Priority Environment Projects for Access PEPA/24 ______________________________________________________________________________________

AN INTRODUCTION TO PRIVATE SECTOR INVOLVEMENT IN PUBLIC INFRASTRUCTURE PROJECTS

This PEPA Tool Traditionally, many environmental infrastructure projects in the fields of water supply, wastewater treatment and waste management (among others) have been implemented by public sector organisations. These have including government departments, local authorities, municipalities and other public agencies. In practice, of course, the private sector has always been involved, but generally only as the supplier of plant, equipment and materials, or as the contractor for the construction component of the project. These days, there is a much wider range of possibilities for involving private companies in public infrastructure projects. These range from technical assistance at the project preparation stage to ‘full privatisation’ of the environmental service that the facility will provide, with many steps in between. One key potential role of the private sector is in the provision of project finance, either to complement public sector finance or for the whole project. The purpose of this PEPA Tool is to identify and review the options that might be considered for involving private companies in the environmental infrastructure projects that are now being developed in all the Candidate Countries. The advantages and disadvantages of each possibility are identified. However, it must be emphasised from the outset the in practice the options available for a particular project will inevitably be constrained by the circumstances in the country in question. For example, the full privatisation of an environmental service is a key policy issue at national level, and this option will not be available unless and until such a policy exists. Why Involve the Private Sector ? Involving private companies in environmental infrastructure projects can provide a wide range of resources to complement those that might be available in the public sector. These include : • Manpower : additional staff; • Finance : investment capital; • Expertise : in project preparation, design, management and implementation; • Experience : in facility management and operation; • Technologies : access to proprietary technologies. In principle at least, these additional resources offer a number of potential advantages to the public agency responsible for securing project implementation and/or providing environmental services. These potential advantages include: • More rapid project implementation through access to additional manpower and expertise; • Removal of financial constraints through access to private finance;

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Priority Environment Projects for Access PEPA/24 ______________________________________________________________________________________

• •

Removal of technical constraints through access to wider expertise and technologies; Transfer of risk to the private sector based on their expertise and experience.

Roles of the Private Sector : An Overview In categorising the different roles of private companies in environmental infrastructure projects (Figure 1) we have considered the different stages in project development and implementation : • Project Preparation : defining the project and preparing a technical specification and financial plan at the level needed to secure funding; • Project Funding : provision of finance for capital investment and (if appropriate) initial operating costs, generally through grants and/or loans from different sources; • Design and Construction : all aspects of project implementation (design, specification, procurement, installation, commissioning) to the point of handover to the operator; • Operation and Maintenance : management and operation of the facility following handover by the contractor; • Revenue and Profit : collection of revenue (e.g. environmental charges) and generation of the expected return on capital employed. The options for private sector involvement may be broadly classified as : • Technical Assistance , mainly focused on Project Preparation; • Private Finance , mainly focused on Project Funding; • Turnkey Contract, mainly focused on Design and Construction; • Operating Contracts , mainly focused on Operation and Maintenance; • Full Privatisation, mainly focused on Revenue and Profit. Each of these options is now considered separately. Its role is explained and its advantages and disadvantages are identified, together with constraints that may limit its use. In practice, these options are not mutually exclusive : thus, for example, Technical Assistance may be combined with Private Finance and/or a Turnkey Contract. However, the approach adopted in relation to Operating Contracts or Full Privatisation is generally more ‘inclusive’ as far as aspects such as Private Finance (if not Technical Assistance) are concerned. Technical Assistance Private sector involvement in project preparation, generally through technical assistance projects, is already relatively well established. It provides additional resources and specialist expertise at what is often a critical point in the project cycle. Private technical assistance can not only accelerate this aspect of the project but also contribute to securing finance by ensuring that the financial aspects of project preparation are adequately covered (this can be a weakness where project preparation is carried out by public sector agencies). However, it does nothing to provide project finance or secure project implementation.

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Priority Environment Projects for Access PEPA/24 ______________________________________________________________________________________

Figure 1 : Options for Private Sector Involvement COMPONENTS OF PROJECT Full Privatisation

Revenue & Profit Operating Contracts (e.g. BOT)

Operation & Maintenance Turnkey Contract

Design & Construction Private Finance

Project Funding Technical e.g. Assistance

Project Preparation

PRIVATE OPTION :

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Increasing degree of private-sector involvement

There are generally few legal or institutional constraints on this aspect of private sector involvement, although an appropriate technical assistance contract does clearly need to exist. The contract must not only cover the sector in question (e.g. waste management) but also be available in the location (e.g. region) and at the level (e.g. municipality) where the project is to be developed. Private Finance Private sector finance from banks or other financial institutions can be used either to complement public finance or occasionally as the sole source of finance for a project. This finance will normally take the form of loans, although in some circumstances equity participation may be a possibility. More than one financial institution may be involved, particularly where they are the sole source of finance. Some financial institutions are willing to assist with project preparation as well as providing finance.

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Priority Environment Projects for Access PEPA/24 ______________________________________________________________________________________

The key advantage of private finance is that it can help projects to proceed more rapidly, by addressing constraints on the availability of public sector finance. However, private finance can be costly – primarily because the financial institution will expect to recover its money over a shorter period (say 8-12 years) than has been traditional for public investment in infrastructure (20-25 years). Private finance also imposes constraints in relation to project preparation (which will need to match the specific requirements of the financial institutions), and does nothing to address the downstream aspects of design, construction, operation and management. In practice, unless there is equity participation there will be little transfer of risk to the financial institution. Financial institutions are generally risk-averse, and if the risk is perceived to be high the financial institution will either walk away from the project or increase the expected rate of return (this effectively transferring the risk back to the public agency). There may be legal or institutional constraints on the use of private finance in public infrastructure projects. However, these constraints are now less common than they were in the past, and the key issue is not so much access to private finance as the effective cost of that finance. Turnkey Contract A turnkey contract involves appointing a single contractor to be responsible for the design and construction phase. The contractor deals with all aspects of project management and implementation, including design, procurement, installation and commissioning. The contractor provides all the manpower, technical expertise and experience to carry out this task, and may also be able to offer access to proprietary technology. Some contracts also offer project finance. The key advantage of this approach is that the contractor will be expected to provide guarantees relating both to project implementation and to the subsequent reliability of the plant. The contractor will therefore assume responsibility for the key risks at the project implementation stage, including delays, cost overrun and plant performance. While guarantees relating to the reliability of the plant will be dependent on operating and maintenance standards, the contractor should also be expected to train the operators staff during the handover period. The main advantage of this approach is the significant transfer of project risk from the public agency to the private contractor. It is also possible that there will be cost savings compared to a wholly ‘in house’ approach, depending on how staff inputs by public agency are costed. However, the public agency will still need to select and manage the contractor, and to develop a specification against which contractors can bid. This needs to be detailed enough to ensure that the needs of the agency are met, without being so detailed that it inhibits innovative (and potentially cost-saving) approaches by the contractor. Finally, this approach will not normally address the issue of project funding, although some contractors will be able to contribute here.

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Priority Environment Projects for Access PEPA/24 ______________________________________________________________________________________

There may be legal or institutional constraints on the use of contractors in this way, but this is increasingly unlikely. However, it may well be necessary to use rigorous and complex tendering procedures, since these will generally be large projects. Operating Contracts Operating contracts involve the private contractor not only constructing the facility but also operating it for a period. In these cases it is usual for the contractor to provide the investment capital, and to recover this capital over the operating period. The options available include : • Build, Operate and Transfer (BOT), in which the private contractor constructs and operates the facility for a specified period. The public agency pays the contractor a fee, which may be a fixed (e.g. monthly) sum, linked to output (e.g. tonnes of waste received at a landfill site) or, more likely, a combination of the two. The fee will cover the operators fixed and variable costs, including recovery of the capital invested by the contractor. In this case, ownership of the facility rests with the public agency; • Build, Own, Operate and Transfer (BOOT), which is similar to BOT except that the contractor owns the facility up to the point of transfer. In practice, this is the most common form of operating contract; • Build Own and Operate (BOO), in which the contractor constructs the facility and then operates it on behalf of the public agency. The initial operating period (over which the capital cost will be recovered) is defined, but there is no requirement to transfer ownership to the public agency at the end of that period. As an alternative to transfer, a further operating contract (at a lower cost) may be negotiated. With this option the contractor provides a wide range of different resources, including manpower, technical expertise, project finance, operating experience and all the associated management and commercial skills. Since the contractor is responsible for operation as well as project implementation, performance guarantees are inherent in the approach. If the contractor does not provide the service he does not get paid, and indeed may be required to provide an equivalent service using an alternative facility. A key advantage of this approach is the transfer of technical and financial risk to the contractor, in relation not only to the construction but also to the operation of the facility. The cost depends strongly on the length of the operating period, which can be similar to the ‘traditional’ amortisation period of public infrastructure investment (15 to 20 years). This can make the effective ‘cost of finance’ much lower than the cost of borrowing from a private bank (over a shorter period), quite apart from the clear benefit in that the contractor will meet the full capital cost of the facility not just part of it. It is, however, important to recognise that in a long-term contract like this the contractor cannot be expected to take responsibility for factors that are completely outside his control, such as inflation. In some circumstances the contractor will also require guarantees relating to the expected ‘inputs’ (for example, the volume of waste arriving at a landfill site). As in the case of a turnkey contract, the public agency will need to select and manage the contractor, using appropriate tendering procedures. This can be a

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Priority Environment Projects for Access PEPA/24 ______________________________________________________________________________________

challenging task, given that many agencies will be adopting this approach for the first time whereas contractors are much more experienced as service providers. It is therefore likely that the agency will need specialist, independent advice on the contracting specification and procedures. The public agency will also need to monitor the standard of service provided. These options still face legal and institutional constraints in many countries. The legal framework for such contracts must exist, and there may also be issues relating to the reemployment of the public authority’s own staff by the contractor. However, it is important to recognise that this approach is not ‘full privatisation’, about which there are much greater concerns. Full Privatisation Full privatisation is the ultimate expression of private involvement in public infrastructure projects. Here the contractor is responsible not only for constructing and operating the facility, but also for generating the income needed to recover his costs and (if he is lucky) make a profit. The key distinction between full privatisation and an operating contract therefore relates to the nature and source of the income received by the contractor. Under an operating contract, the contractor will normally receive income from the public agency according to an agreed formula which reflects (at least in part) the throughput of the facility. In full privatisation, the contractor is normally responsible for generating income directly from those to whom he provides a service – households, industry etc. If the service provided is poor or the cost high relative to competitors, the contractor will lose market share and his income will be reduced. The public agency may also impose constraints on the charges that the contractor can levy, particularly where a private monopoly exists (for example, in water supply). The advantage of this approach is that it transfers virtually all risk to the contractor as well as securing rapid and complete implementation of the project. As in the case of an operating contract, the contractor provides all the technical, financial and management resources that are needed for project implementation and (in theory at least, indefinite) operation. The key issue for the public agency is again the procedure for contracting out the service, and in this case it is almost certain that specialist advice will be needed. The agency will also need to monitor not only service standards but also (in many cases) the charges that the contractor makes for the service. The use of this option is far more likely to be constrained by legal or institutional issues. There must be a legal framework that permits the privatisation of public services in general and environmental services in particular. As in the case of operating contracts, institutional issues are more likely to relate to existing (public agency) staff and whether or not (and if so on what terms) they will be re-employed by the contractor if they become redundant.

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Priority Environment Projects for Access PEPA/24 ______________________________________________________________________________________

Risk Versus Cost The main advantage of involving the private is not simply that it ‘gets things done’ but also that it progressively transfers risk away from the public agency. The extent to which risk is transferred depends both on the role of the private sector (Table 1) and on the steps taken by the public agency to ensure that potential risk transfers do in fact take place. As already noted, this can be difficult if the public agency is not experienced in this area. The aspects of risk that need to be considered here are : • • • • • •

Regulatory Risk : the risk associated with permitting of the facility, including meeting environmental requirements; Completion Risk : the risk associated with project completion, including time delays and cost over-runs (in practice, this is often the greatest risk for public agencies); Technology Risk : the risk associated with the performance of the technology, plant or facility (generally on acceptance following installation and commissioning); Operating Risk : the risk associated with operating or maintenance problems that affect the performance of the plant or facility; Input/Supply Risk : the risk associated with the flow of input (waste, water, effluent) to the facility; Revenue Risk : the risk associated with collecting the expected revenue for operating the facility.

Table 1 : Risk Transfer to the Private Sector Role of Aspects of Risk Private Regulatory Completion Technology Operating Input/Supply Revenue Sector Risk Risk Risk Risk Risk Risk No* No* No* No No No Technical Assistance No* No* No* No* No* No Private Finance Probable* Yes Yes No* No No Turnkey Contract Yes Yes Yes Yes Yes No Operating Contracts Yes Yes Yes Yes Yes Yes Full Privatisation * No/limited risk transfer, but possible reduction in risk as a result of private sector role

The reduction in risk to the public agency must be balanced against any potential increase in costs. In practice, all options that are to be considered need to be compared against the ‘in-house’ option in terms of the cash flows to/from the public agency. In this context, it is necessary to evaluate all options (including ‘in-house’) in terms of Net Present Value. The reason for this is that options such as operating contracts and net present value do not involve capital expenditure by the agency and so cannot be evaluated in terms of parameters such as rate of return or payback period.

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Priority Environment Projects for Access PEPA/24 ______________________________________________________________________________________

If such an evaluation is carried out, some ‘private’ options will probably appear to be more costly than the ‘in-house’ option. It is, however, important to ‘factor in’ an allowance for risks that are transferred to the contractor. For example, what happens if the ‘in-house’ option suffers a 10% cost overrun, or is delayed by two years because finance is not available? Wider Issues The role of the private sector can be an important issue in the context of project prioritisation (PEPA/22). For example, options such as operating contracts and full privatisation effectively remove a project from the pipeline, allowing resources (for example, funds and project preparation resources) to be focused on other projects. However, it is important to recognise that involving the private sector does not remove all responsibility for the project from the public agency. It is important for the agency to act as an ‘informed consumer’ of the services that the private companies are being asked to provide. This can be a demanding task, since to the companies involved this is a routine task while for the public agency may be the first and only occasion when such issues as tendering for a BOT contract have to be addressed. It follows that assistance may be needed, particularly where the commercial aspects of the negotiation/tender are involved. Finally, it must be emphasised that it is not always appropriate to consider private sector involvement. In particular, the project needs to be large enough to justify the ‘overhead’ involved in establishing some form of public/private partnership – from the perspective not only of the public authority but also of the private contractors. Certainly, larger contracts (even if they are built up from a number of smaller projects) are likely to stimulate greater interest from the private sector and (ultimately) more competitive tenders.

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