Joint leaps and safe landings
With recent changes in regulations that govern the nature of public-private partnerships, the Internal Revenue Service laid the groundwork for local governments to cultivate long-term relationships with water and wastewater service providers. That opened the door for more efficient outsourcing, while at the same time prompting new questions about partnership risks.
Two years ago, operations, maintenance and management (OM&M) contracts were limited to five years. In 1997, however, the IRS finalized its Private Activity Bond Regulations, which liberalized the rules for private management contracts and extended allowable OM&M terms to 20 years.
With long-term contracts came expanded service options. For example, in water and wastewater contracts, a lengthy partnership may allow local governments to outsource billing, collection and customer service. Similarly, it provides time for the partnership to plan and complete capital improvement projects.
Each of those new services presents new exposures for the partners. And participants on both sides are finding that risk management is essential in structuring a successful union.
Sharing and assigning risk In public-private partnerships, the public sector must manage its risk exposure in order to achieve its objectives in a manner consistent with public interest, safety, environmental factors and the law. In some cases, it can reduce its risk by obtaining insurance or requiring the private partner to provide contract security. In other cases, the risk is shared between the partners or assigned to the partner best able to manage or minimize it.
Often, local governments are anxious to transfer risk to the private partner in OM&M contracts. That makes sense, as long as the partner is equipped to manage the risk; if it is not equipped, it will price the risk into its service fee to protect itself from undue financial liability. In many cases, the price is high, even when the probability of occurrence is low, making it more cost-efficient for the public party to retain the risk. Therefore, local officials should consider two principles when assigning risk in long-term partnerships:
* The risk should be assigned to the party or parties best able to prevent a loss from occurring and to overcome the adverse consequences should a loss occur; and
* The risk should not be assigned without cost-benefit consideration.
Standard risks in OM&M A long-term OM&M contract for water and/or wastewater facilities generally addresses the following major risks. * Quantity and quality of input. The public sector partner is responsible for ensuring that influent to the wastewater facility and the raw water entering the drinking water treatment plant (inputs) meet acceptable qualitative and quantitative parameters. Those parameters are specified in the service contract, and the private partners performance and cost guarantees are based upon the public partners ability to meet them.
Franklin, Ohio, for instance, recently signed a 20-year service contract for design, build, finance and operation of a 5-mgd water treatment plant. We understood that we should take the risk for the quality and quantity of raw water entering our facility, says Mayor James Mears. Because we wanted to put as much risk as possible onto the vendor, we negotiated the variability of raw water quality and quantity that would be acceptable. * Operations. The private partner should take all the risk for operating the facility in compliance with regulations and industry practice, provided the inputs meet the quality and quantity requirements.
* Construction. The private partner should bear construction risks, including completing the project on time and within budget, and meeting required performance levels. However, the public partner assumes the risk of uncontrollables, such as changes in law that affect the project or changes in scope requested by the public entity.
Uncontrollables also include risks that fall outside the control of either partner. For example, losses generated by utility loss, subsurface conditions, unforeseen site conditions, or the presence of unanticipated hazardous waste at the site are assumed by the public partner. Acts of God, however, typically are insured by the private party.
* Performance. For a new capital investment, the private partner would take the performance, cost and timing risk. For an existing system, however, the risk is often shared by both partners. Sometimes, the public partner assumes the risk, and all major repair and replacement expenditures are simply passed to the local government; sometimes the private firm agrees to take all the risk for all major repair and replacement, and adjusts its service fee for taking the risk.
* Regulatory changes. Typically, the public partner assumes regulatory risk, which includes changes in discharge regulations for a wastewater treatment facility; drinking water standards for a water treatment plant; or other changes that could affect performance or cost. In a few cases, the private partner has proposed and accepted certain regulatory risks as part of the win strategy in its proposal. However, compliance with regulatory changes falls ultimately to the public partner.
There are some risks the public sector cannot transfer to the private sector, says Paul Eisenhardt, vice president for Malcolm Pirnie, a utility management consulting firm based in White Plains, N.Y. The public sector retains ultimate responsibility for the permit and regulatory compliance [because] it will be held ultimately responsible by the regulatory agencies.
* Market changes. The price of certain items, such as labor, chemicals, power, insurance and others, will change over time because of inflation and other market conditions. Most of those costs are absorbed in annual pay increases that are limited by an escalation factor (usually an industry index), and the private firm takes the risk.
* Policy changes. Policy changes by the public sector or other major changes can affect the partnership and, in many cases, the public partner might wish to have a termination clause in the initial agreement. The risk of policy changes is assumed by the public partner in the form of a termination-for-convenience payment, which includes reasonable demobilization costs; reasonable transition costs (if the public partner requires such assistance); repayment of outstanding debt to the private partner; and, in most cases, consideration for lost revenue.
The termination-for-convenience clause is becoming an industry standard, according to Eisenhardt. Newer contracts ask the proposers to specify what their termination costs would be if the program were to be terminated by the public partner, and they ask for those costs scheduled over the life of the agreement, he says.
* Default and termination. For the private party to take risk it has negotiated to take, there must be fair and reasonable default and termination language in the agreement. The private partner needs, prior to termination, notice of default (nonperformance), a reasonable time to cure (correct) the default and time extensions if the default is being cured when the initial cure period expires.
When a partnership is terminated because of the private partners default, the public partner must protect itself from expected damages, costs to correct the default and reasonable costs for a replacement service provider, whether it be the local government or another private service provider. In some cases, there is an additional nominal payment to the public partner to cover liquidated damages resulting from the termination.
Tools of the management trade Although every public-private partnership will have standard risks such as those described, there are other items in water and wastewater partnerships that must be assessed for proper risk management (see the table on this page). Furthermore, the risks can be mitigated with a variety of tools: * Insurance and performance bonds. Risk can be reduced by obtaining insurance or contract security, provided by the public partner through performance bonds, a letter of credit or a parent company guarantee. Although insurance is purchased by the private partner, the local government stipulates the type of coverage, amount of coverage, deductibles, the party obligated to pay deductibles, and the circumstances in which a claim may be made. Separate insurance is purchased by the public entity to cover its liabilities as facility/systems owner.
Insurance management must be addressed by the public sector in the service agreement, Eisenhardt says. As the owner, the public sector has to have insurance to cover catastrophic loss and other liabilities.
* Indemnification clauses. Indemnification clauses clearly outlined in the service agreement also can serve as effective risk management tools. Indemnification usually is limited to damages, costs, expenses, etc., that are a direct result of one partys negligence, willful misconduct, action or inaction, or breach of contract. (The agreement clauses should apply to both parties.)
* Properly defined terms and conditions. The responsibilities and obligations of both parties must be clearly outlined under terms and conditions of the service agreement. With that in place, each party understands its responsibilities, making it easier to thoroughly manage the risk.
* Vendor quality control procedures and owner oversight. The private partners quality control programs should ensure sound operation and maintenance practices. They should emphasize training, safety, accuracy and the knowledge of modern-day utilities management technology including computerized preventive maintenance programs, inventory control systems, process control programs, laboratory control programs, client reporting and site security. Additionally, the public partner, asthe owner of the water or wastewater facility, retains responsibilities for oversight and should participate in monitoring the partnership.
Long-term OM&M contracts have expanded the possibilities for local governments to improve efficiencies in their water and wastewater services. Both public and private parties must be at risk (have something to lose) in order to keep the partnership focused, but, by allocating and managing risk equally, the partners can ensure that they benefit equally, too.
Douglas Herbst is senior vice president, total water management division, for Earth Tech, Long Beach, Calif., and he is president of the National Council for Public Private Partnerships, Washington, D.C.
Under a new EPA rule implementing risk management planning and public disclosure provisions of the Clean Air Act, an estimated 66,000 entities nationwide will be required to file risk management plans by June 21. According to EPA, more than 9,000 of the regulated entities are publicly owned treatment works and water treatment systems, and more than 3,000 are publicly owned electric and gas utilities. Facilities storing, handling or distributing large quantities of chemicals such as chlorine, chlorine dioxide, aqueous ammonia, methane and propane will be subject to the new rule.
The Risk Management Planning (RMP) rule is, in many ways, a direct outgrowth of the 1984 Bhopal, India, tragedy, in which 2,500 people were killed and more than 200,000 were injured when methyl isocynate leaked from a Union Carbide pesticides plant. In 1986, the U.S. government enacted the Emergency Planning and Community Right-to-Know Act, which requires communities to develop emergency response plans based on information provided by industry about hazardous chemicals. The Clean Air Act, which encompasses the RMP rule, was passed in 1990.
For regulatory purposes, EPA has classified chemical processes according to the risks they pose, placing them into three programs:
* Program 1 requirements apply to processes for which a worst-case release would not affect the public.
* Program 2 requirements apply to operations that do not involve chemical processing (e.g., retail and non-chemical manufacturing).
* Program 3 requirements apply to high-risk, complex chemical processing operations and to processes subject to OSHAs Process Safety Management Standard. Publicly owned treatment works and water treatment systems that qualify under Programs 2 and 3 will be required to complete a series of risk management planning activities. They will have to analyze the offsite consequences of potential chemical releases; produce a five-year history of certain accidental releases; implement prevention and emergency response programs;
establish a management system for supervision of program implementation; and produce a risk management plan summarizing and documenting activities for all relevant processes. Facilities incorporating only Program 1 processes are exempt from the prevention, emergency response and management system requirements.
To assist local governments in complying with the RMP rule, EPA is developing RMP*Submit, a Windows-based software program for electronic reporting. It will allow facilities to conduct data quality checks and accept limited graphics, and it will include online help, defining data elements and instructions. A waiver will be available to those facilities that cannot comply electronically.
EPA also is developing RMP* Info, which will make RMP data available to the public over the Internet. However, the agency is limiting the online availability of offsite consequence analyses. Furthermore, it has made provisions for protecting confidential data such as financial or commercial information. To qualify for such protection, a facility must take steps to prevent disclosure of the confidential information and show that disclosure would likely cause substantial harm to the companys competitive position.
As the June deadline for filing risk management plans approaches, communities that have not filed must take several steps. First, officials must determine whether any of the communitys processes fall under the RMP rule and, if so, which program applies.
They must then review operations and identify existing risk management activities such as employee training or emergency planning, which can go a long way toward meeting the rules provisions. Finally, they must develop a strategy for implementing additional risk management practices and ensure that it is managed appropriately.
This article was written by Clyde Bays, environmental services manager in the Houston office of Carter & Burgess, a Fort Worth, Texas-based consulting firm.
Cities seeking to rehabilitate brownfields typically have been hindered by potentially enormous cleanup costs; strenuous regulatory demands; third-party interests; and possible liability. Those risks often are enough to deter cities from pursuing redevelopment, but, with the availability of environmental insurance, that could change.
A decade ago, environmental liabilities were insured virtually in the dark. Field data was limited, making it difficult for insurers to assess risk. As a result, many large companies exited the environmental insurance business altogether, rather than expose themselves to such a volatile market.
A few companies began employing environmental experts to study the real risks beneath brownfields cleanups. Additionally, they looked at data culled from Superfund histories and used the information to assist them in evaluating site risks realistically.
Today, environmental insurance is available to cover every party and every aspect of brownfields redevelopment. For example, it may cover risks borne by contractors, developers, subcontractors, financial institutions and future property buyers.
Basic environmental liability coverage insures the policyholder for third-party bodily injury or property claims arising from on-site pollution. A separate policy is purchased for each brownfield project, and terms may range from two to five years (even up to 10 years), with limits up to $100 million.
Cities may wish to purchase additional coverage for: * Pollution and remediation legal liability. The policy covers on-site and off-site losses, expenses for remediation and legal defense. It also covers losses resulting from sudden or gradual contamination at the site, as well as losses resulting from contamination that originated at the brownfield and migrated to an adjacent site.
* Commercial property redevelopment. The policy provides first- and third-party coverage for those involved in the transfer or redevelopment of a contaminated site. It may be written for an individual property or a portfolio.
* Remediation stop loss. The policy protects the holder against losses resulting from cost overruns during scheduled remedial activities.
For example, if the estimated cost of cleanup is $600,000 and actual costs reach $2 million, insurance can be purchased to help offset the overrun.
Because of the availability and scope of todays environmental insurance, Pittsburgh recently was able to sell a brownfield for commercial redevelopment. The 15-acre parcel, once home to a paint manufacturer, was contaminated with solvents, petroleum and other paint products. Additionally, its proximity to the Ohio River made the site particularly sensitive.
The property was valued at $2 million to $3 million because of its prime location, but the city sought to sell it for $250,000 because of the considerable contamination and substantial estimated remediation costs. To make the package more attractive to a developer, city officials asked an environmental insurer to meet with the developer to discuss insuring the property transfer.
Ultimately, the developer purchased a commercial property redevelopment policy that included $4 million in coverage for pollution liability, remediation liability and legal defense expense. The cost per $1 million dollars of insurance was between $15,000 and $20,000, with a discount for multiple millions of dollars of coverage, leading to a total cost of less than $60,000. Additionally, the developer purchased a remediation stop loss policy that provided coverage in the event that cleanup costs exceeded the original estimate of $600,000. The price of $1 million in cost-overrun coverage also was less than $60,000.
Following the sale of the property, the insurer was able to contain liabilities by assessing risk regularly and performing follow-up inspections of the site. It recommended experienced cleanup contractors and guidelines for new construction (a safe distance from the river), and it trained on-site personnel to recognize and report unusual evidence of residual contamination at the property.
Local governments are finding that environmental insurance reduces their risks in either transferring brownfields to a developer or redeveloping the properties themselves. The coverage is playing a key role in returning abandoned, contaminated sites to productive use.
This article was written by Bob Hallenbeck, vice president of government affairs for ECS Companies, a risk management services group based in Exton, Pa.