Privatising water services in Central and Eastern Europe

Czech Republic

"Dobra Voda" (the name of a Czech mineral water meaning "good water") accurately describes the thirst for private sector participation in water projects in Central and Eastern Europe over the last few years. Indeed, in certain countries such as Bulgaria and Romania, water privatisation has been undertaken before privatisation in other utility sectors. With investment requirements for water infrastructure in the region of Euro 200 billion over the next fifteen years, Central and Eastern Europe should remain a fertile ground for water privatisation.

The closure of two of the largest water deals in the world last year in Sofia and Bucharest, both structured on a project finance basis, has also provided additional impetus and new and ground breaking templates for further water and other infrastructure transactions in the region.

This article seeks to examine some of the more recent trends in private sector participation in water projects in Central and Eastern Europe.

Regional Variations

Whilst Central and Eastern Europe has been one of the most active areas for water projects over the last few years, private sector participation in water projects has varied from country to country. Certain countries such as the Czech Republic have embraced private sector participation in the provision of water and sewerage services with a number of foreign operators with equity stakes in local water companies. In other countries, such as Poland, limited progress has been made in involving the private sector in the provision of water and sewerage services.

Project Financing

Project finance techniques have been used in a variety of infrastructure projects in Central and Eastern Europe. However it is only recently that project financing in water in Central and Eastern Europe has become a reality.

With the ever increasing financial and budgetary constraints on local municipalities compounded by the highly capital intensive nature of water projects, project financing from the private sector is proving a popular alternative to municipal funding. Indeed, water deals in the region have been structured off balance sheet without any municipal guarantees: an attractive option for both the public and private sector.

Taking security over the project revenue stream and assets which is a key feature of project finance deals has always been an issue in the civil law systems of Central and Eastern Europe. However, developments in the relevant legislation and practice in many countries together with increased familiarity with project structures and the need for security means that security packages acceptable to project finance lenders can be developed.

The Sofia and Bucharest concession projects were both structured on a project finance basis to enable the winning bidder to project finance the deal. It is anticipated that the success of these projects is likely to lead to more water project financing in the region.

Role of the Municipalities

One of the key features of water projects in Central and Eastern Europe is the municipal nature of such projects. Not only are the infrastructure assets usually owned by one or more municipalities, regulation of the service is also devolved to the municipal level as it is considered that the municipalities are in the best position to understand the local needs and circumstances. The Sofia and Bucharest water projects have highlighted that one of the ingredients for success is to deal with one municipality and in particular one decision making body.

Size Matters

A project of significant size is always likely to attract potential bidders and financiers as generally its larger revenue stream is likely to make it more financially viable and worthwhile for sponsors. Whilst it is likely that the large cities in the region will always attract interest from potential sponsors and developers, the issue of involvement of the private sector in small municipal projects, an issue that arises worldwide, remains to be addressed. Development of model contracts, packaging of deals and more basic forms of private sector participation (service or management contracts), may all provide part of the answer. This is an area that should attract more attention once the large cities and towns have involved the private sector and these benefits are apparent.

Concession Financing

There is no one form of private sector participation arrangement that fits all water projects in the region. Whilst concessions, management contracts, operating contracts and service contracts have all been used depending on the individual circumstances of the project, there has been an increasing trend towards concession arrangements. Water assets and facilities in chronically poor condition requiring significant investment and increased political willingness to embrace the private sector in the light of its success elsewhere in the world are all factors in making concession arrangements more attractive to municipalities.

The process can also be viewed as a manifestation of a wider trend world-wide towards concession arrangements. The benefits of a single point of responsibility for the obligations to provide the water and sewerage services in a concession may also be an attractive feature for municipalities. Whilst operating contracts can also be beneficial and operate successfully in many countries in the region, the division of responsibility for operating and capital expenditure between the private and public sector has caused problems on a number of occasions in the past.

Multilateral Involvement

Another key feature of water projects in the region has been the role of the multilaterals in helping to not only identify water projects but also finance them. For example, in the Sofia water project, the European Bank for Reconstruction and Development helped the Municipality of Sofia in identifying and preliminary preparation work for the Project. It then conducted the procurement for international advisers for the Municipality and during the project monitored the procurement arrangements. Finally, it provided the senior loan facilities to the winning bidder. Similarly, on the Bucharest Water Project, the International Finance Corporation were the financial adviser to the Municipality of Bucharest and advised the Municipality throughout the Project.

Open Competitive Tender

There is an increasing acceptance of the need for open international competitive tender for the large water deals and both the Sofia and Bucharest Water Projects were awarded following the "pliego" tender approach.

The essence of the pliego approach is that full project documentation (not just a heads of terms) are developed and circulated to pre-qualified bidders who submit comments on the documentation. This process is repeated twice in order that the public authority fully understands the views of the bidders on the project documentation and can decide whether to alter the risk profile on the documentation to take account of the comments of bidders. Bidders are then required to submit signed contract documentation with their bids.

This approach enhances the negotiating strength of the Municipality (once a preferred bidder has been declared, the balance of negotiating strength shifts to the preferred bidder) and maintains transparency (bidders are essentially bidding on a single variable usually the lowest tariffs as all contract terms are identical for each bidder).

The use of open competitive tendering in both the Sofia and Bucharest projects heightened invested confidence, provided a platform for multilateral support, maintained transparency and again can be used as a model in procurement processes for other projects in the region.

Joint Venture Approach

In view of the highly political nature of water projects, municipalities are quite naturally reluctant to pass responsibility for the relevant water and sewerage assets and powers for provision of the service to the private sector. Their role in regulation either through the contract with the winning bidder or under statutory regulation is often not viewed by municipalities as providing sufficient involvement in such an important service. As a result, in many deals in the region, the public authorities have taken an equity stake in the project company, which provides the municipality with shareholder rights in addition to the contractual rights under the relevant concession or operating contract.

Whilst it can be argued that such shareholding is unnecessary and can lead to conflicting priorities of the public authorities (acting in their interests as shareholders and for customers) and management inertia, such public sector shareholding has proved a pragmatic option and enabled a number of water projects to take place that otherwise may not have received municipal approval.

Regulation

The cost plus nature of much price regulation in Central and Eastern Europe combined with the fragmented nature of service regulation with a large number of public authorities involved has meant that regulation is often undertaken by contract. Both the Sofia and Bucharest project set out in the concession contract detailed performance requirements from the concessionaire together with tariffs and tariff adjustment formulae. Whilst it is often considered that an independent experienced regulator would be the optimal regulatory solution, in the absence of such a regulatory framework, regulation through the contract provides a pragmatic way forward.

The competitive tariffs bid to win the Sofia and Bucharest water concession projects should encourage municipal development of private sector participation in water projects in the region. With these templates for procurement processes, project documentation and a successful outcome, the trend of increasing private sector participation in the water sector in Central and Eastern Europe should continue and there remain many exciting opportunities for private sector participants.

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

Richard Temple led the international legal team advising the Municipality of Sofia on the Sofia water project and the International Finance Corporation on the Bucharest water project.

FIG 1

Sofia Water Project

Services to be Provided - Water and sewerage services

Population Served - 1.2 million

Type of Contract - Concession arrangement

Investment Requirements - Approximately US$ 150 million

Concession Term - 25 years

Financial Close - 5th October 2000

Special Features - First water privatisation in Bulgaria

- The first major municipal infrastructure concession in Bulgaria

- First water concession project financing in Central & Eastern Europe

FIG 2

Bucharest Water Project

Services to be Provided - Water and sewerage services

Population Served - 2.2 million

Type of Contract - Concession arrangement

Investment Requirements - Up to approximately US$ 1 billion

Concession Term - 25 years

Financial Close - 17th November 2000

Special Features - First major municipal infrastructure concession under the new Romanian concession law

- One of the first successfully internationally tendered major water concession contracts worldwide