l 39 Viewpoint The World Bank May 1996 Note No. 80 Sydney's Water-A Suitable Case for Private Treatment? Ross Chapman Until recently, Sydney's water was captured, sumed in Sydney will be treated by these plants. and Sandy stored, treated, and reticulated by Sydney Wa- This analysis of the Sydney experience may pro- Cuthbertson ter, a state-owned corporation. Sydney Water vide insights for other agencies contemplating had been a statutory authority, the Sydney Wa- the private provision of treatment services. ter Board, until it was corporatized in 1995. The water supply system, designed in the nine- Choosing the operator teenth century and restructured in the mid- twentieth, drew on raw water that was of good Once the decision had been made to involve quality by world standards, and until 1989 treat- the private sector in providing treatment sys- ment went little further than screening, disin- tems, important questions arose about how fection, and fluoridation. But as water quality many contracts should be awarded and what guidelines became more stringent, Sydney's raw restrictions should be placed on successful water came under increasing stress. tenderers. The Board determined that three con- tracts would be awarded for the four proposed After establishing that consumers were willing treatment systems, combining the two smallest to pay for maintaining the quality, the Board systems under a single contract. The successful decided to contract for a privately built, owned, bidder for the largest project would be ineli- and operated (BOO) system for water treatment. gible to tender for the other two. Under the pro- Responsibility for harvesting and storing raw tocol for accepting bids, only bidders that had water and delivering treated water would re- not successfully bid for one of the other con- main with the Board (and later, Sydney Water). tracts, and that met the minimum acceptable Several factors persuaded the Board to adopt technical standards, would be considered. the BOO system for water treatment. It faced major capital outlays to upgrade and expand The initial allocation of bargaining power under wastewater treatment capacity. There was a these procedures helps set the basis for negotia- growing likelihood that it would be corporatized, tions that may be required during the life of a making a 'delegated service" approach involv- contract. For example, if it became necessary to ing the private sector and providing access to a expand plant capacity during a contract, the water full range of international technology attractive. treatment company would need to renegotiate And the subsequent involvement of seventeen water tariffs to recover its expansion costs. By consortia in the "tournament" for the market re- opting for several operators, the Board gains ac- vealed a level of competition likely to produce cess to information from each that can be used outcomes that the Board, relatively inexperi- as a benchmark in assessing the performance of enced with filtration systems, would find diffi- the others and in negotiating tariff adjustments. cult to match. In 1993, the Board contracted with It also gains access to a wider range of water two consortia-Australian Water Systems and treatment technologies, strengthening its hand in North-West Transfield-for two water treatment future expansions and upgrading. plants. A third contract was let to another con- sortium, Wyuna Water, in 1994. By the end of This approach has costs, however. For example, the century, almost all the drinking water con- the successful bidders for the second and third L'Lda Private Sector Development Department . Vice Presidency for Finance and Private Sector Development Sydney's Water-A Suitable Case for Private Treatment? contracts may not have been the lowest-cost Risk sharing bidders meeting the Board's minimum techni- cal specifications. And if firms could win all The Board put the tariff structure in the bench- three contracts, they might offer more attrac- mark tenders to provide what it considered ad- tive bids, reflecting size economies and any equate protection for the financiers against the expected benefits in subsequent bargaining. financial risks associated with the projects' large The Board minimized the cost to the system of fixed costs, while leaving the consortia to bear this exclusionary protocol by awarding the larg- risks relating to volume-related operating costs. est of the three contracts first. It priced treatment at cost at the margin to pro- tect consumer interests. And as the following Two other factors affected the selection pro- paragraphs show, the Board structured the wa- cess. The Water Board prepared its own re- ter treatment agreements according to the prin- ports and design plans. This gave it a fallback ciple that specific risks should reside with the option should the BOO approach have to be parties best able to assess and manage them. abandoned for some reason. The detailed pro- cess specification in these studies, later pro- Completion and commissioning risks. The wa- vided to the tenderers, yielded important time ter treatment company is responsible for com- and cost savings to the successful tenderers. pleting the project on time and to specifications The Board also established a capability to as- that meet agreed acceptance tests demonstrat- sess bids and negotiate the final terms of wa- ing that the plant is ready for continued use at ter treatment agreements. This required the the required capacity. The water treatment agree- Board to incur substantial costs in setting up a ment assigns the completion and commission- new legal and commercial "infrastructure." The ing risks to the water treatment company through Board wanted to be able to deal with the risk- the availability component of the tariff, which sharing implications of the BOO path, and the is based on the fixed costs expected under timely Board's legal advisers recommended that it completion of the construction phase. cover contingencies in great detail and antici- pate a wide variety of specific events that could Market risks. Although the fixed availability affect its risks. charge in the tariff partly insures the water treat- ment company against plant usage that falls The water treatment tariff structure short of the designed capacity, the company otherwise bears the risks of fluctuating demand The water treatment tariff structure agreed to from Sydney Water by agreeing to meet all has two parts.' First, an availability charge is demand. The contract specifies that Sydney fixed, independent of the volume treated, to Water must assist the water treatment company cover about 80 percent of the financing, es- in designing capacity to meet demand by pro- tablishment, and fixed costs incurred by the viding information on its demand management water treatment companies in the timely con- strategy, including demand projections for the struction and operation of the plant. Penal- next two, five, and ten years. ties are charged in the event of breakdown. Second, a usage charge is set, a megaliter rate Granting exclusive rights to treat water for a that declines with quantity. The agreed tariffs designated market involves tradeoffs. The gov- are subject to change if the treated water falls ernment-through the Board-has tied its short of the quality specified in the contract hands with respect to competition for the con- or the quality of the raw water supplied for tract-winning treatment plants. But the contracts treatment either exceeds or falls below pa- themselves should reflect this exclusivity, in rameters based on the highest and lowest the terms offered by the treatment companies. water quality over the preceding twenty-five If the Board's demand projections miss the mark years. and capacity increases are called for, the con- tract provides for adjustments to the tariff to accords with the company's full autonomy in shift risk arising from inadequate projections daily operations under the water treatment away from the water treatment company. agreement. The operators expect that contracts will be renewed at the end of the contract pe- Performance quality and quantity risks. These riod. This expectation and a provision allowing risks lie with the water treatment company pro- Sydney Water to buy the plant assets at a price vided they do not involve plant expansion, in based on its own evaluation provide incentives which case the risks would be shared through for the operators to avoid running down the a renegotiated tariff. If the water treatment com- assets toward the end of the contract period. pany fails to meet quality standards or required volumes, Sydney Water has recourse to three Upstream risks. Sydney Water will continue to measures: tariff reduction or nonpayment, step- be responsible for operating and maintaining in rights, and termination of the contract. Moni- assets "upstream" of the treatment process. toring provisions give Sydney Water the right These include the catchment, the river systems to satisfy itself that the water treatment com- within it, and any canals, pipelines, dams, and pany is operating and maintaining the plant in reservoirs used in storing and reticulating the accordance with the water treatment agreement. raw water. In announcing its catchment man- If Sydney Water finds that the company is fail- agement policy during the bidding process, the ing to do so, it will notify the company. which Board committed itself to a set of environmental must respond with an action plan to be agreed standards to reduce uncertainty for tenderers. upon. The company will carry out approved quality tests whose results will be subject to Financing and economic risks. The water treat- audit, and Sydney Water will have the right to ment company carries the risks of changes in conduct its own tests. Disputes over results will interest or inflation rates during the construc- be settled by a third party. tion period. But once the plant is commissioned, an indexing formula will take effect that will Raw water supply risks. Whereas the risks re- allocate the risks of inflation and changes in lating to the output (clean bulk water) reside operating costs between the company and entirely with the water treatment company, risks Sydney Water. Few details have been revealed relating to the variable quality of the input (raw about this important aspect of risk sharing. water) are shared by Sydney Water and the com- pany. The quality of the raw water that Sydney Technology risks. The water treatment company Water harvests in its catchments is only partly bears the responsibility for technology, which under its control because of storms and floods. must be proven and must meet required stan- The water treatment agreement accounts for this dards and specifications. But the contract speci- partial control by specifying that, to avoid a pen- fies that changes in water quality requirements alty tariff under the terms of the contract, Sydney that call for new technology will trigger a re- Water must provide raw water whose quality negotiation of the tariff, thereby sharing the falls within a range established over the past risks of unforeseen changes in the standards twenty-five years. This provision gives Sydney agreed to in the water treatment agreement. Water an incentive to manage its catchments so that raw water quality is at least maintained in The water treatment agreement specifies ap- the established range. propriate contractual terms for technology transfer to Sydney Water and serves as the ba- Operation and maintenance risks. The risks of sis for a collaborative and cooperative relation- operating and maintaining the plant-functions ship between the Board and the water treatment that include providing staffing, skills, chemical company. The water treatment company is ex- supplies, power, process control, and disposal- pected to keep abreast of technology, perform reside with the water treatment company. This on-site research, and share findings with Sydney EN Sydney's Water-A Suitable Case for Private Treatment? Water. This expectation is formalized by a com- desired standard. By shifting the risk associated ponent in the negotiated tariff to cover research with poor catchment management back to and development costs of the water treatment Sydney Water, the tariff structure provides an company. incentive for Sydney Water to manage the catch- ment well. The agreement also gives a discount Natural disasters. In an emergency, whether in the tariff for raw water that is of exception- or not caused by natural disaster, Sydney Wa- ally high quality. If Sydney Water had built and ter has the right to take whatever action it operated the treatment plants itself, there would deems necessary to safeguard the system's se- also have been incentives to find efficient com- curity and maintain supply, including bypass- binations of treating water and improving catch- ing the treatment plants. In such events, Sydney ment management. Water will compensate the water treatment company, reimbursing access fees and treat- Conclusion ment costs. The BOO option adopted by the Water Board Regulalted pricing and the BOOs for its new water treatment plants will receive its first real test as the largest of the plants comes The Government Pricing Tribunal of New South on line and Sydney Water's costs start to re- Wales was established in 1992 to review and flect the price of delivering better-quality wa- set prices for services considered government ter. Willingness-to-pay studies support the monopolies, including those of the Water decision to meet more stringent water quality Board. The Tribunal (now the Independent guidelines. But how much of the cost of rais- Pricing and Regulatory Tribunal) regulates ing quality is actually passed on to consumers The Note series Is an open forum intended to Sydney Water's prices by capping its revenues. will be determined by the Independent Pric- encourage dissemina- Its approach to the BOO treatment plants has ing and Regulatory Tribunal, which has sent tion of and debate on been cautious. While noting that the BOO clear signals that it will not rubber-stamp a full ideas, innovations, and best practices for projects were proposed long before it was es- pass-on of the costs of the new contractual expanding the private tablished, the Tribunal has made clear that it arrangements. Despite efforts to meet the de- sector. The views expects Sydney Water to inform the Tribunal mand for increased quality through the least published are those of the authors and should about the contracts and about Sydney Water's expensive route, Sydney Water may find itself not be attributed to the obligations, to explain the risks involved and having to reduce costs (and services) elsewhere World Bank or any of its the sharing of these risks, and to demonstrate to achieve acceptable rates of return. A failure affiliated orgarnizations. Nor do any of the con- that the scheme is more cost-effective when to achieve substantial cost savings elsewhere clusions represent adjusted for risk than alternatives, including may mean politically unacceptable price in- official policy of the direct provision by Sydney Water. The Tribu- creases for some consumers as Sydnev Water world Bankor of its nal has warned that it will not automatically introduces volumetric pricing and phases out or the countries they pass on cost increases to customers unless the cross-subsidies. represent. increases can be justified on economic or en- Comments are welcome. vironmental grounds. This Note is based on a longer article by the authors: "Privatising Please call the FPD Sydney's Water Treatment,' Agenda: A journal ofPolicyAnaljsis and Note line to leave a Environmental regulation Reform 3 (1): 45-58 (1996). message (202-458-11 11) ' Although the detail of final contracts is confidential, the essential or contact Suzanne details of pricing and deliverv structure were specified in the origi- Smith, editor, Room Critics have argued that the treatment plants re- nal tender documents and have been amplified in interviews. G8105, The World Bank, duce the incentives to improve catchment man- 1818 H Street, NW, Washington, D.C. 20433, agement and that better catchment management Ross Chapman, Director, Centre for Inter- or Internet address is an alternative to more intensive treatment. national Economics, Sydney, and Sandy ssmith7@worldbank.org. The tariff structure in the water treatment agree- Cuthbertson, Managing Director, Centrefor SPrinted on recycled ment, however, recognizes that abnormally low International Economics, Canberra (email: paper. raw water quality will raise treatment costs for a cie@spirit.com.au)