How performance-based contracts could help South African municipalities improve water supply

Out-Law Analysis | 13 Jan 2021 | 10:23 am | 8 min. read

South Africa is a water-scarce country, and many municipalities in South Africa face the risk of the taps running dry if significant interventions are not made in water resources and the water supply sector.

The involvement of the private sector will be needed to realise these interventions, as government currently lacks both the budget and institutional capability to address widespread infrastructure maintenance and investment backlogs.

However, innovative contracting mechanisms are needed which can draw the private sector into contracting with the municipality in a mutually beneficial fashion. Performance-based contracts present a strong potential avenue for this, provided that municipalities can be equipped with the tools to enter into such contracts and heed a number of key considerations.

Barclay Claire July_2019

Claire Barclay

Partner

Given the successful use of performance-based contracts in the context of energy efficiency contracts, there may well be scope to use of these contracts to curb the losses to municipalities of non-revenue water

The need for private investment to address non-revenue water

The Department of Water and Sanitation released the National Water and Sanitation Master Plan in November 2019. The plan sets out a pathway for investment in the water sector, and one of the critical interventions identified is to address non-revenue water (NRW) lost by municipalities and other water services providers.

NRW consists of commercial losses, which is water provided to an end user without cost recovery (due to incorrect metering, non-billing, and so on); and physical losses, such as leaks and losses during treatment. Addressing NRW is critically important given that NRW accounts for 41% of municipal water across South Africa including around 34% in the metropolitan municipalities, far in excess of the global benchmark of 10 to 20%.

The master plan calls for a reduction in NRW in municipalities of 15% below the “business as usual” case by 2030. Although this would still not reduce NRW to international standards, it would represent significant savings for municipalities, which the plan estimates at around R2 billion per annum. These losses are largely due to ageing infrastructure and lack of investment, and the master plan identifies a significant infrastructure refurbishment and renewal backlog in the water sector of around R391 billion.

It is clear that this backlog cannot be addressed from government funding alone, and while the master plan acknowledges that the water sector and institutional arrangements are not optimised for private sector participation, it calls for assessing “opportunities for public private partnerships (PPP) throughout the water and sanitation business value chain".

Performance-based contracts for NRW savings in South Africa

Performance-based contracts have been used in a number of jurisdictions around the world as a means of enabling private sector participation in addressing NRW, and as with PPPs, have the advantage of relieving the capital expenditure burden on municipalities.

In South Africa, a project spearheaded by the private sector with strong interests in ensuring security of water supply has recently commenced development. The project is seeking to reduce NRW in Polokwane municipality from 65% to around 35%. Although financing is still to be determined, and a PPP is being considered alongside other mechanisms, using a performance-based contract could have several advantages.

While a shared savings model is most advantageous to a municipality, the private sector is unlikely to agree to the risk in this model without some kind of payment underpin from the municipality

Under the typical performance-based contract structure, the municipality would procure a private sector party to undertake interventions in respect of NRW. This could entail interventions to curtail commercial losses such as the provision of new, accurate water meters and a more efficient back-office system in the form of an improved billings and recovery system; or to reduce physical losses through addressing faults in the water distribution network such as replacement of meters, identifying and fixing leaks, and upgrading pumps and other devices in the network to ensure correct pressure.

To compensate for the private sector's performance, the municipality would retain any savings resulting from the reduction of NRW, although other variations of a payment mechanism are possible such as agreeing to a gain share with the municipality where the private party is paid by the municipality for the interventions as a proportion of and upon achieving savings for the municipality.

This is as opposed to the standard fee-for-service model usually applied by government, whereby a municipality would pay a fixed cost for a pre-defined intervention on a time and expenses basis. Combining elements of shared savings and fee-for-service payment models is a payment structure comprising a fixed fee and bonuses or penalties related to achieving savings targets.

While a shared savings model is most advantageous to a municipality, the private sector is unlikely to agree to the risk in this model without some kind of payment underpin from the municipality. This approach would also discourage most small, medium and micro enterprise (SMME) contractors whose balance sheets simply cannot cushion the risk of late payments by municipalities.

Performance-based contracts modelled along the lines of a shared savings arrangement are not unknown to South African municipalities. In the context of introducing energy efficiency measures into public buildings, a number of municipalities, particularly in the Western Cape Province, have concluded shared savings contracts with energy services companies (ESCOs) to provide interventions that help reduce the municipality's energy costs, the saving being shared or passed on to the ESCO to cover the capital cost of the intervention.

Given the successful use of performance-based contracts in the context of energy efficiency contracts, there may well be scope to use of these contracts to curb the losses to municipalities of NRW.

Considerations for municipalities

Key factors for a municipality to consider when determining whether to reduce NRW through performance-based contracts include:

  • for any intervention to be meaningful, municipalities must have current data or up-to-date audits on deficiencies in their water distribution network or back-office function, including under-recovery from lack of enforcement
  • allowing the private sector to determine its own interventions is preferable to a prescriptive or fixed scope of defined services. This constitutes a departure from the traditional way in which municipalities have procured goods and services, which may prove difficult to implement as the South African procurement framework is generally built around the concept of a clearly defined demand or need, a fixed scope of work, and more straightforward contract management
  • the contract should dictate the degree of flexibility that the private sector has to carry out the contract. Interventions that do not present commercial returns for the private sector would be best left for the public sector
  • accurate measuring and monitoring of savings performance must be possible, and stated clearly in the performance-based contract. An accurate baseline and a methodology for evaluating and allocating savings must be set out
  • sustainable interventions must be core to the NRW solution offered. With municipal budgets being stretched, a solution that realises savings in the short term but is not robust, or which requires significant future maintenance would not be beneficial. Similarly, the impact of the contract on communities should be considered
  • if municipalities are to encourage SMMEs to participate in performance-based contracts, then financial support mechanisms may need to be established to cater for delays in the municipal payment system. As has been seen in the context of energy savings contracts, when municipalities delay in payment or passing the shared saving to the service provider, this has dire consequences for the service provider who has often secured a loan to purchase the equipment required to perform a particular intervention. Defaulting on debt service repayments can in some instances lead to a service provider becoming insolvent. There is a space for a guarantee facility to be established to provide lenders with a guarantee in the event of a default by the NRW service provider on its debt service repayments
  • a critical consideration for a municipality is how to structure the procurement of performance-based contracts. It needs to be considered whether a performance-based contract is a municipal service, or a municipal PPP. The above description of a performance-based contract is based on the assumption that such a contract would not be a PPP, and also that from a regulatory standpoint, it would not be considered a municipal service

Provision of municipal water services

The provision of municipal water services is dealt with under the Municipal Systems Act (MSA) and Water Services Act (WSA). Under section 76 of the MSA, a municipality must conduct a review of whether to provide a municipal service through an internal division or department in the municipality, or through an external or corporately distinct entity such as a private party or a municipal entity.

When undertaking such a review, section 78 of the MSA requires first exploring internal mechanisms. When exploring an external mechanism, including performance-based contracts, a feasibility study process including public consultation has to be carried out.

The WSA further creates the concept of a Water Services Authority for the provision of water services, some of which amount to a "municipal service", with most municipalities being a Water Services Authority in relation to their local area.

The MSA review process presupposes that what is being contracted is a municipal service. Within water services, the provision of potable water systems and domestic sewage treatment and disposal are considered municipal services.

Functions performed by a municipality which do not amount to a municipal service are what the Municipal Service Delivery and PPP Guidelines term a "municipal support activity", which are not regulated under sections 76-78 of the MSA. Accordingly, when contracting for a support activity, municipalities do not have to undergo the feasibility process unless the support activity is being procured as a PPP, in which case the feasibility requirements of the Municipal Finance Management Act (MFMA) must be followed.

The style of performance-based contract described above does not amount to the private party carrying out a municipal service – the private party does not take over potable water supply or domestic sanitation services. The private party would also not be considered a "water services provider" for the purposes of the WSA.

Rather, the private party is providing either a physical intervention – essentially a works contract or contract for goods with an "alternative" compensation mechanism based on the savings yielded by the intervention – or commercial services such as billing and collections management, which are considered a municipal support activity. Therefore, under either form of intervention, section 78 of the MSA would not apply and instead this would be procured using traditional supply chain management procurement of contracts for works, goods or services.

Municipal PPPs are regulated under section 120 of the MFMA, as well as the Municipal PPP Regulations. A municipal PPP is defined as one where the private party takes over performance of a municipal function or acquires management or use of municipal property for its own commercial purpose, and also requires substantial financial, technical and operational risk transfer to the private party.

Although a performance-based contract may generally involve the taking over of a municipal function, including municipal support activities, such contracts would usually not satisfy the second part of the enquiry and so would not be considered a PPP. That is, there would not be substantial financial, technical and operational risk transfer.

In particular, shared savings contracts do not transfer substantial financial risk, and with physical interventions there would not be operational risk transfer. Similarly, taking over commercial functions will usually not constitute a substantial transfer of technical or financial risk.

Co-written by Reuben Cronjé of Pinsent Masons.