E. Strategies for Small and Medium Sized Sanitation Utilities

Prof. Dr. K.-U. Rudolph
International Consultants for Water Engineering and Management
Germany

The Scenario

The presentation on SSIPs highlights one of the most important points to make when it comes to discussing water supply services in low income areas: where there are people, there is a water supply system. Now, the system may be official and emanate from a centralised source, or it may derive from a community-based provider or vendor, or even from an unofficial source. Either way, without some form of water supply service, there could be no human settlement. This is why PPP models can be found even where we would think there could be no PPP models. Innovative private solutions inevitably arise in places where the public utility is unable to provide adequate levels of service. Sometimes, innovative arrangements will be much more costly than the official service provider, and the fact that people still rely on them provides an important lesson in willingness-to-pay. Although the World Bank says that people are willing to pay somewhere in the range of 2% to 8% of their net income on water and sanitation services, many urban residents actually pay much higher rates to private vendors when the need is great enough. This behaviour is not uncommon in developing countries.

Small utilities represent the majority of water providers around the world, but they are much harder to operate. Lower population densities (as in rural areas) hinder economies of scale by providing limited numbers of customers per meter of network. This leads to relatively high specific costs. On the other hand, operators under these conditions often resort to compromising certain elements of the system (by lowering effluent standards, for example), so that the networks themselves are the cost drivers for smaller systems, not the plants. This presents a very different scenario when compared to water supply systems in big cities around the world. The low turnover per utility severely hinders full cost recovery, creating a demand for tailor-made and innovative approaches. Many of the solutions to these challenges in the small-to-medium sized projects will not be found in classic technical engineering textbooks.

At present, there is only a very limited interest within the water industry and among private sector professionals for private sector involvement in the smaller water sector projects. This will most likely change, however, as most of the major urban water markets will be supplied by Private Sector Participation (PSP) contracts within the next ten years. The large cities that will remain without private companies may not have the political will to invite private participation. This means that smaller cities and smaller contracts are likely to become more attractive to private operators than they are at the present time. In other words, in the future, we are likely to see smaller systems representing a much higher percentage of the global market volume in water supply and sanitation projects.

Measures For Involving Private Partners - Start From The End-Point.

The first thing to do is to start with the calculation of the total costs for providing a given service. A municipality begins by deciding what it would like to accomplish, and then must calculate the investments and the annual costs necessary to provide the desired services. After that, it is necessary to factor in depreciation and interest (etc). In many cases, and especially where private capital is potentially involved, municipalities will not be able to differentiate between water supply services and sanitation services. Experience shows that while a private concessionaire (or private company) can cut water services to a non-paying household, it cannot cut sanitation services. Therefore most of the companies believe that smaller utilities have to combine both.

Experience suggests that it is wise to start from the end-point. After calculating what you would like to have and the total costs associated with that desired standard, then it is necessary to compare these calculations to the estimated budget, which should be based on the maximum affordable price for water. This means beginning with the question: "What kind of service does the customer expect? And how much will they be willing to pay to pay for it?" Beginning with a textbook technical solution is not a wise way to attract investment. For example, in order to eliminate or reduce unaccounted-for-water, a network needs proper metering and billing systems. A system that lacks adequate metering will have to rely on a monthly per capita billing system. Either way, the end result must be to guarantee sufficient revenue streams for refinancing, especially when private capital is involved. Of course, from the point of view of the private participant or shareholder, the cash flow is the most important element.

Decision-makers must also remember to weigh levels of economic acceptability or water tariff affordability on the one hand with the disadvantages of not providing adequate levels of services and environmental controls on the other hand. A system that does not consider environmental impacts, for instance, will result in externalities that will end up costing much more in the long run. This was the experience of Germany at reunification, when there were horrible environmental scenes in places like Bitterfeld.

Another lesson from the experiences of small utilities is that they often require combining services into integrated systems. One can find examples in crowded rural areas where populated village centres may have a gravity-based sewer system as well as a vacuum system or truck hauling system. In these cases, no single solution is adequate.

Many international financing loans miss this point. Instead, their loans often end up supporting uniform, inefficient systems by subsidising water tariffs at levels well below affordability limits. This scenario will invariably stifle the pursuit of innovative solutions. Municipalities that subsidise, in other words, may end up with a nice new network, but not necessarily an efficient, economical or market-driven system. It is also possible that the system will not be environmentally sustainable. In cases where the investment is subsidised, the incentive for optimising the system is also limited to the investment.

Optimising System Design

In Germany, an effective way to select innovative solutions has been demonstrated by the so-called Betreibermodell. This approach typically involves a service contract or a BOT, although the contracts are different from case to case. The model is based on the idea of tendering a full service under competitive bid and placing the responsibility for selecting the right type of arrangement and facility on the operating firms vying for the contract. Through competition, new ideas and technologies will surface, providing the municipality with a sound chance of reviewing a variety of potential solutions. This may be a good approach for water markets because private operators who are responsible for the technology are also more likely to take bigger risks to demonstrate its effectiveness. Traditional engineering consulting firms might otherwise be too afraid of assuming liability for operating costs and therefore tend to propose textbook facilities that may not be the most appropriate (or cost effective) solution.

The idea of holistic and integrated optimisation was the principal argument for the Betreibermodell in Germany, and we have as a result several convincing examples of new plants and networks. Very often, however, the solution does not lie in simply building new plants in Greenfield sites. We need a combination of different approaches. A municipality may have technical knowledge of existing facilities, but will not be able to determine accurately what investment levels are required for the future. Although knowledge of the network is important, it is not sufficient to enable completely accurate procurement. Hence the relevance of innovative cooperation models, such as Public-Private Partnerships.

Many small municipalities are near large industrial complexes, such as Bitterfeld in Germany where a private operator is providing services to a small municipality that neighbours an industrial complex. By combining services for both markets, the firm is able to take better advantage of economies of scale. This also occurs in developing countries. There are examples in India, where small utilities are combining services with nearby private industries and profiting from more advantageous scale ratios as well as from enhanced management capacities.

Negotiating Contracts

One of the biggest challenges facing private investment in water supply systems has to do with fixed costs. System design must be flexible enough in order to take into account real water tariffs. When the price per cubic meter goes up, people will reduce their consumption. Although this can be a very positive environmental externality in many developing countries where water conservation is badly needed, it is not good news for a private investor (unless the calculations have accounted for it). Decreased consumption may have a negative effect on prices because the cost for delivering a cubic meter of water will not change by more than 10% to 20% - roughly the margin of the variable costs. This means the price per cubic meter may have to rise.

In order to implement a fair water price, the contract partners will require tremendous power for negotiating - and flexibility for re-negotiating - contracts. This is why the World Bank and the European Bank for Reconstruction and Development (EBRD) are often recommending referee boards. They realise that post-award negotiations are often vital and sometimes unavoidable. This situation limits the amount of truly fair competition. What begins as a competitive system often ends up as a private monopoly for a certain number of years. This is why contract regulation is so important.

Given the complexity of contract negotiations, a highly recommended approach involves using a price formula that is LOS ("level of service") driven.

Several "management contracts" have been effective in a number of smaller water supply and sanitation projects. Here the private operator assumes responsibility for operation and contributes know-how and private financing, but does not own any of the assets. Representatives of the company usually serve on an Executive Board, and there are some guarantee parameters to ensure revenues. Germany has several such PSP-models that have worked well and have managed to avoid problems with the unions because they provide a transition period for personnel and take a step-wise approach to privatisation, which grows from year-to-year.

By comparison, Germany actually has a large number of small privatisation models - and an outstanding variety of different models, as well. The smallest one serves a population of 2,800 in Bavaria, where there is more money than in developing countries, but a low population density outside the cities. Berlin's water supply system with 3.6 mio. p.e. is on the opposite end of the spectrum. A PSP project was concluded there in November 1999.

Systems are complex. As a result, municipalities need to develop a regulatory system in order to be able to enforce the contracts, to ensure that the private partners are meeting their obligations, and to safeguard adequate levels of service for the population. The private partner should be a "lion," but a strong lion can become dangerous. Municipalities should never sign a contract implementing models that might become unstable or make them vulnerable in the long run.

To summarise the relative importance of the various elements of water supply and sanitation system projects in smaller cities: 50% of the success lies in the procurement; 30% in negotiating and building the system; and 20% in the effectiveness of the system's regulations. Privatisation is not a self-re-financing arrangement, and the cost for water is not zero after privatisation. The one common denominator is that private capital always has to be repaid. Since this is universally true, it makes more sense in the long run to pursue controlled and well-organised Public-Private Partnerships, rather than the less formal arrangements that arise to fill vacuums left by inefficient systems.

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