Sofia Water: Structuring Successful Water Projects

United Kingdom

The Municipality of Sofia signed a groundbreaking deal with International Water Limited on the 23rd December 1999 for the provision under concession of water and wastewater services to 1.2 million customers in Sofia.

The project is the first water privatisation, one of the first utility privatisations and the first major municipal infrastructure concession in Bulgaria. It is also one of the first water concessions to be successfully tendered in Central & Eastern Europe on a project finance basis. The project will deliver in excess of 150 million US dollars in investment over the next 15 years and bring access to clean water and improved sewerage services meeting EU standards to consumers in Sofia at a competitive price without municipal subsidy or state guarantees.

Water projects have proven notoriously difficult to undertake with politics, revenue risk and a host of other issues frustrating most projects. Indeed, an earlier attempt to privatise the Sofia water system in 1996 failed. So how was the deal achieved in this case and what were the key ingredients of this success?

Political Will

In common with most water and sewerage projects in Central & Eastern Europe, asset ownership and regulation of water projects in Bulgaria has been devolved to the municipal level. Tendering of the concession was therefore a municipal project with the public water infrastructure assets and the rights and obligations to provide the service vested in the Municipality.

Given this background, the will of the Municipality to undertake the project and the sustainability of that intent throughout the process was a fundamental ingredient of success. In addition, while the Municipal Council approved the scope of the privatisation project at the outset and later approved the winning bidder, it delegated responsibility for the day to day management of the project and decision-making to a specially created "Tender Commission".

The Tender Commission comprised eleven members selected by the Municipal Council to represent a variety of different political interests and stakeholders within the Municipal Council. As a dedicated body with appropriate decision making power, the Tender Commission played a key role in ensuring the smooth progress of the project. Its presence removed the need to revert all decisions back to the Municipal Council for approval and greatly reduced the risk of the project "stalling" at key stages in the process.

The Commission was strongly led by the Deputy Mayor, Mr Ivan Getchev, together with the Head of the Privatisation Commission, Mr Assen Djulgerov, who together built the required consensus in the Tender Commission on the key issues. All members of the Tender Commission demonstrated considerable commitment to the project, working closely with the international advisory team to understand and resolve all aspects of this innovative transaction.

The involvement of only one municipality in the project undoubtedly facilitated its success. All too often multiple municipalities are involved in single transactions resulting in a variety of potentially intractable problems associated with conflicting priorities, divergent political agendas, disputes over asset ownership and poor co-ordination between the parties. The Sofia water concession, with only one municipality involved, was well-placed to avoid these difficulties.

Financial Viability

Substantial investment will be required to rehabilitate, upgrade and expand the Sofia water and wastewater systems over the concession term with a minimum150 million US dollars in capital investment required over the next 15 years. A key issue for the Municipality was therefore whether the tariffs needed to fund the infrastructure investment would rove affordable to consumers.

Preliminary studies were carried out with the support of the European Bank for Reconstruction and Development ("EBRD") to confirm the bankability and financial sustainability of the proposed concession under a variety of scenarios taking specific account of affordability criteria. The transaction was then structured by the advisory team to ensure that it would be sufficiently robust in financial terms to attract potential international water operators and investors while remaining affordable to the population of Sofia.

The success of this strategy was reflected in the strength of competition generated, with eight of the top international water companies seeking pre-qualification, in the quality of the bids received from the three pre-qualified firms who submitted full bids for the tender and in the relatively limited increase in tariffs required by the winning bidder.

The existing tariff structure is based on separate volumetric charges for water and wastewater treatment and collection. Tariffs vary for different consumer groups. No change in tariff structure will result from award of the Concession.

Multilateral Involvement

The EBRD have supported the Municipality throughout the development and implementation of the project. The EBRD initially supported the Municipality in developing the initial concession concept and then worked with them to appoint the advisory team and to create a transparent and effective procurement process

This tender was awarded in May 1998 to a consortium comprising PricewaterhouseCoopers (project managers and financial advisors), CMS Cameron McKenna (international legal counsel), Hyder Consulting (technical advisors) and Legacom (local legal advisors). Under a separate contract the Municipality, with EBRD support, appointed a local law firm, Eurolex Bulgaria Ltd, to act as its in-house project manager and local legal adviser.

Throughout the tender process the EBRD played an important role as guarantor of the transparency of the tender process, provided comment on the bankability of the project documentation and provided helpful advice to the Municipality on various aspects of the project including, for example, drafting EBRD model guidelines for dispute resolution for water concession projects.

In addition the EBRD provided a commitment in principle to all the bidders to act as senior lenders for the project on a limited recourse basis greatly enhancing the robustness and appetite of the bidders for the project. Their extensive involvement in the development of the project provided further comfort to bidders.

The Tender Process

The tender process followed a three-stage process:
Phase 1: Pre-qualification
Phase 2: Preparation of Bids
Phase 3: Clarifications with Preferred Bidder

Phase 2 of the process was based on a "pliego" approach to ensure maximum transparency and to preserve the Municipality's negotiating power. Rarely used in Europe the pliego approach was central to the success of this transaction.

The essence of the pliego approach is that pre-qualified bidders are invited to provide comments on detailed drafts of the Municipality’s contract documents. In the course of the Sofia tender, two rounds of comments took place and, to the extent that the comments involved a more efficient sharing of project risk and were approved by the Tender Commission, revisions were accommodated into subsequent iterations of the project documents.

Bidders were asked at the time of bid submission to confirm their full acceptance of the final contract on which their bid was based. Only minor non-material clarifications of the project documents were then permitted during the 30 days allowed under Municipal Ordinance for final discussions with the Preferred Bidder pre-Commercial Close. This approach ensured that all bidders were bidding on the same documentation with identical risk allocation, maximising transparency.

In addition the "arms-length" approach backed-up by the restrictions on material changes to the contract after bids had been submitted, provided the Municipality with substantial protection against the inevitable shift in the balance of negotiating power post-selection of Preferred Bidder.

The tender evaluation, which was monitored and approved by the EBRD, consisted of an evaluation of the bidders' Technical Proposals followed by a separate evaluation of their Financial Proposals. Although the results of each part of the evaluation were combined to give a single overall "score", the relative weightings employed ensured that the Tariff or price of water was the key decision variable in the evaluation. (There being no doubt that all bidders for the project were experienced operators and had the capability to satisfactorily undertake the project).

The transaction generated considerable interest from the leading international water companies with eight consortia seeking pre-qualification and four consortia (later reduced to three by merger) invited to prepare detailed bids. All three final consortia, International Water Ltd, Suez Lyonnaise des Eaux and Vivendi/Marubeni/Berliner Wasser Betriebe submitted bids in full compliance with the tender rules - a mark of the success of the process.

Joint Venture Structure

The essence of the project structure involves the granting of a municipal concession by the Municipality to a special purpose project company including a right of use of the municipally owned infrastructure assets (pipes, water treatment plants, etc.). The operating assets (staff accommodation, cars, computers, etc.) will be transferred to the project company as an in-kind contribution in return for a minority shareholding in the project company to be held by the current municipal owned operating company.

The approach, while unusual in concession arrangements, provides the Municipality with additional comfort through its representation at director and shareholder level in the project company. Although the structure can, in theory, affect the smooth running of the project vehicle and lead to conflicts of interest for the Municipality in balancing its interest as shareholder and to the customers, it has been successfully used in other water projects in Central & Eastern Europe.

Majority shareholding and management control will be passed to the private sector enabling them to effectively run the company and make use of their management expertise in operating water and sewerage companies.

Legal Framework

Major changes were needed to Bulgarian legislation to facilitate implementation of the project. In particular, a variety of amendments were needed to the Municipal Property Act (No 44/21.05.1996 as amended) under which the concession agreement was to be granted. Such amendments had to be undertaken at the national level and lobbying was required to ensure passage of the legislation.

One of the main areas to require amendment was the permitted duration of the concession. The law originally permitted concessions of only 15 years with a possible extension after that initial period for a further 10 years. Following amendments to the Municipal Property Act, this initial period was extended to 35 years with a further 15 year extension.

The municipal tender process was also inadequate to permit an international two stage tender process. The law had originally been formulated with a view to holding tenders for municipal construction contracts. As such, it envisaged only a one stage tender process with unacceptably short timeframes for a tender for an international municipal infrastructure project. Various amendments were needed to the municipal resolution to permit a two stage tender involving both pre-qualification followed by a full tender process as well as to permit realistic timeframes between and during stages.

Again, it is noted that the political will of the Municipality to drive through these amendments to the legislation greatly facilitated the Project.

Regulation

Water regulation in Bulgaria is primarily devolved to the municipal level and there was no independent regulatory body to oversee the implementation and enforcement of the concession.

Bearing in mind the limited timeframe, it was decided that regulation of the project company should be through the terms of the concession agreement itself. This involved setting out detailed performance criteria to be met by the concession company including quality, quantity, coverage, leakage, unaccounted for water etc. which resulted in an output driven contract, an approach widely used on other concession projects.

By setting standards to be achieved, rather than focusing on quantity of investment or types of technology to be provided, monitoring and regulatory requirements can be kept to a minimum allowing the project company substantial freedom in how it achieves its objectives.

In relation to price regulation, the winning bidder was chosen on the basis of tariffs defined over the full 25 year life of the concession, subject only to limited provision for tariff adjustment and indexation as set out in the concession agreement.

An Excellent Result

The winning bidder was International Water Limited (Sofijska Voda AD) with a highly competitive bid requiring a tariff increase of some 15 per cent in real terms with no municipal subsidy or state guarantee required. This was an excellent outcome for the Municipality in view of the amount of investment needed (in the region of 150 million US dollars) and the project's risk profile.

Following Commercial Close in December 1999, all parties have been working hard to resolve a number of conditions precedent and Financial Close is expected to be achieved in the near future.

While the success of the Project can only be judged over the life of the concession, the strong relations already developing between the Concessionaire and the Municipality bode well for the future. It is to be hoped that the lessons learnt on this transaction can be transferred to other projects in Bulgaria, including the ongoing Water Companies Restructuring and Modernisation Project, and other potential concession projects elsewhere in Central and Eastern Europe allowing the benefits of this approach to be shared more widely.

This article has been jointly written by Richard Temple, Partner, CMS Cameron McKenna and John Gibbs, Assistant Director, PricewaterhouseCoopers.

Richard Temple led the legal team and John Gibbs was project manager for the advisory team and lead financial adviser to the Municipality of Sofia on the Sofia Water and Wastewater Concession Project.

For further information please contact Richard Temple on richard.temple@cms-cmck.com or on +44 (0)20 7367 3738.