a system funded with tax-advantaged debt. Often, a concession contract provides for some form of lump-sum fee arrangement, under which the operator receives a monthly lump-sum payment for operating the system, and bears the risks and benefits of operating the system above or below its target economics.

A lump-sum fee structure involves considerable risk for the operator, especially if it is operating in unfamiliar territory. Firstly, there is the risk of an unforeseen increase in operating costs – such as fuel, personnel or chemicals, not only from regular market forces of supply and demand, but also from such unpredictable forces as unexpected currency fluctuations. Secondly, there is the risk that a change in law may significantly increase a facility’s operating costs.

Another risk is that the facility may have to be expanded to serve new users or to compensate for an unexpected loss of input supply for treatment or waste disposal sites for output. Collection risks may also be greater than expected, especially if local laws do not provide meaningful or timely remedies against late paying or defaulting customers. Thus, any lump-sum concession contract should include covenants that allocate clearly the costs of addressing such risks.

Another common method of calculating fees is known as "cost-plus," whereby certain costs of operating the facility are passed through to the government in addition to a fixed amount payable to the operator. A cost-plus structure is often more attractive to an operator than a lump-sum fee structure, since it removes the risk associated with potential shifts in operating costs. However, the government will probably be resistant to a cost-plus structure that does not include incentives for the operator to minimise operating costs. Therefore, the government will usually require the formulation of an annual budget, which includes incentives for cost reductions. This monitoring and budgeting function increases the cost of operation and may give the government more control over the day-to-day operations of the project than is desirable from the operator’s viewpoint.

The provision of drinking water and wastewater treatment are highly regulated activities, and a change in the laws governing these services can have dramatic effects on the economics and operation of a facility. As discussed above, if the concession contract is not a straight cost-plus, the operator often negotiates for the pass through of any material increased costs associated with a change in law. The concession contract should also establish a clear mechanism for estimating the cost increases that result from a change in law and determining what constitutes a change in law.

The concession contract must also address the operator’s obligations if there is a change in law. There are a variety of options for defining the operator’s obligations in this situation. One option is for the operator to simply inform the government of the applicable change in law and thereafter it becomes the government’s obligation to fund and implement the required changes. A variation on this includes having the government fund the improvements while the operator is responsible for implementing them. Another option is for the operator to inform the government of the change in law and provide a plan for compliance, including bidding out the work and arranging the funding based on the government’s direct or indirect credit. Finally, the operator can notify the government of the change, formulate a plan for compliance and implement the plan using its own credit – passing through the cost of compliance.

Which option to use is usually a function of the duration of the concession, the extent to which the operator is in total or only partial control over the system, the economics of the risk/reward ratio of the concession to the operator, and the cost and availability of funds to each party.

In many privatising concessions (i.e., concessions for systems that are already up and running), the fate of existing personnel is probably one of the most politically delicate issues that the concession contract must address. Clearly, much of the savings offered by an operator are derived from greater operational efficiency, which often leads to reductions in employee levels. While the government may desire to benefit from these savings, it is rarely – if ever – willing to accept the political consequences of allowing the operator to layoff workers. Consequently, many agreements require the private operator to hire all existing water department employees. Further, governments often ask for a predetermined period – often several years –before the operator can make any staff reductions (other than for cause).

However, the political reality may require the operator to agree to no layoffs for an even longer period than the government has requested. For example, in the concession contract between the City of Atlanta and United Water, United Water agreed to a no-layoff (without cause) policy for the duration of the concession contract, which significantly exceeded the three-year no-layoff period requested by the city.

Despite these political realities, the operator can negotiate some terms that will aid it in reducing staff levels. For example, the operator can negotiate for the government to re-deploy some of the personnel to other parts of the government. The operator can also agree to pay for training and out-placement of a certain number of workers. Buyout programmes and early retirement incentives are also often used.

Some operators have been known to resort to other more indirect methods to "right-size" their staffing levels. For example, the operator can reserve the right to re-test employees, introducing new and more stringent competency standards, as well as requiring drug testing to weed out undesirable or unreliable workers. These new policies along with normal attrition may be just as effective in reducing staff levels as explicit contract terms for the reduction of staff.

If the operator receives payment from end-users, the price charged to customers will be of critical importance. In many concession contracts, the government retains the right to set or regulate water and wastewater treatment prices. In setting prices, the government will want to ensure that the rates are affordable for consumers, while the operator will want to ensure that they are sufficient to cover operating and maintenance costs and provide at least a reasonable return on capital.

Once the government has turned over a system to a private operator, it may become difficult to convince the government to order an increase in water and wastewater rates, unless the grounds for such increases have been clearly defined. Likewise, the government will want to be sure that the pricing formulas also provide for a reduction in water charges as efficiencies are recognised.

Rate discussions should not only take into account current annual operating costs, but should also consider if major maintenance sinking funds, or capital improvement reserves, or future source acquisition reserves, are also warranted. Prudent operators also take into account bad debt and collection reserves, especially in some foreign countries where enforcement rights are limited and the local service population may be unused to paying for water and wastewater treatment.

The doctrine of force majeure excuses the parties for nonperformance in circumstances that are beyond their control. In the US, force majeure law is well developed and contractual force majeure provisions can be formulated based upon a known body of law. In contrast, in many foreign jurisdictions, force majeure law may not be as well developed, and the concession contract should contain a detailed description of force majeure rights and obligations.

When negotiating force majeure provisions in foreign countries, it is critical that the operator invest the time and effort necessary to fully understand in advance the local conditions and circumstances that are outside of its control and that could adversely impact the operation of the facility.

Typical topics addressed in force majeure provisions include:

• notice requirements;
• what constitutes force majeure;
• whether the enumerated concepts are the exclusive force majeure provisions, or do other local law concepts apply as well;
• how long force majeure relief will be granted; and
• if an extended force majeure gives rise to a right of termination or contract suspension.

Intellectual property issues are often overlooked in concession contracts, but with today’s increasing reliance on computerisation of all aspects of industry – bookkeeping, research and design, billing, customer care, system monitoring – intellectual property issues should not be ignored. This risk cuts both ways, from the operator’s concern that its proprietary designs and software systems not be copied or appropriated by the host government for use in other systems, to the government’s concern that a termination (voluntary or involuntary) of the concession provisions relating to intellectual property should address, among other things:

• who owns the intellectual property that is generated in connection with operating the facility;
• what rights each party will have to use key intellectual property both during and after the expiration of the concession contract – including relevant licensing arrangements; and
• any issues relating to the intellectual property of third parties that might be utilised during the operator’s tenure.

This article has identified several areas that should be considered when negotiating concession contracts; many others apply as well. The key to a successful negotiation is an in-depth appreciation of the individual system’s requirements, a fair evaluation of the parties’ expectations, and a good understanding of relevant local law conditions.