Among the strengths of concessions is their ability to bring private money into the construction of new service systems or the substantial renovation of existing systems. Combining the responsibility for investment and operation gives the concessionaire strong incentives to make efficient investment decisions and to develop innovative technological solutions, since any gains in efficiency will usually increase profits. In some countries, concessions have been successful in improving water services and reducing water charges. Concession operations are also less prone to political interference than government-operated utility services, because the service stays under the same operator regardless of changes in governments.
Among their weaknesses is the fact that large-scale concessions can be politically controversial and difficult/expensive to organise. In particular, concessions often suffer from a failure to undertake sufficient dialogue and joint planning with affected parties (users, employees) prior to entering into long-term contractual commitments. Although concession contracts specify performance targets, price adjustment mechanisms and service standards, government oversight of the concessionaire's performance against those standards is critical. This often requires governments to significantly expand their regulatory capacity.
In addition, it is difficult to set fixed bidding and contractual frameworks for concessions that are to last for 25 years or more. No one can predict in advance - with the level of certainty applied in traditional public sector bid specifications - the most efficient and effective ways to provide the desired service over that period of time.13 A number of methods for combining predictability and flexibility are being explored, such as having the bidders offer a total amount of investment that they are willing to make based upon a specified service fee - without specifying how the total investment will be allocated; or including contract terms that set the framework for agreeing revisions to capital investment programs and tariffs at specified intervals throughout the contract period.
Some also argue that the benefits of open competition are limited in the concession market since only a small number of large, international companies are usually able to meet the pre-qualification criteria for bidding to run a concession. In addition, concessions essentially create a monopoly, which then protects the concessionaire from most forms of competition during contract renegotiation. Comparing the performance of the concessionaire to service providers in other locations by collecting and publicising information on levels of service (see discussion in Chapter 7) is one way to address such issues.
Box 8.10 BOT Water-treatment Project The 15-year, US$933 million build-operate-transfer (BOT) water project in Izmit, Turkey, was the country's first BOT water treatment project and one of the first BOT water projects in the world. The large size and long (36-month) construction period required multi-sourcing of finance to spread the risk. Export credit agencies (ECAs) participated in the transaction to help cover political and commercial risks. The municipal government was an equity holder in the project company. Originally conceived in 1968 as a publicly financed, design-build 'turnkey' contract, the project faced many hurdles, including an absence of available public finance. The biggest obstacle to private investment in the project was the absence of a law that gave private operators the right to develop such BOT projects. This problem was finally remedied in 1995 when the Turkish Treasury developed a model financial structure to encourage private investment in infrastructure projects. The original design-build contract was awarded to a British company that was subsequently acquired by Thames Water in 1989. Chase Bank was appointed the government's financial advisor in 1990. Thames Water's ownership of the project was formalised in August 1995, when it signed an implementation agreement with the Turkish government for a 15-year operating contract covering Izmit's domestic and industrial water supply. The primary components of the project were: • completion of the Yuvacik dam (started in 1987); • construction of a water-treatment plant with a capacity of 480,000m3/day, two pumping stations and a 142km water pipeline to provide potable water to the city's domestic customers and untreated raw water to the city's industrial zone in the east; • laying of a water distribution system in Izmit; and • construction of more than 100km of trunk lines between Izmit and Istanbul that would supply 37 million gallons/day to Iski, the Istanbul water authority. An implementation and water sales agreement governed the relationship between the project company and the municipality of Izmit by establishing the selling price and the payment conditions. Under the agreement, the contractor delivered water to the municipality on the basis of a take-or-pay agreement that obligated the city of Izmit to pay for a minimum of 300,000m3/day (whether any water was taken or not) and a maximum of 480,000m3/day. The agreement thereby set an annual price that guaranteed the coverage of costs such as debt service, operation and maintenance, taxes and a minimum return to investors. Repayments to the project company were in US dollars, thus mitigating the currency risk, while Turkey itself was the ultimate guarantor of the city's payment obligations. To mitigate the construction risk, the project company was required to ensure that the construction contract was turnkey, lump sum, fixed price and without escalation, and that the liability of the construction contractor was joint and several. Thames Water had unlimited obligations to guarantee timely construction and thus faced significant penalties for not meeting the construction schedule. Undertakings by the municipality included securing rights of way, providing works and services, and arranging the subordinated loans to fund force majeure incidents, municipal default and increases in the project's costs as a result of changes in the scope of work or legal requirements. In order to secure the consortium's commitment to the project, shareholders could not sell their shares without the approval of the municipality. Default or termination of the agreement could be activated by municipality payment default, force majeure or company default. In each instance, the municipality was required to buy out the shareholders' interest and assume all obligations to senior lenders. The buyout price allowed for the recovery of accumulated equity return (from the escrow, or bond, account in which the municipality deposited monthly revenues), legal reserves for dividends, and the nominal value of paid-in-equity minus any shareholder liabilities (such as unsatisfied claims, direct damages and deficits in working capital). The structure of the agreement thus allocates construction and operations risks to the parties that are in the best position to mitigate those risks. The municipality's equity participation not only provided a clear signal of the city's commitment, but also provided it with the opportunity to share in the project's financial returns.
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