WATER GLOBAL PRACTICE WSS GSG UTILITY TURNAROUND SERIES Case Study— Alföldvíz, Hungary By András Kis and Maria Salvetti AUGUST 2017 Key Characteristics of Aggregation Case Study ALFÖLDVÍZ, HUNGARY Context • High-income country • Aggregation covering urban and rural areas • High level of water supply and sanitation (WSS) performance Purpose Economic efficiency, performance, professionalization Scope WSS functions and services Scale • Administrative boundaries • Localities covered: 131 for water and 81 for wastewater • Population covered: 564,000 inhabitants for water and 399,000 for wastewater • Coverage: 100% for water; 71% for wastewater • Connections: 257,557 for water and 191,359 for wastewater • Network length: 4,580 km for water and 2,680 km for wastewater Process Top-down Governance • Delegated • Public company • Decision making: municipalities and the Hungarian state are the utility’s shareholders • Asset transfer: assets remain the property of municipalities and are transferred to the operator for the duration of the delegation contract; municipalities receive rental fee in return for this transfer • Liability: liabilities and debts from previous operators are not taken over by aggregated utility • Staff transfer: all staff was transferred • Clear entry and exit rules Outcome Positive, with decreased water operating expenses but increased wastewater operating expenses (because of network expansion); slight improvement in performance Findings A merger project team has been created that is dedicated to expansion of the service area, ensuring relationships with future member municipalities; many municipalities insist on using their own water resources (which are costly) instead of using water from the integrated system; aggregation appears beneficial, especially for service quality and sustainability in small municipalities 1 In 2011, when the Hungarian parliament voted on the 34 water utilities. Those companies were operating aggregation reform of WSS services , the Békés County predominantly at the county level and in larger towns. Water Utilities Joint Stock Company (predecessor of After the 1989 change of regime, Act LXV of 1990 on Alföldvíz utility) expected the sector to undergo a Local Governments declared that local governments major reorganization and anticipated that there was a were responsible for providing water and sanitation risk of losing some service areas. The company decided services. Act XXXIII of 1991 stipulated that the assets of to pursue enlarging the utility operating area to state-owned companies were to be transferred to local develop and benefit from potential economies of scale. governments. The former companies that had been As such, Békés became an early mover in seeking set- operating on a county level split into several smaller tlements to join its operating area. It developed a quick water utility companies, driven by the municipalities’ expansion strategy that was supported by a dedicated desire to achieve independence in local service provi- merger project team and was based on the signing of sion to match their obligations of supplying services. management contracts with municipalities where ser- Some municipalities contracted with private operators vices were taken over. The Alföldvíz aggregation through management contracts or concessions, but brought about a clear increase in economic efficiency most settlements continued to be supplied by munici- but only a slight increase in performance. pally owned water utility companies. In 1989, there were 38 water utilities, and by 2010 there were more From Fragmentation to Aggregation of than 400, predominantly owned by local governments. Hungary’s WSS Utilities However, in 2012, the 33 largest companies were pro- viding drinking water for 85 percent of the Hungarian After World War II, during the Communist era, population. Nevertheless, the large number of water Hungary’s water sector was highly fragmented. There utilities meant that there were huge differences in ser- were more than 400 water utilities, most of which were vice levels, prices, cost recovery, and operating owned by local councils. The aim in the 1950s was to ­ efficiency, as well as in sustainability. Recognizing halt and reverse fragmentation by connecting that situation, the Hungarian parliament adopted Act the neighboring water utility systems in the country. CCIX of 2011 on Water Utility Services. That act A  number of state-owned water utilities were then reflected a new vision for the sector, including national ­ created, and small water utilities were merged. That regulation through a regulatory agency, uniform process resulted in the integration of water services into tariff-setting p ­ ­ rocedures, and achievement of major aggregation within the sector. As FIGURE 1. Water Utilities in Hungary a result, a wave of aggregation swept the country, triggered by a 450 regulatory requirement on the 400 minimum size required to obtain 350 an operating license. From Number of utilities 300 January 1, 2017 onward, water 250 utility companies have to serve at 200 least 150,000 consumer equiva- 150 100 lents (CE) to be allowed to oper- 50 ate. The number of utilities fell 0 from more than 400 in 2010 to 1950 1962 1989 2010 2012 2013 2014 2016 41 by 2017 (figure 1). 2 Case Study—Alföldvíz, Hungary A Quick Expansion of the Operating Area Utility Act was 150,000. Thus, from a compliance per- Supported by a Dedicated Merger Project spective, the company was not under any pressure to Team expand its operating area. However, the company management expected the sector to undergo a major The legal predecessor of Alföldvíz, Békés Megyei reorganization, and it anticipated a potential risk of Vízmű és Kútkarbantartó Vállalat (Békés County Water losing service areas to other operators. The company Utility and Well Maintenance Company), was founded management decided that being a passive observer of in 1954 and renamed Békés Megyei Víz- és Csatornamű the aggregation process might turn out to be much less Vállalat (Békés County Water and Sanitation Utility advantageous than actively pursuing the enlargement Company) in 1963. In the 1960s and 1970s, the com- of the service area. The management also concluded pany played a major role in constructing water and that it had an opportunity to develop and benefit from sanitation infrastructure in the southeastern region of potential economies of scale. Therefore, Békés Megyei Hungary. In the 1980s, the focus gradually shifted Vízművek became an early mover in seeking settle- toward improving the quality of service provision. In ments to join. the 1990s, disaggregation took place and the settle- ments located in the southern part of Békés county The aggregation process was already in full force when, decided to leave Békés Megyei Víz- és Csatornamű as part of a corporate restructuring in 2013, the name Vállalat. In 2003, the company became a joint stock Békés Megyei Víziközmű was changed to Alföldvíz company and was renamed Békés Megyei Vízművek (Great Plains Water). The new name refers to a larger Részvénytársaság (Békés County Water Utilities Joint geographical territory than Békés County, reflecting Stock Company); at that time, it served a reduced num- corresponding ambitions to become the service sup- ber of 53 settlements. In 2004, however, the southern plier of municipalities in other counties of the Alföld settlements rejoined the company, increasing the (Great Plains) as well. In three years, the company number of served municipalities to 66. All 66 munici- increased in size by about 70 percent, reaching a CE palities received drinking water services; 27 also were figure that is more than four times higher than the reg- served by a sewer. At the end of 2011, Békés Megyei ulatory threshold of 150,000. (See figure 2.) Vízművek served about 370,000 consumer equiva- Alföldvíz established a dedicated merger project lents, whereas the legal obligation set by the Water team. The team, which was composed of staff from the human resources, finance, FIGURE 2. Population Served by Alföldvíz Utility and customer service depart- ments, developed a ­methodology 700,000 to assess potential aggregating municipalities. The project team 600,000 visited municipalities’ water Consumer equivalents 500,000 utility facilities and collected 400,000 ­elevant data for decision mak- r ing. Then, for each municipality, 300,000 the team completed a check list 200,000 and  assigned the municipality 100,000 a  grade. The service area 0 expanded  mainly to the west; 2010 2011 2012 2013 2014 2015 however, it  never became fully Case Study—Alföldvíz, Hungary 3 MAP 1. Alföldvíz Drinking Water Supply in January 2017 homogeneous because some territories in eastern utilities (which was considered too risky and could areas are served by Gyulai Közüzemi Kft. and others in also entail substantial legal fees). the west are served by Szegedi Vízmű. Alfoldviz had The operating contract between a municipality and to amend its management information system and Alföldvíz included a rental fee for the assets owned by central databases to enable such a patchwork the municipality and transferred to the utility. If the expansion, gradually adding more and more munici- ­ estimated future cash flow from water service within a palities. Overall, between 2011 and 2015, the number given municipality was promising, a notable rental fee of municipalities served by Alföldvíz nearly doubled, was offered. If the predicted financial situation was increasing from 66 to 131. (See map 1.) deemed to be dire, a symbolic rental fee of 1 HUF/m3 (water and wastewater alike) was proposed.1 Some Quick Expansion Based on Management municipalities promptly accepted the fee, but others and Operating Contracts with tried to negotiate better conditions. Before 2012, many Municipalities small municipalities received a relatively high rental As a principle of expansion, Alföldvíz decided to aggre- fee from their own water utility company, significantly gate by signing management and operating contracts contributing to the municipal budget. At the same with municipalities, rather than by merging with water time, this additional revenue often came at the expense 4 Case Study—Alföldvíz, Hungary of delayed asset maintenance and reconstruction. General  Assembly and vote. The Hungarian state Because of Act CCIX on Water Utility Services and its holds 28.34 percent of the utility’s capital. legal requirements, those small municipalities had to Alföldvíz hired the staff previously employed by water aggregate with large utilities—which many mayors and services it took over, but not all employees were given municipal councils found difficult to accept. As a the same positions they had held previously. The com- result, some small municipalities delayed the aggrega- pany interviewed each employee and then placed that tion decision until the legal deadline was reached. person in a position in line with the person’s back- For Alföldvíz, it was evident from the beginning that ground and the company’s needs. When necessary, providing service in certain small municipalities would employees were retrained or assigned mentors, or be a loss-making activity. Hence, a lot of internal dis- both. New staff members were trained on the use of the cussion took place about whether to sign an operating integrated information technology (IT) system. Lower contract with those municipalities. Ultimately Alföldvíz salaries were gradually raised to close the gap with the decided to apply a “principle of solidarity” across the usually higher Alföldvíz salaries. For all the employees operating area, even if this meant an additional finan- of the old company who were hired by Alföldvíz, legal cial burden. A related argument was that if those small continuity was applied: their previous service time municipalities were left without a service provider, the was registered, and they did not lose their seniority. regulator would assign an “operator of last resort,” appointing a water utility to provide services in those Increased Economic Efficiency and Slightly locations. Finally, there was an expectation that sooner Improved Performance after Aggregation or later, cost-recovering tariffs could be introduced in Water service–related indicators clearly show improved each municipality. (This has not happened yet.) economic efficiency after aggregation. Unit operating Contracting municipalities were given an opportunity expenditures declined, whether compared to the number to buy a certain amount of shares in Alföldvíz capital; of water connections, the volume of produced and sold doing so would allow them to take part in the water, or the population served with water. (See figure 3) FIGURE 3. Economic Efficiency of Alföldvíz Utility a. Opex per cubic meter b. Opex per water and wastewater connection 250 25 Aggregation Aggregation 200 20 Hungarian forint Hungarian forint 150 15 100 10 50 5 0 0 2010 2011 2012 2013 2014 2015 2016 2010 2011 2012 2013 2014 2015 2016 Opex/m3 (water produced) Opex/connection (water) Opex/m3 (water sold) Opex/connection (wastewater) Opex/m3 (wastewater collected) Note: Opex = operating expenses. Case Study—Alföldvíz, Hungary 5 Indicators representing the economic efficiency of payment customer service, and a bank card–based ­ operation show improvement as a result of aggrega- system). All offices now use an electronic document tion of common costs and total costs as well as the management system, advanced IT solutions are decrease of employees per connection. The Alföldvíz applied, and all staff members are part of a corporate management identified several expenditure catego- training program. In some of the service areas taken ries where economies of scale are present, such as over, basic life and fire safety rules had not been acquiring the operating permit, back-office opera- implemented. In these locations, Alföldvíz took action tions, customer service, IT, central procurement, to ensure that hazards were minimized. Moreover, bookkeeping, the finance department, and the legal appropriate asset inventory had been absent in many department. The company has one accredited labora- of the merging municipalities. Introducing the tory that can comfortably serve a larger and growing methodology is a big Alföldvíz asset inventory ­ operating area. Specific tools and technologies are improvement, but it is also a tedious, time-consuming employed more efficiently than before, including task that has yet not been completed for all municipal- equipment for network inspection, machinery for ities. On the technical side, however, nonrevenue cleaning water storage tanks, and water meter calibra- water increased from 25 percent to about 30 percent tion technology. Some of the operational teams of the right after aggregation. That increase was because of company have not changed. Hence, the same number the bad condition of the network transferred to the of workers serve an expanded service area. A uniform aggregated utility. (See figure 4.) and high-level customer service function replaced previous customer service arrangements of varying Wastewater-related indicators draw a somewhat quality in different settlements (for example, not all more ambiguous picture because no clear trend municipalities previously had a call center, online emerges. Growing unit costs are related not only to the change in the characteris- tics of the service area but also FIGURE 4. Efficiency of Alföldvíz Utility to the upgrading of wastewater treatment. In 2013, 54 percent 3.5 35 of the collected wastewater Aggregation was treated with tertiary tech- 3.0 30 nology, but in 2014 that figure 2.5 25 increased to 81 percent. In 2015, there were a lot more 2.0 20 Percent sewer blockages than there had 1.5 15 been in the previous years. The increase in blockages reflects 1.0 10 the poor condition of the sewer 0.5 5 networks transferred to the aggregated utility. Overall, 0.0 0 2010 2011 2012 2013 2014 2015 2016 Alföldvíz’s aggregation is con- Sewer blockages nb/km/year sidered a success because it Sta productivity sta / W + WW connections lowered operating costs while Nonrevenue water % providing improved service, Note: nb = number; W = water; WW = wastewater. especially in rural areas. 6 Case Study—Alföldvíz, Hungary Aggregation Case Study at a Glance discussions to determine whether it should sign an contract with small, unprofitable munici- operating ­ Key Lessons Learned from the Aggregation palities. Ultimately, Alföldvíz applied a principle of Case Study solidarity. In addition, Alföldvíz considered that if Lesson 1: Defining Principles but Allowing Flexibility in those small, unprofitable municipalities were left Implementation Ensures Local Ownership unsupplied, the regulator would assign a provider of National reforms are more likely to be successful when last resort, appointing a water utility to provide ser- they follow the principle of subsidiarity and allow flex- vices in those locations. ibility for local stakeholders to own the aggregation process and adapt it to their local context. In Hungary, Lesson 3: Managing Staff Transfer is Key to Mitigating the Water Utility Services act, passed in 2011, states Transaction Costs that water licenses shall be issued to providers reach- All employees from previous companies were trans- ing a certain level of aggregation, expressed in con- ferred to Alföldvíz. The salary gap between transferred sumer equivalent. But no administrative limits such as staff and other employees was gradually closed by watershed or regional boundaries were set. The utility raising lower salaries to the highest level of those for of Alföldvíz increased its operating area by 70 percent ­similar jobs. in three years, reaching a consumer-equivalent market four times higher than the regulatory threshold. Lesson 4: Establishing a System of Checks and Balances among Shareholders is Important Lesson 2: Cherry-Picking Practices can Undermine the Alföldvíz was set up as a public company, signing man- Outcome of an Aggregation Whose Purpose Involves Externalities Such as Cross-Subsidies or Capacity agement and operating contracts with municipalities Transfers when service provision was taken over. Those munici- palities were given the opportunity to purchase a stake In Hungary, when aggregation reform was passed in in Alföldvíz; doing so would allow them to take part in 2011, Alföldvíz decided to actively pursue enlarging its the General Assembly and vote. As a result, a new operating area, and it carefully selected the munici- shareholder structure evolved, with 28.3 percent of the palities where it would take over service provision. shares owned by the Hungarian state and from 0.002 The company established a dedicated merger project percent to 32.9 percent owned by the individual team, which developed a methodology to discrimi- municipalities in the operating area. nate between potential merging municipalities. The team used a checklist to evaluate and assign a grade to each municipality. However, in addition to this selec- Note tion process for aggregation, the company held 1. HUF = Hungarian forint. 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