Performance Contracts: Shaking Up The Municipal Water Market?

By Jim Lauria

Performance contracts promise to shake up the municipal water market — and to open the drinking water and wastewater sectors to new heights of innovation, efficiency, and funding opportunities.  As Steve Hoffman wrote in Planet Water: Investing in the World’s Most Valuable Resource, “the water industry is being rationalized from a delivery-based approach to a solution-based system.”

Instead of manufacturers delivering equipment to an installation and driving away, or consulting engineers wrapping up most of their work once a new facility is online, performance contracts put the risk — and the reward — of performance on the supplier side.  Contracted operators deliver water for a negotiated sum, or earn their pay as incentives for achieving agreed-upon goals — for instance, cost savings over previous systems.  Utilities reduce their up-front expenditures, their risk and, often, the need to go to voters for bond measures.

To investors, that’s like a long, cool drink of water on a hot day.  A contract guaranteeing a certain level of performance, seasoned with the security of working with municipalities on the most inelastic of commodities — it’s a solid bet.  Coupled with growing interest in non-traditional financing tools like public-private partnerships and private activity bonds, performance contracts offer increasingly attractive opportunities for investors, which in turn open up great opportunities for municipalities.

To equipment manufacturers, performance contracts are a call to the drawing board, a chance to grow their business through innovation and product improvement rather than face the gauntlet formed when engineers only specify predictable, plain-vanilla, previously-approved technologies in traditional installations.

To consulting engineers, it’s a huge disruption.  Replacing the old design-bid-build model with design-build-operate or even design-build-own-operate arrangements changes the business model for many consulting firms.  In the new system, the money comes from efficiencies in operating expenses (OPEX) rather than a piece of the capital expenses (CAPEX).  The paycheck is spread over long contracts – no more bid ‘em, build ‘em and move on. 

On the flip side, the shift creates opportunities for consulting engineers to focus their training and expertise on pilot testing, creating OPEX efficiencies and overseeing construction.  A lesson from the electric and gas utilities is that scalability — turning successful pilot plants into commercial realities that deliver the same benefits — is a huge challenge, notes Linda Jackman, vice president of industry strategy for Oracle Utilities.  That makes understanding pilot design and scale a key competency for the new generation of successful consulting engineers.

Consulting engineers’ expertise must bridge into the burgeoning world of data, which means tomorrow’s consulting engineers (and many of today’s) need to serve up their hydraulics with a data analysis chaser.

On The Books

Many leading consulting engineering firms have begun to master the new approach.

“Combining technology and services has been embraced and is moving forward as a financing and delivery model for more and more water utilities,” says Jim Keene, a former general manager of Veolia Water and public works investment banker who now consults utilities and infrastructure firms.

In fact, Veolia was an early adopter.  According to the web site of NCPPP, the National Center for Public-Private Partnerships (www.ncppp.org), Veolia was engaged in 2002 by the City of Indianapolis to manage its 143 million gallon per day (MGD) waterworks system.  The 20-year, $1.5 billion contract covered operations, maintenance and customer service, and laid out 40 agreed-upon performance metrics ranging from operations to community engagement.

NCPPP’s site also details the contract between Seattle Public Utilities and CH2M Hill to design, build and operate an ozonation and UV disinfection system at its 180 MGD Cedar Water Treatment Facility.  CH2M Hill won a 15-year contract, renewable for an additional 10 years, and Seattle figured it would save about $50 million compared to a traditional design/bid/build model.

The movement to performance contracts is global.  The Singapore Public Utilities Board contracted with Sembcorp to design, build, own and operate the NEWater Changi facility.  At 60 MGD, Changi is the biggest wastewater treatment plant in the NEWater system, and cost $200 million to build.  But that’s just one-third of the cost associated with the 25-year contract — the other two-thirds are OPEX.  With Black & Veatch on board as consulting engineers, Sembcorp was able to build significant efficiencies into the design that should pay off in a substantially more lucrative contract during the operating phase.  Carefully quantifying those efficiencies, as Black & Veatch engineers noted in a 2009 World Water article, also allowed them to consider the triple bottom line — people, profit, planet — in their plans.

Different World

The world of the performance contract is substantially different than the conventional water industry environment.  When CAPEX was king, saving money on equipment created a false sense of economy — project costs funded by highly visible tax levies or bond issues were reduced, but inefficient operations could quietly eat up the savings, notes water investment analyst Debra Coy, principal at Svanda and Coy Consulting and advisor at XPV Capital Corp.

Under a performance contract, efficient OPEX is the name of the game.  Performance contracts “come up with ways to incentivize efficiency,” says Coy, in turn promoting more and faster innovation.  The new contracts also force water suppliers to do a better job of monitoring their operating performance, she adds.

Information Age

Equipment manufacturers see the opportunity in contract operators’ push for efficiency.  If improved products can show a strong return on investment, operators — particularly private ones, less encumbered than public entities by the need to go to the electorate for funding — are more likely to invest in them.

The electronic measurement, control and telemetry systems that increasingly weave together water treatment equipment allow fewer operators to control more machinery, and provide the hard data needed to quantify performance under the new contracts will become ever more important.  That’s also why it’s no surprise that information and energy companies were early players in the performance contract market. 

Johnson Controls inked a 10-year performance contract with the city of Tyler, TX, by calculating $2.2 million worth of revenues lost annually due to inaccurate meter readings.  They also identified another $915,000 in savings that could be captured by replacing inefficient equipment in the city’s sewer infrastructure with energy-efficient motors and speed controllers. 

The contract paid Johnson Controls from the cost savings, which the company guaranteed would be at least $25 million over the life of the contract.  But what’s more, it allowed the company to install 31,000 new meters that can be read electronically from afar.  That crammed a decade’s worth of sales into an 8-month period and created an OPEX-efficient environment that yielded profitable, payable performance.

Financing the Projects

One of the significant elements in the Tyler, TX, performance contract is that it allowed the city to substantially upgrade its infrastructure without a tax increase or voter referendum.  Instead, savings were channeled into equipment purchases.

It’s hard for many public utilities to imagine financing without having to market a project to voters.  Classic utility financing comes from loans, general obligation bonds (repaid from the tax base through a general fund) or revenue bonds, which tap user fees from the financed project, like a toll on a bridge.  Other utilities plumb reserves built up from accumulated user fees, investments or rental on facilities, or connect with grants that often require them to team up with other public entities to form a regional project big enough to attract state or federal funds.

The new model — design/build/operate — can be funded either publicly or privately, notes Keene in Chicago.

Among the most exciting funding mechanisms for new-model projects is the public-private partnership (PPP).  PPPs are a contractual agreement between a public agency and a private entity to share skills, resources, risks and rewards, Richard Norment, executive director of the National Council for Public-Private Partnership (NCPPP) told members of the Water and Wastewater Equipment Manufacturers Association at a recent conference.

Funding for a PPP can come from a wide variety of sources including fees, a tax district, long-term maintenance contracts or a concession model.  Most of those don’t require voter approval.

PPPs are not privatization, Norment emphasized — there’s far more public control and oversight of a PPP than of a private water supplier.   Adds Lynette Berk, a management consultant in Orange County, CA, “although water will likely always remain ‘public property’ for obvious reasons, PPPs are popping up to relieve the financial strain of some public entities.”

Another strain reliever is the private activity bond (PAB), an instrument that isn’t fully tax-exempt — it’s still subject to the alternative minimum tax — but that can streamline borrowing and reduce the borrowing cost for private utilities because it’s tied to the strict government regulations surrounding tariffs and the cost of capital.

The problem to date with PABs is that state caps have limited their availability for water projects.  In fact, water and sewer projects only accounted for 1.3 percent of the PABs issued in 2007, according to the American Water Works Association, compared to 65 percent used for housing projects that year.  The National Utility Contractors Association is anxiously hoping for the passage of the Sustainable Water Infrastructure Act currently before Congress, which would eliminate state volume caps on PABs for water/wastewater projects, opening the door to as much as $5 billion in private capital.

Certificates of participation (COPs) — a lease purchase tool in which investors essentially buy pieces of capital equipment held by a bank in return for shares of the utility’s lease payments — also open up connections to private funding.  COPs don’t require voter approval, and they spread payment out over the life of the asset, blunting the blow of the early years of a CAPEX project and smoothing out ebbs and flows in annual expenditures.

Obstacles Remain

Though there is plenty of interest in PPPs, PABs and COPs, they aren’t commonplace yet. 

State volume caps on PABs have kept that money scarce.  But PPPs, despite their benefits, haven’t been a runaway hit either, noted Norment.  Part of the challenge is that the contracts are complicated to write.  They also require municipalities to step into unfamiliar waters — for starters, they need to get a law on the books even before the RFP stage that grants a public entity the legal authority to engage in a PPP.  The utility may find itself in partnership with several private companies at a time, and many find it uncomfortable to cede control to a private company. 

Also, the bidding process is much more nuanced and complicated than a classic RFP — utilities have to evaluate which bids deliver better value, which is a lot more challenging than calculating the lowest price on tightly specified bids.

Private companies have their doubts, too, notes Joe Zuback, president of Global Water Advisors and former chief technology officer at Siemens Water Technologies.  The biggest impediment, he says, is the sense of “unlimited liability.”  Companies have to believe the risk is manageable and quantifiable.  That must start with good communication between utilities and corporations.

Detailed plans, clear metrics, agreed-upon milestones, third-party verification and a clearly defined revenue stream are all vital to the success of performance contracts.  The companies that can adapt to new ways of envisioning, operating and financing water projects — and can communicate clearly with the utilities they’ll serve — will dominate the coming decades.

For equipment suppliers, information technology providers and engineers, performance contracting offers unparalleled opportunities to reward innovation and efficiency.  Ultimately, that’s good for the water industry — and for the resource itself.