A Systematic Approach for the Selection of Contract Strategies (A Case Study of Water Supply Development Project in Indonesia) Ari

Sandhyavitri Civil Engineering Department, Faculty of Engineering, University of Riau, Pekanbaru ari@unri.ac.id Phone: +62 761 7070556

Abstract
This paper describes the use of the Pendulum Obligation Diagram (POD) and a set of Assessment Criteria (AC) assisting decision-making process in selecting contract strategies for construction, operation and maintenance of water supply projects. The use of POD and AC are useful in comparing the relative merits of alternative contract strategies in the development of water supply projects. A case study illustrates the benefits that can be derived from the systematic collection of revenue. It also demonstrates that the chances of meeting stakeholders objectives can be greatly improved by using these decision making tools. This paper undertakes a study of the development of a water supply scheme planned for Padang city (in Indonesia). Various options were developed, it was summarized that a full concession contract strategy will best meet most of the project requirements (on fresh capital investment and efficiency). This contract may also be attractive to investors as the projected IRR is relatively high (14.27%) and CPBT is relatively short (12.99 years) and a BOT contract strategy could meet partial project requirements on financing and operation of new water treatment plant facilities and may also yield good economic parameters (e.g. the IRR is 14.42% and CPBT is 10.41 years). On the other hand, lease and partial concession contracts were not recommended. A systematic procedure in the identification of all stakeholders requirements for the water projects in Indonesia, including key economic parameters, using the POD and AC tools may significantly assist decision making in the selection of best value for money contract strategies. Key words: POD, AC, private sector participation (PSP), stakeholders, requirements, project, and economic parameters. Introduction The World Water Vision 2025 (WWV) has indicated that the annual capital investment requirement in the water supply and sanitation sector now, and up to 2025, will be in the range of US$ 30 billion to US$ 75 billion (Owen, 2001). This level of financial commitment will only be achieved if the investment conditions and environment are improved to the extent that the private sector will participate in the development of water supply facilities. Private sector participation (PSP) would significantly reduce the burden on governments currently presented with the need to finance water projects. The development of a water supply scheme for Padang city in Indonesia was relatively slow, it was recoded that service coverage was limited to 54% of the

population in 2000 and it was not significantly improved up to 2007, hence it is a need to find out an appropriate contract strategy to meet stakeholder objectives in terms of project financing, sustainability operation and maintenance. Pendulum Obligation Diagram (POD) and Assessment Criteria (AC) (developed by the author) were use to assist decision-making process in selecting contract strategies for development (construction), operation and maintenance of the water supply industry in Indonesia, 2002. To what extend these approach may assist the selection process of contract strategy suit to a water supply project was demonstrated in this paper. Objectives The objectives of this paper is to utilise of Pendulum Obligation Diagram (POD) and a set of Assessment Criteria (AC) in assisting process in selecting contract strategies for development of a water supply projects. A case study in development of water supply project appraisal in Indonesia was also presented to demonstrate the use of POD and AC. Literature Study Private Sector Participation (PSP) has been promoted as necessary for obtaining financial resources for the development of the water supply sector in developing countries for improving both service coverage and performance quality (Owen, 2001; Steklov, 2001; Wolfe, 2001; and Janssens, 1997). Factors affecting the success, or failure, of private sector participation This paper identified a range of factors influencing the success or failure of PSP in water projects, but the emphasis is placed on seven (see Figure 1): Political will is required to support and accomplish PSP. An adequate legal framework must be in place before adoption of PSP. This should be related to re-allocation of water, water transfer, water licences, water pricing, contractual arrangements ,and long-term industry structural aspects to ensure a sustainable water industry. An independent regulatory system is also necessary. This should encompass: environmental regulation, protection of river water and wetlands, water quality standards, level of service standards, financial performance, and water charges. This will require: (i) technical standards, which are based on appropriate scientific criteria; and (ii) competent staff, who are able to carry out operations and maintenance (O&M) of the new, and systems. An adequate database for: water resources management; the existing urban water systems; socio-economic conditions; and geographical conditions. Such information is fundamental for private investors and project promoters to develop feasibility studies for water projects. Acceptable elemental risk (external and internal risks) of the projects, such as: transferred project asset conditions; operational performance; market demand; and climatic conditions. Community acceptability of the principle of PSP in the water supply sector. The community also needs to be committed to connecting to the water service, and

accept economic water tariffs measured by willingness to pay (WTP) which must be linked to quality of service. Acceptable global risk. These risks are essentially: political stability, which is essential to sustainable development (changes in the government regime should not significantly affect the existing regulations and laws); access to capital funding; a sufficiently large pool of skilled operations staff; and adequate revenue generation, enabling project promoters to service O&M costs, debt, and generate profits. These seven significant factors were also reported in Sandhyavitri, 2002, Owen, 2001, and Janssens, 1997. Hence, it is a common sense that various factors above are also inherent in any water supply development projects in many countries. Research Methodology Literature study was applied in the initial research activities. Field survey to the field was also carryout together with interviewing various parties involving in the water supply area in Padang, Indonesia (encompassing project managers level of Padang water supply operators, consumers and regulatory body). The main objectives of this survey is to obtain information related to project financing issues, technical and administration performance during project operation. The simulation of project economic parameters uses Caspar Software package.

Discussion
Typical PSP contracts This paper classifies PSP contracts in three major groups: Low degree of private participation this may include service contracts, management contracts, and leasing. The private sector mainly provides the working capital to carry out works as stated in the contracts. Government retains the ownership of water assets and pays the private sector investor using contractual mechanisms. Government is also able to take advantage of the private sectors experience, and efficiency of performance and skills in the O&M of water systems and service. High degree of private participation this may include Build Operate Transfer (BOT) and concession contracts. In BOT contracts, public authorities pay private firms to treat a certain amount of water produced. To provide the basis for project financing, the revenue stream is secured through a take-or-pay arrangement, or fixed payments are made irrespective of whether or not the service is used. In concession contracts the private sector (the concessionaire) has the overall responsibility for financing the expansion of water systems, O&M facilities, delivery of services, and collecting revenues from the customers. The contract period is negotiated to allow for retirement of debts, providing a return on equity for investors, and a reasonable profit for the operators. The fixed assets remain the property of the public authority (project principal), but the operation of all facilities is entrusted to the concessionaire. Full privatisation within this contract arrangement, the private sector (concessionaire) has overall responsibility for project finance, O&M facilities and revenue generation. The existing assets are handed over from the public authority (project principal) to the concessionaire.

When PSP is used in the provision of public services (utilities, transport, etc) the government's role changes from being the financial provider or operator, to becoming an industrial regulator1. Pendulum Obligations Diagram (POD) POD was a simple diagram that describe key requirements of a water supply project (Figure 2). These are grouped under the categories of: (i) capital investment; (ii) working capital for O&M; and (iii) efficiency requirements, and tabulated as the Scale of Obligations. These three major requirements, in the context of the project objectives, are described as follows: Capital investment. It is necessary to establish whether the project principal and promoters have adequate capital to finance the construction or development of the projects. If the existing principal and project promoters do not have the required financial capability, but the projects are urgently needed, BOT and Concession contracts are likely to yield the best solution. Working capital for the operation and maintenance (O&M) of projects. Working capital is used here in its widest sense to mean financial, technical, human resources, equipment, and managerial capabilities. O&M activities may include: conservation of catchments, transport of bulk water, distribution of treated water to the customers, maintenance of network systems and overall facilities, administration and billing, and quality management. Efficiency. The most efficiency sensitive work within the project life cycle occurs in the project O&M phase as these activities have longer duration and involve high costs. Thus there is a need to improve efficiency of the following O&M activities: cost saving in the treatment of water, reduction of leakage rates, improvement of billing efficiency and revenue collection rates, improvement of service quality, and quality control. PSP will involve the transfer of at least some of these obligations from the government to the private sector. The extent to which this is necessary is shown by the degree of swing of the pendulum. As the pendulum swings progressively from left to right more project obligations are transferred from the government to the private sector, and the pendulums progress indicates the corresponding contract strategy. When the pendulum is shown at Public Sector (PS), the government is obliged to fulfil all of the requirements for financing, operation, and management of the entire water supply project, such as providing water infrastructure and facilities, which may include: (i) construction of dams, reservoirs, treatment plants and distribution systems; and (ii) providing any necessary equipment and service. As the pendulum swings towards the private sector, the governments obligation is reduced. For example, under Service Contract (SC), the private sector may be given the responsibility of managing leakage with the objective of improving efficiency within the distribution system (e.g. reduce leakage rates). Under Management Contract (MC), the private sector may provide capital works, and improve efficiency
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In the case of the water supply industry this means the regulation of water tariffs as well as water quality, to ensure customers will receive better service quality than was previously provided

within water treatment plants; and under Leasing Contract (LC), the private firm may also invest capital for the development of plants or distribution systems. Ultimately, under BOT (BC) and concession contracts (CC), the roles of the private entity are further extended to cover overall capital investment, O&M costs and efficiency tasks. The shift in the balance of obligations from the public sector to the private sector in moving from a service contract (SC) to concession contract (CC) may also be illustrated by a definition of the tasks which fall to both sectors, as shown in Figure 3. Assessment Criteria Seven assessment criteria, which may be used to assist the process of: (i) identification of strengths and weaknesses of PSP contract strategies; and (ii) selection of appropriate PSP contracts for water supply projects are identified. These criteria (Table 2) are: Capital investment identifies which parties are responsible for providing capital investment. Financing O&M indicates the allocation of O&M costs for water treatment plant, distribution systems and management offices. The costs may include: (i) staff payments; (ii) electricity and fuel; (iii) chemical costs; (iv) financial cost; and (v) administration. Obligations These may include overall descriptions of the private sector companys responsibilities in either financing, operation or management of a water scheme. The roles of the water company may also be described in this diagram. Efficiency of O&M The project operators have as their main objective to improve efficiency of the O&M activities, such as efficiency in using electricity, chemical materials, equipment, staff, and reducing leakage2. Commercial risk Commercial risk is inherent in any privately funded water project, thus the project principal or promoters should appreciate the degree of commercial risks, which have been passed to other parties, or indeed how risks have been shared between their organisation and other parties; and what risks have been retained in order to minimise the risk premium paid. Economic parameters - These are illustrated by the IRR, NPV, cash pay back time (CPBT) and Maximum investment requirements of a project. Contract duration - Different contact lengts for different PSP options are identified as being between 2 to 30 years. Case Study This paper undertaken a study of the development of a water supply scheme planned for Padang city in Indonesia, which had the main objectives of: (i) increasing service coverage from 54% of the population in 2000 to 67% of the population in 2007; (ii)
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Leakage reduction identifies which parties are responsible for leakage mitigation and control. These responsibilities should be clearly stated in the contract. High levels of technical performance and professionalism are required to ensure success of leakage reduction programmes. Billing and revenue collection higher billing efficiency usually needs to be achieved, as this will improve revenue generation. Quality the term quality is abstract and subjective. In order to make it less subjective, there is a need to establish quality specifications against various parameters set by formal organisations. For example: (i) the water quality standards are referred to the standards of the World Health Organisation (WHO), or the government of Indonesia; and (ii) the efficiency standards for O&M of the water utilities should comply with the standards of the Public Works Department

maintaining uninterrupted supply of 150 litres per capita per day (lcd) by 2005; and (iii) complying with the World Health Organisation (WHO) water quality standards. The project duration is 25 years (January 2000 to December 2024), divided into 4 packages encompassing: (i) project finance, (ii) construction, (iii) operation and maintenance (O&M) and (iv) revenue generation. The main aspects of project finance are loan resources, loan repayments, and the fluctuation of interest and exchange rates. The construction and operation phases have 35 activities. The planned construction period was divided into 4 phases. Phase 1 of duration 49 months to be commissioned in January 2004, and Phase 2 taking 25 months to be commissioned in February 2006, with Phases 3 and 4 to be commissioned in April 2008 and in April 2009 respectively. Plant operation would be in 3 phases, related to increased water demand and production capacity. The main aspects of the revenue package are: establishment of tariffs, billing and revenue collection. These packages ware simulated using Caspar Software. The requirement of stakeholders The main requirements of specific stakeholders were: 1. Principal (Municipality) had to identify the financial resources for such a project (e.g. private sector finance). 2. Lenders (e.g. Asian Development Bank or ) require a punctual loan repayment schedule, and high commercial viability for the project (i.e. commercially attractive project IRR and NPV figures). 3. Promoter and operator (water companies) have three main requirements: (i) generation of adequate revenue to cover O&M, service debts and yield profits; (ii) efficiency improvement; and (iii) gaining public esteem. 4. Consumers (domestic, commercial and industrial sectors) have the main requirements: (i) obtaining adequate water quality; (ii) reliability of water quantity (no disruption); and (iii) reasonable water bills. Thus, for the selection of appropriate PSP options, these stakeholders' requirement should be taken into account. The main requirement of the project principal is a large capital investment to meet rapid increases in water demand within the city. Thus, Service Contract and Management Contract strategies were considered inappropriate for such a project, as both of these contract strategies do not provide large capital investment. This can be seen at the magnitude of obligation of the private sector in Figure 2. Hence the author investigated four contract strategies that could be appropriate for financing, developing and operating such a project in more detail. These encompass: (i) lease contract; (ii) BOT; (iii) partial concession contract; and (iv) full concession contract. Lease Contract (Affermage) Possible application: The private sector leases treatment plant (stage I). This would include: operation of water treatment plant facilities; and maintaining reservoirs, intakes and distribution systems in the southern and eastern areas of the city over a 20 year contract period.

Obligations of the private sector are to: Operate and manage a water treatment plant (stage I) with the capacity of 160 l/s; supply clean water to an agreed number of customers; commence staff training; read water meters and issue bills; collect revenue from the customers; transfer the collection fees to an Escrow account 3; develop the existing plant from 160 l/s to 220 l/s; expand distribution systems to cover 6,200 new connections; and at the end of the contract period return all facilities to government control. Financial analysis: The commercial data for such a contract strategy for the investors is projected to be an IRR of 10.15%, with the NPV of Rp. 3.31 billion (US$ 0.47 million) and a cash pay back time (CPBT) of 11.83 years. Recommendation: Such an option would probably be commercially attractive to an investor as the economic parameters are relative high, but this option is not recommended, as the type of contract attracts low capital investment, CPBT is relatively long (compared to the 20 years project life cycle) and generates little improvement of water treatment plant facilities and distribution systems (Figure 4). BOT Contract Possible application: The private sector finances, constructs and operates water treatment plants (stages I and II, reservoirs and water intakes over a 20 year contract period. Obligations of the private sector are to: Finance and construct 2 new water treatment plants (with capacities at stage I of 160 l/s, and stage II of 200 l/s). This also includes the construction of reservoirs and intakes stated in the project plan; operate and manage the new facilities and supply bulk water to the existing water company; maintain agreed minimum water quality and quantity production, and achieve the standard performance benchmarks agreed between the existing water company and BOT contractors; and at the end of the contract period return all facilities to government control. Financial analysis: Project should yield an IRR of 14.42%, with an NPV of Rp. 21.48 billion (US$ 3.07) and a CPBT of 10.41 years. Commercial risks: A fixed-fee is set for treatment of water and maintenance of the water treatment facilities. This is paid directly by the project promoter to the private contractor via an escrow account. Recommendation: Such a contract may (i) improve treatment plant capacity; and (ii) be commercially attractive to an investor (the NPV and the IRR of the project are relatively high); this option is not however recommended. This contract does not meet the project principals requirements (that of fresh capital investment for the improvement of water plants and extension of distribution systems). Moreover, the existing infrastructure owner does not have the capability to provide adequate
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Escrow account is an account established by the Government and the private sector for collecting the revenue from customers. The money within the escrow is then proportionally divided between these parties based on the contract agreement.

network distribution systems and to pay the fixed fee for the water produced by the private sector. Concession Contract (Partial) Possible application: The government authorises the total management of new water supply systems (for example: the construction and operation of water treatment plants, reservoirs, intakes and distribution systems) to a private sector investor in a specified area of the city over a 25 years contract period. Obligations of the private sector are to: provide capital investment of 31.71 billion (US$ 4.53 million) for financing and construction of new water treatment plants (stages I and II with the total capacity of 260 l/s) and distribution systems; supply 653,000 m3 of clean water per month to cover 181,400 customers; operation of new treatment plants with operation costs per m3 of water of Rp. 600 and a selling cost of Rp. 1,100; maintain distribution systems and all treatment plant facilities; read water meters, issue bills and collect revenues from the customers; transfer the collected revenues to the escrow account; and at the end of the contract period return all facilities to government control. Financial analysis Analysis indicates that the projected NPV of the project would be Rp. 36.65 billion (US$ 5.23 million), with an IRR of 6.12% and a total investment of Rp. 30.82 billion (US$ 4.40 million) with a CPBT of 17.97 years. Recommendation: Although this option provides the overall facilities required to meet an increase of water demand, such a contract is unattractive to investors as the projected IRR is relatively low and CPBT is long. Thus, this option is not recommended for application in this project. Concession Contract (Full) Possible application: The private sector takes over total management of water supply systems (for example: the construction and operation of all of water plant facilities, reservoirs, intakes and distribution systems) for the entire city over a 25 year contract period. Obligations of the private sector are to: finance and construct new water facilities and distribution systems with agreed capital investment of Rp. 31.71 billion (US$ 4.53 million); operate and manage the entire water supply systems (both existing and newly developed); read water meters, issue bills and collect revenues from the customers; transfer the collected revenues to the escrow account; and at the end of the contract period return all facilities to the government control. Financial analysis this arrangement woul yield an NPV of Rp. 102.76 billion (US$ 14.68 million), with the IRR of 14.27% and a CPBT of 12.99 years. Recommendation: This option is recommended for such a project, as the type of contract would yield significant improvement of the water treatment plants and distribution systems. This option would also best meet the requirements of the project principal and the project promoters (i.e. to have an access to large capital investment and working capital, and improve efficiency). Moreover, this contract should yield

relatively high IRR and NPV, with a relatively short CPBT. Thus, this option would be commercially attractive to investors. Conclusion and recommendation For this case study the recommendations are that the first option would be a full concession contract as such a contract will best meet most of the project requirements (on fresh capital investment and efficiency). This contract may also be attractive to investors as the projected IRR is relatively high (14.27%) and CPBT is relatively short (12.99 years). The second option would be a BOT contract as this contract could meet partial project requirements on financing and operation of new water treatment plant facilities. Such a contract may also yield good economic parameters (e.g. the IRR is 14.42% and CPBT is 10.41 years). On the other hand, lease and partial concession contracts were not recommended. The Authors have realised that the political and social environments would probably result in strong opposition if full management of water assets was given to the private sector. Based on a willingness to pay (WTP) survey carried out in the city in 2000 the Authors identified that only 20% of the water users were happy to have a fully privatised water utility, 20% felt that partial privatisation of O&M of the water utility was acceptable. Hence it is likely that a full concession contract might prove unacceptable to the water consumers, and therefore a compromise recommendation is made that the project principals and project promoters follow a BOT contract strategy. This type of approach maybe used as a generic model that may assist project principals and managers in the selection of contract strategies, which best meet project's requirements. By systematically assessing the requirements of the project principal and promoter, and inputting this information to the figures, along with all the other relevant data, the various contract strategy options may be prioritised in order of maximum benefit to the parties to the contract.

Appendix

DATABASE of the existing water supply systems

LEGAL FRAMEWORK

POLITICAL WILL

REGULATORY SYSTEMS

ACCEPTABLE ELEMENTAL RISK Asset conditions Operational performance Market/demand Climate

EFFECTIVE PSP
Requirements

COMMUNITY ACCEPTABILITY
Willingness to connect Willingness to pay (WTP) Water conservation measure

ACCEPTABLE GLOBAL RISK:

Stable political environment Access to capital Access to capable operators Adequate revenue Access to technology

.
Figure 1 Country conditions for effective PSP

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Concession Contract (CC)

SCALE OF OBLIGATIONSCAPITAL INVESTMENTPlanning and

designWater resources, dams, reservoirs and intakesMain trunksNetwork systems and water metersTreatment plants and pumpsWORKING CAPITALQuality managementCatchmentsBulk waterTreatment of raw waterSupplying waterRepairs and maintenanceAdmin. and billingEFFICI-ENCYQuality controlQuality of serviceTreatment costsBilling and revenue collectionsLeakage rates

Public Sector (PS)

BOT Contract (BC)

Leasing (LC)

Service Contract (SC)

Management Contract (MC)

DEGREE OF PSP

Figure 2 Scale of Pendulum Obligations

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Pay contractors

Government
OwnershipCatchment areasRegulatorDistribution/sell bulk of waterFinancing capital investmentO & MTreatment plants Development facilities/ servicesDistribution systems, and water supplyCommercial risksRepair, service and maintenanceAdministrationBilling and revenue collection

Private Sector

Carry out works/services

Supply water and services

Customers

Pay bills

Government
OwnershipRegulatorMonitoring Concession

Escrow Account
Government fee

Operation fee

Customers
Supply water and carry out service

Figure 3 Change of the public obligation in financing and operation of water sector from the public sector to the private sector

Private Sector
Financing capital investment Development facilities Catchment areas Distribution/sell bulk of water Water treatment plants Distribution systems, and water supply Repair, service and maintenance Administration Billing and revenue collection Commercial risks O&M
Pay bills

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120000 100000 80000 60000 NPV (Rp.) 40000 20000 0 2002 2003 2007 2008 2011 2012 2016 2020 2021 2023 -20000 -40000 -60000 year 2025 2000 2001 2005 2006 2010 2013 2015 2017 2018 2022

Lease contract BOT contract Partial Concession contract Full Concession contract

Figure 4 Comparison cash flows of four contract options

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Table 1. Range of private sector participation can play in water industry Private Sector Participation (PSP) Low degree of High degree of participation participation Relatively low capital Relatively high capital works works and investments. Private sector involved in Private sector invests, supplying (as suppliers) constructs and operates water and operating (as subsupply facilities. contractors) of a water Government as regulators and utility. sometimes also involved in some Government provides all operation and management of water supply facilities. infrastructure and Government owns the facilities, owns the assets, facilities. and controls and manages the facilities. (Adopted from the Public Work Department of Indonesia, 1999). Full privatised Divestiture of the government's assets to private sector. Private sector owns the overall assets.

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Table 2 Summary of the possible PSP features for the case study project Criteria Type of Contract Strategies Sub-criteria Source of investment Scale of capital investment Size of project Obligations ementManagFinancing O&M Lease Shared between public and private sectors Small (Public sector Rp. 2.20 billion; Private Rp. 2.4 billion) Small (water treatment plant facilities, WPs) Operate WPs and develop its capacity BOT Private sector Medium Rp. 8.30 billion or US$ 1.19million Medium (WPs) Finance and operate several WPs Concession (partial) Private sector Large Rp. 31.71 billion or US$ 4.53 million Concession (full) Private sector

Investment

Large Rp. 31.71 billion or US$ 4.53 million Large Large (Overall new Overall facilities water supply (new and the facilities) existing ones) Finance and Finance and operate new water operate overall supply facilities facilities

Obligations of the private sector

Limited to operate, manage and develop the existing WPs

Limited to finance, build and operate new WPs.

Efficiency in O&M

Efficiency in O&M Leakage rate reduction Billing and rev. collection Quality

Limited to water treatment plant facilities (WPs) n.a. n.a. Improved water quality

Limited to several WPs n.a. n.a. Improved water quality and quantity

Complex (Finance, build, operate and management of water supply facilities on a partial basis) Overall new water supply facilities Partial network systems Limited customers Improved water quality and quantity as well as service performance Private sector

Complex (Finance, build, operate and management of the overall water supply schemes within the city) Overall water supply facilities (new and the old ones) Overall network systems Overall customers Improved water quality and quantity as well as the overall service performance Private sector

Risks

Commercial risks

Public sector (pays the private operator using fixed rate basis)

Public sector (pays the private sector using fixed rate basis)

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ParametersEconomic

IRR NPV

10.15% Rp. 3.11 billion or US$ 0.47 million 11.83 years 20 years Not recommended

14.42% Rp. 21.48 billion or US$ 3.07 million 10.41 years 20 years Possibly recommended (as second option)

6.12% Rp. 36.65 billion or US$ 5.24 million 17.97 years 25 years Not recommended

14.27% Rp. 102.76 billion or US$ 14.68 million 12.99 years 25 years Recommended (as first option)

CPBT

Contract period Recommendation

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