Regina’s wastewater plant – Is a P3 the right answer?

So, the big vote is tomorrow. Regina residents have been back and forth with regards to the P3 debate, but there still seems to be a lot of undecided voters and confusion regarding the proposed project. Still haven’t decided? Want the lowdown? I’m going to do my best to explain.The first thing that’s required when making a decision is to understand what P3s are all about, and that requires in turn an understanding of the traditional approach for public infrastructure and how the P3 differs from that traditional approach.

There are essentially five aspects of a large public infrastructure project. Each component is crucial to get right in order for a project to be successful.

• Design: The process of designing the project. This includes not only things like blueprints for a building but also planning of service capacity, specifics of how the service will be delivered, intended operation fees, compliance with regulations and so on.
• Build: The actual construction of the public work, including building construction and any terraforming that is required. This phase sometimes requires engineers to respond to changing conditions and ensure that the project does not grow beyond its intended size.
• Finance: The method of financing for the project. Sometimes a project is paid for out of existing treasury, but typically long-term debt is involved.
• Operate: The operation of the service. This not only includes staff to perform necessary duties as part of normal operation but overseers to ensure that the service is meeting the needs of the community and that things like workplace safety are being observed.
• Maintain: For any public infrastructure project, varying amounts of ongoing maintenance are going to be required. This is the process of repairing and upkeeping the service after the project has been completed.

In the traditional design, build, finance, operate, maintain approach or the DBFOM approach, the public sector is responsible for all aspects of the construction and operation of public infrastructure. In some cases, the public sector, especially the federal government, may in fact directly employ engineers and analysts to design, construction workers to build, and various employees to operate and maintain this infrastructure. However, far more frequently, the actual design process is completed by private contractors. These contractors provide expertise not available in-house, who design the project according to a set of criteria laid out by the city such as required service level, budget, etc. The design is then put out to competitive tender and will end up being built by a private company who builds the project according to that design. The project is financed with the cooperation of a bank or lending service, typically private in nature. Private contractors are frequently involved in overseeing or advising the public sector project throughout its lifespan, again providing experience that might not have otherwise been directly employed by the municipality. Sometimes a single company may be involved in multiple steps.

In other words, a private company is typically involved in any large public infrastructure project. So what makes P3s different? In a P3, at least two of these five pieces are handled exclusively by a private partner, who from the beginning is contracted to be involved in the project via a competitive selection process. The details depend on the project and it’s hard to make sweeping generalizations, but in a P3 two or more parts of the DBFOM process are handled directly by the private partner, meaning that the private company makes all the decisions and gets the payoff associated with that step. For example, if the private partner operates the service after it’s built, then they may profit from service fees. In the case of a full DBFOM P3, as is the case with Regina’s Wastewater Treatment Plant, the private partner will be fully responsible for the design, construction, financing, operation, and maintenance of the plant.

It’s important to note that in a P3, the public service is just that – publicly owned. The service itself is not privatized, what is privatized is two or more of the five aforementioned aspects of the project. This is why the City of Regina is quick to point out that p3 is not privatization in the strict sense.

One question we might ask before going any further: How does the Private partner recoup their initial costs? More importantly, how do they earn a profit? After all, as we already stated, the big advantage of the private sector is power of the market: market prices and competition create an incentive to deliver a high-quality product. The private company must hope to make a profit in order to be willing to get involved with a project, especially over such a long term (30 years in the case of Regina). There are three main avenues of private profit. The first is interest paid to the private investors on the amount of their initial monetary investment the project. The second is service fees paid by the public sector (the City) to the company running the service. The third is utility fees or service fees paid directly by the users of the service – you and me. In the case of Regina, all three will be avenues of profit for the private sector – the City will pay performance-based fees to the private partner as well as interest on investment, and the partner will also collect the sewage portion of the water bill you pay every month. The rate paid will be determined jointly by the City and the company. However, the specifics are as of yet unknown and will be ironed during final contract negotiations.

So now that we’ve gone over P3 basics, what makes for a good P3?

• Competitive and transparent tender process
• Public sector knows exactly what it wants out of the P3
• The selected partner has a proven track record and can deliver a greater expertise than is available in-house
• Appropriate risk is transferred to the private sector to achieve value-for-money goal
• Clear risk-cost analysis and transparent, sensible financing options available
• Incentives to deliver on promises point in the right direction
• Proper evaluation model in place

First off, it’s important to leverage one of the private sector’s biggest advantages, which is incentive driven by competition. The tendering process is the most crucial in this regard because essentially a DBFOM P3 means giving the victorious bidder a monopoly. For this reason, the public sector should consider as many bidders as possible and consider many factors beyond simple price point in order to make the process as competitive as possible. Competition induces the private sector to lower costs, raise quality, and provide innovative solutions in their bids. Indeed, the idea of P3s providing a greater chance for innovation seems to be a central theme of the points made by P3 advocates. It’s important to provide a fair, open, and competitive environment to maximize these benefits. It is also very important to have transparency through all steps of the procurement process including the bidding process. Because the project will be publicly-owned and thus publicly scrutinized it’s best to avoid smudged decisions that could imply corruption on the part of the decision makers.

Another thing to consider while on the topic of innovation is consideration of all options that are presented – even if they don’t fall within the original concept that the public decision makers envisioned when deciding to embark on the initial phases of the project. It’s important to keep in mind what we want out of the P3, and not only in terms of things like value-for-money but also in terms of the end goal. Is the project itself necessary or are there alternatives?

Furthermore it’s crucial that the selected partner has a proven track record in the field, specific to the type of project that is to be undertaken. It’s important that the partner selected has proven capable of delivering the same type of project, and on a large scale, not only on budget but also effectively and that said projects were of high quality and performed as expected. This ensures that we leverage one of the private sector’s other big advantages which is a greater level of expertise due to specialization. Private-sector firms are often more specialized, larger, and have more experience in the construction and operation of businesses than government. They do this work in many places and can thus lower costs and increase profits. A successful P3 is one where one of the primary benefits is harnessing the advanced expertise available in the private sector.

Probably the greatest appeal of the P3 is the offloading of risk onto the private sector. Unforeseen problems with major infrastructure projects are relatively commonplace, both in the short-term (during construction) and also in the long-term. Cost overruns, design issues, work strikes, schedule delays and problems caused by poor planning are all types of risk associated with such projects. In the case of projects undertaken directly by the public sector, these risks are borne by the public alone (the taxpayer). In a P3, the private partner is on the hook for their portions of the project. The way for the public sector to attain value for money is by transferring the optimal amount of risk to the private partner. One should not consider risk transfer in and of itself is to be a good reason to do a P3. The goal of a P3 should be to transfer risk to the party best able to manage it at the minimal cost. The risks transferred to the private sector should be those most ideally managed by the expertise of the private sector. The public sector is better at managing risks associated with permits, legal frameworks, and changes in jurisdiction and regulation. The private sector is better at managing risks associated with design, cost-efficient investment, operation, technological innovation. Some risks must be borne by both sectors, like user demand, disasters, etc. Probably the greatest amount of initial risk is during financing and construction. If the private partner does not generate good results in those areas, it reaps most of the consequences, rather than taxpayers. This has been the mayor’s response each and every time he has been asked a question about cost overruns.

All of this put together is factor into value-for-money calculations that often lead to P3s generating better value-for-money estimations than the traditional public DFBOM approach. One thing to consider however is how accurate these risk calculations are and on what metrics they are based. Opponents to P3s will point out that these risk calculations are often dubious and hidden from the public eye. Yet very often the entire justification for a P3 rests on these potentially sketchy risk-cost analyses. Private P3 financing almost always has a higher interest rate and is usually paid back over a longer term than direct municipal borrowing. The private sector thus has a strong incentive to bring projects in on time and on budget, which is part of the P3 appeal. On the other hand, once the risky construction phase is completed, this risk declines dramatically. Debt is often refinanced at lower rates, which makes borrowing cheaper and increases profits, and owner equity is often “flipped.” The public sector must quantify the long-term project risk over the course of the entire project with this in mind and enter into contracts that clearly shift as much risk as possible onto the private sector.

Risk transfer is all about creating the incentives necessary to ensure that a private sector contractor does what it’s supposed to do. The public wants a reliable and cost-effective piece of infrastructure not only during the 30-year contract term but also for hopefully many years afterwards. Thus, the best P3 deals include both year-to-year performance checks and a final check at the end of the 30-year term. If the thirty-year-old plant doesn’t meet the standards, the private sector doesn’t get all (or maybe any) of the money that they could have if they had taken better care of it. If the outcomes of these inspections has a drastic effect on the finances of the investors then we can expect that they will be strongly incentivized to deliver the service levels required by the City.

So does Regina have the pieces in place in order to make the wastewater treatment plant a successful endeavor? Here are some reasons to think twice:

• A lack of transparency provided by the City of Regina in describing its tendering process. Indeed, a common theme that seems to keep coming up is the total lack of information provided to the public that might make a pro-P3-in-general person think twice about the specifics of the proposed plant project
• Regina will definitely need a Wastewater treatment plant at some point in it’s future. But the need may be different than the City of Regina thinks, if only it were to consider various other options for dealing with its wastewater. Wastewater does not only refer to raw sewage but all burden on the wastewater system such as wasted water and stormwater that leaks into the system (a major problem in Regina). We and other environmental groups have suggested certain courses of action to the city such as utilizing individual parcel assessments (IPAs) to estimate the stormwater load and levy appropriate fees to landowners. Even keeping this system revenue neutral will create a significant economic incentive for the conscientious use of urban land. There are also other alternatives for dealing with large amounts of wastewater other than a full-blown plant that can reduce service needs. Perhaps the project does not have to be as ambitious and/or is not as urgent as the City claims.
• Clearly, the City Council is eager to go the P3 for a very understandable financial reason: the Harper government will provide up to $58.5 million in funding to the project – on a condition that it be a P3. That’s right: no P3, no money. This is a purely ideological policy on the part of the Harper government, which should base funding on the feasibility and importance of projects, not simply on whether the project is a P3 or not. That said, Regina residents should not dismiss the idea of a P3 on ideological ground either. Rather we should make our decision based on sound logic, taking all factors into consideration, and not feel pushed into a decision based on this federal money alone.
• It’s unknown what companies are going to be considered by the City. We want companies that are going to be up to the job, while preferably also being Canadian to avoid a monopoly over our wastewater being foreign-owned. The Mayor assures us that the selected company will be a good one and we will have nothing to worry about – but a lot can change in 30 years and there have already been numerous examples of P3 partners that failed years into their contract.
• In terms of financing, is appropriate risk being transferred to the private sector to make this a beneficial value-for-money deal? Well, in terms of investment, the partner will only have a one-quarter stake in the financing. The project will be roughly 25% funded by each of the province, the city, the private partner, and the federal government (with the feds paying up to a maximum of $58.5 million). This says that the actual risk transferred to the private sector will be lower than if it was wholly financed by them – especially after the construction period is over. Because their investment is lower, it’s easier for them to walk away.
• The value-for-money analysis has been done by private consultants who have used undisclosed calculations of risk to arrive at this deal being better value for money – but if the project is successful and there are no significant cost overruns (and remember that the private partner is incentivised strongly to deliver on-time and on-budget) then the project is going to end up costing more total dollars. This is because the public sector can generally borrow money at much lower interest rates than the private sector. This advantage is compounded over the 30+ years of the contract, so a seemingly small difference in financing costs can have a drastic effect on the total costs of the project. In other words, if problems do occur after the construction phase, the city still bears most of the risk, and if problems do not occur, the project will be more expensive. The only way this deal will make sense is if there are significant problems during construction – and no one hopes for that to happen. On the City of Regina webpage on the topic of Risks and Opportunities, they explicitly state that they are going to ignore the independent voices of economists and academics. All of their analysis and conclusions will come directly from two companies who have an enormous incentive to convince the public that P3s are the best things since sliced bread. They are trying to invalidate opposing opinions without even stating them, and then just presenting one side of the story.
  

  “When trying to estimate the risks of a significant capital project like the sewage treatment plant the City turned to firms that have experience managing major capital projects — like Deloitte and AECOM. While some economists and academics have their own views on risk, many have no practical experience to bring to their analysis”

• Finally, in terms of incentives for the private company to continues to deliver high-quality service over a full 30 years, consider this: 30 years is generally far beyond the horizon of the private sector, which tends to plan almost exclusively within the next five years. Why? Because a lot can change in thirty years. This uncertainty tends to drive up the expectations that private investors have regarding the performance of their investments year-to-year. Private investors like to see return on investment (ROI) of 8%-10% per year, ideally. The Mayor continues to make the point that a steady revenue stream over 30 years is a strong incentive for a private company. But he does this while also admitting that the return on investment for the company will steadily shrink over the length of the contract. In other words, most of the profits will be earned shortly after construction. Once the private company is no longer making as big of a ROI, their risk is essentially gone. If all goes well they will be happy to continue to collect the cheques, but if there are significant problems with the plant 15, 20, or 25 years from now, they can simply walk away and the taxpayer will suffer.

Note that this is not an argument against all forms of P3s. In my opinion, P3s are something that could potentially be done well. But there are just too many factors working against the City in this case, as well as too many unknowns. There may have been other P3 approaches that could have served the city better, but the lack of transparency, the ignoring opposing opinions, the giving in to federal pressure, the fact that the private partner will only be investing a quarter of the project’s cost and the sheer length of the 30-year commitment to this model are just too much reason not to vote “no” tomorrow. I would recommend voting YES to the traditional approach – although I admit that it’s a shame that we couldn’t have explored a broader list of options.