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close this bookWater for Urban Areas (UNU, 2000, 243 p.)
close this folder7. The role of the private sector in the provision of water and wastewater services in urban areas
close this folderPreparing for a private sector venture
View the document(introduction...)
View the documentPre-contract analysis
View the documentChoosing among the options
View the documentMaking sure that the desired option is of interest to the private sector
View the documentFinding and contracting a suitable partner

Pre-contract analysis

Once a government has determined that private sector participation appears financially and politically feasible, a careful assessment should be undertaken before moving on to the next stage of choosing an option. Five main questions need to be answered:

1. What is the state of the existing utility?

2. How compatible is the existing regulatory regime with private sector participation?

3. How committed - or opposed - to private sector participation are key stakeholders?

4. Is the deal financially feasible for the private sector?

5. What are the main risks that need to be allocated or mitigated to ensure that private sector participation can succeed?

Assessment of the utility

The purpose of this analysis is to assess the current performance of the utility and the quality of information available about its management and operation and to identify those conditions that might make it attractive for a potential private sector partner. The government will need to gather - or identify as unavailable information on matters such as: the utility's present and projected service area; the current characteristics of the service (water quality, pressure, supply security, sewer flooding, or metering); a basic inventory of the assets and their condition and serviceability; human resources (numbers, skills, wage rates, conditions of service, pension arrangements); financial performance and tariffs (level and structure, subsidy arrangements, collection performance, disconnection policy); consumer preferences, affordability, and willingness to pay. The data collected in this evaluation will provide valuable information on the nature of the investment and related costs required to improve services, on potential efficiency gains that could achieved, on future desired performance standards, and on asset rehabilitation needs. A clear understanding of the utility's present performance is an essential condition for deciding on what form of private sector partnership would be desirable and feasible. It will also help to identify areas where data are lacking or may be inaccurate and lead to the conclusion that improving the data base may be necessary.

Regulatory/institutional analysis

The possible nature and effectiveness of a private sector arrangement depend on the regulatory mechanisms that will govern the private sector participation. Because any decisions about the private sector option, industry structure, and regulatory framework are closely linked, consideration of regulatory matters must be faced early on. Entering a private sector arrangement without an appropriate and effective regulatory structure can lead to costly mistakes and an acrimonious process to rectify matters later on. The objective of the analysis of regulatory issues is to: (a) identify elements in the existing broad framework of laws, constitutional requirements, and regulatory activities that could impede private sector participation or affect the viability of a specific option; (b) consider the potential for restructuring the present regulatory regime to open up the spectrum of options; (c) develop the sector-specific regulations that would govern the relationship between the public sector and the private partner; (d) help specify the powers that will remain in the public sector, identify who will exercise these powers and at what level of government, and create new regulatory arrangements as needed; and (e) decide which elements of regulation should be incorporated into the private sector contracts, how much the contracts limit the discretion of any public sector regulators, and what safeguards the contracts should contain against regulatory and political risk.

In assessing how the broad regulatory framework will affect the choice and design of a private sector arrangement and the attractiveness of that arrangement to the private sector, governments need to consider a wide range of laws and regulations related to: the constitutional and legislative division of responsibility for public services among national, regional, and local governments; inter-jurisdictional arrangements, if service responsibilities are decentralized and the system covers several jurisdictions; laws that govern private sector intervention in the provision of public services; water resource management and environment; labour; taxes; procurement of goods and services; currency control; public health and safety; and social policy.

Some elements of the existing framework cannot be changed or may take time to change. That may rule out a preferred option for private sector participation. If it does, it is best to recognize this early - and to adopt a stepwise approach to private sector participation that allows time to improve the general legal and regulatory framework. For example, if collection performance or requirements for providing subsidized services pose unacceptable revenue risks for the private partner, the best alternative might be to choose a private sector arrangement that reduces commercial risk by adopting a fee-based management contract type of arrangement. Or it might be possible to incorporate explicit safeguards into the contract - such as provisions allowing for additional payment for unexpected investments, protection from environmental liability, specified compensation or price adjustments for changes in service standards, and minimum revenue guarantees.

Stakeholder analysis

A range of stakeholders have a legitimate interest in the water business. Such key stakeholders and their potential support or opposition must be identified early. Stakeholders might oppose concessions or divestiture, for example, but accept management contracts, which give the private sector a more limited role. Or stakeholders might oppose any arrangement that has the private sector acting alone, but support joint ventures with the public sector. Generally these key stakeholders include: the national government (ministries with some jurisdiction over water-related matters, such as the ministries of health, environment, and urban and economic development); provincial and local governments that will act (or may act) as grantors of private sector contracts, regulators, partners, or financiers of the utility; regional or local planning departments, which coordinate land-use and infrastructure planning; other established regulatory entities (such as water commissions, environmental agencies, and competition and fair trade commissions); political parties and individual politicians; labour unions; utility management and staff; consumer organizations; and advocacy non-governmental organizations concerned with some aspect of utility conduct and operations.

Table 7.3 Potential stakeholder issues and policy responses

Stakeholder group

Possible issues

Policy decisions required

Ways to get inputs


Staff redundancies Changes in employment conditions

Redundancy packages and other arrangements encouraging staff to leave

Open and continuous consultations and negotiations with staff


Consumers' preferences Willingness to pay

System for planning extensions Tariff methodology Design of a subsidy scheme

Social Assessment, participation, public relations/consultation campaigns

Environmental interests

Major environmental consequences

Environmental standards to be applied Liability for past pollution

Consultation with environmental groups

Existing government agencies

Major shifts in the allocation of responsibilities

Implementation of new regulatory system Redefinition of responsibilities among government agencies

Intensive consultation

Other citizens


Resettlement policy

Direct consultation with affected groups

Once the key stakeholders have been identified, government will have to engage in a dialogue with all of them to gain support or to defuse opposition to the proposed private participation. To bring these stakeholders on board, government may have to consider a variety of conciliatory actions or safeguards (table 7.3), which may include protection for: (a) labour and management through redundancy packages, worker share allocations, minimum wages and working conditions, health and safety measures; (b) contractors or suppliers through regulatory rules to ensure competition in subcontracting and procurement; (c) customers through tariff adjustment rules, subsidy policies, complaint mechanisms; (d) public health and environmental protection through regulation of service standards, penalties for default. Although such safeguards can secure sufficient support to allow private sector participation to proceed and to ensure that it benefits users, they all involve costs that need to be carefully considered.

Among the most important stakeholders are utility staff and unions. Often, improving the efficiency of management and operations and introducing better technologies and know-how can be achieved only by restructuring personnel policies and reducing a costly and bloated workforce. Unless the staff's fear of layoffs can be managed, government's initiative is probably not possible.

The example of Buenos Aires in Argentina shows how government could deal with labour issues. The public water company in Buenos Aires, like many around the world, was heavily overstaffed. It had 7,600 employees, or about 8 employees for every 1,000 connections -around twice as many as needed to operate efficiently. Under a preferred plan, 1,600 employees accepted voluntary early retirement on severance packages financed by the government at a cost of around US$40 million. Soon after taking over the operation, the concessionaire offered another voluntary early retirement programme. This offer was accepted by 2,000 employees, at a cost to the concessionaire of around US$50 million. Within six months of the start of the concession, the number of employees had been reduced by almost half. The cost of achieving this reduction was considerable, but it was viewed as an investment necessary to achieve the efficiency targets sought by the concessionaire. Today, many of the former employees are among the 8,000 or so small contractors now providing services to the Buenos Aires company.

Analysis of financial and tariff conditions

Perhaps the most critical issue in selecting a private participation option relates to financial concerns. Unless the private sector feels that the deal is financially feasible, it will not enter. Typically, the following questions must be answered: If the private sector partner is expected to invest in rehabilitating the system or expanding coverage, how will that affect the tariff? Will the current tariff cover costs after allowing for expected efficiency gains? If the projected tariff exceeds what some households are willing to pay, will the government provide subsidies? If not, could investment programmes be reduced to match the financial capacity of the consumers? Unless these issues are analysed seriously and realistically early on, much time and resources may be spent on options that turn out not to be financially feasible or not affordable. To find answers to these issues requires detailed financial work, including: assessing the financial status of the water and sanitation utility, and testing the financial and tariff implications of hoped-for service expansions and efficiency. Such financial analysis will narrow the options to arrangements that are feasible and sustainable.

Key parameters to be considered in this analysis include: (1) the utility's current operating and maintenance cost for water supply, treatment, and distribution, and for sewage collection and treatment; (2) current tariff levels and structure and collection efficiency; (3) current and projected water consumption; (4) the cost of capital improvements to the water supply, distribution, and sewerage systems, and annual expenditures necessary to achieve intended service levels; (5) the availability of funding for service improvements through grants, equity, and loans; (6) the additional annual operating costs due to system expansions, considering the efficiency gains that private operation might achieve.

Risk analysis

It is important for governments to recognize risks and to consider how they might best be allocated between the public and private sectors. Early thinking about the risks associated with private sector participation can save time later on and help ensure that the resulting private sector arrangement comes close to what was originally intended. Different risks are associated with different options, but they fall into two general categories. For fee-based service/management-type contracts, the most significant risk is that the performance of the private contractor may fall short of expectations. Arrangements need to be in place to monitor the contractor's performance, and to ensure that water quality and other standards required from the operator can be enforced. If adequate staff are not available to monitor performance, the government might consider contracting with a third party - an audit firm, for example. For lease/concession/BOT-type arrangements that require the private operator/investor to depend on tariff revenues for financing operating costs and investments, incentives need to be in place for the contractor to improve the efficiency of operations and investments. Under a natural monopoly situation, there is always the concern and risk that the contractor will reap windfall profits by charging excessive tariffs or reducing service quality. These risks need to be managed carefully through the design of appropriate and effective monitoring and regulatory systems and arrangements.

The special problem of smaller cities

Private sector participation is easiest and most attractive in larger metropolitan areas, say cities with populations of at least half a million. Yet smaller municipalities have just as much need for better water and sanitation services and can also benefit from private participation. But their financial, economic, institutional, and technical conditions present difficult problems. A private contractor will often find it harder to make sufficient returns on its investments in small networks unless the operator can benefit from economies of scale by operating several smaller systems located close to each other. Also the generally lower average household income in smaller towns makes it more difficult for families to pay tariffs that cover costs and yield a reasonable return. Limited administrative skills and institutional capacity in many smaller municipalities limit their ability to undertake the effort needed to design, implement, and supervise private sector arrangements. Local officials and their staff will need assistance from higher-level government agencies in preparing for private sector entry. There are several ways to tackle these problems. The most effective is for several smaller towns to form an association and a single administrative entity, which provide the economies necessary to undertake private participation efficiently and competently. The national government can help smaller cities by supplying advisory services, financial models, and contractual documents.