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The term privatization encompasses a broad range of private sector participation in public services. Partnerships between the public and private sectors in the water and wastewater industry range from providing basic services and supplies to the design, construction, finance, operation, and ownership of public utilities. The primary focus of this guidance is local government’s use of the private sector to finance and operate their wastewater facilities. The basic reasons that the public sector historically privatized services were to realize cost savings, utilize expertise, achieve efficiencies in construction and operation, access private capital, and improve the quality of wastewater services.

As the pace of constructing water pollution control facilities escalated in the 1970s, due to federal and state environmental legislation and EPA’s Construction Grant program, so too did the interest of the private sector in wastewater operations. In the 1980s the availability of tax incentives, e.g., investment tax credits, accelerated depreciation and tax exempt debt availability, (tax-exempt debt and tax-deductible interest payments) for private investment in public utilities stimulated interest in the privatization of publicly owned wastewater treatment works (POTW). However, over time tax laws and IRS rulings that affect privatization have been modified. The Tax Reform Act of 1986 removed many of the tax incentives for public-private

partnerships and reduced interest in certain types of privatization. Subsequent tax bills/rulings have re s t o red many of the tax incentives lost in 1986. For example, the forms involving private ownership. In 1997, IRS Revenue Procedure 97-13 on Qualified Tax-Exempt Bonds allows management contracts for up to 20 years instead of the 5 year period previously allowed.

Executive Order 12803 was issued in 1992 to simplify federal requirements related to the sale or lease of federal grant-funded infrastructure facilities. Among its more important features, the Executive Order allows state and local wastewater treatment investments to be recovered from the proceeds of a lease or sale prior to any claim by the federal government for funds provided by EPA construction grants. Repayment of federal grants at their depreciated value only occurs to the extent that the transfer price under a sale, the concession fees in connection with a lease, or concession fees under a lease or the concession fees in connection with a maintenance and management operations agreement, is higher than the total state and local investment in the facility. Also, grants are recouped at their depreciated value. So iIn the event that all EPA construction grants are fully depreciated, there would be no federal grant Rrecoupment. but tThe privatization agreement itself, however, would require EPA approval review to assure that it may be approved as consistent with EPA construction grants' authority requirements.

Other Executive Orders that affect privatization taken into account in the application of this Guidance include E.O. 12875, which directs federal agencies to review their regulatory requirements with respect to wastewater privatization

and E.O. 12893, which encourages agencies to seek public-private partnerships, and for agencies, in conjunction with state and local governments, to remove regulatory and legal barriers to privatization.

This guidance focuses special attention on the sale, or lease and operations, maintenance and management agreements involving concession fees referred to as concession operations agreements in this guidance) types of privatization that require EPA review and approval under Executive Order 12803. The guidance also examines contract operations of local wastewater treatment facilities, which is currently the most common type of privatization, not subject to Executive Order 12803.

The Current Level of Privatization

Historically public wastewater collection and treatment services have primarily been provided by local governments. However, small subdivisions and trailer parks have traditionally used privately owned and operated wastewater services since their inception. Unlike utilities such as electricity or natural gas, which have been viewed by the public as necessities to every household and local business, the demand for water pollution control most often reflected a region-wide need to address the threat of water pollution to public health. As a result, while the private sector often provided the utility services for gas and electric to the public, local governments provided wastewater services to ensure health protection for its citizens from municipal and industrial pollution.

Over time the participation of the private sector in directly providing water-related services has grown within the United States. Public drinking water systems are frequently owned by a private company (over 40 percent of drinking water systems are private, regulated, water utility systems). Privatization of public wastewater treatment has been less common. It is somewhat difficult to obtain exact growth estimates for wastewater privatization because much of the information is proprietary. Recent industry newsletters and reports give a general indication that growth is occurring. One report indicates that in terms of dollars spent, less than 2 percent of the wastewater industry is privatized. Reports do indicate that there are 280 small to mid-size (1 to 10 mgd) facilities and 40 large facilities (over 10 mgd) now using private partners for wastewater operations. Public-private contract operations are reported to have grown annually at a rate of 15-20 percent, and produced revenues of $0.4 billion $1.1 billion out of the $23 billion expended for POTWs. Nearly all of the privatization has been in the form of contract operations. While many communities have explored the outright sale or lease of facilities to private entities as allowed under E.O. 12803, this these options has have not been used in the wastewater are a primarily because of discharge permit and tax-related issues. These issues are fully industry for the reasons discussed in this guidance.

The Appeal of Privatization

In recent years, there has been increased interest in public-private partnerships. Local governments are becoming more focused on the benefits of privatization at the same time that the private sector is anxious to expand markets and revenues. Reasons for

the increase in local government interest in privatization include the desire to increase efficiency of local government operations, reduce costs of providing services, improve environmental protection, and access private capital for infrastructure investment. Assured performance, strict accountability, and in many cases, improved service are also benefits which may be obtained.

Increased efficiency– Private companies may be able to operate facilities more efficiently

while meeting permit limits. The private companies often will employ innovative operation and maintenance methods, and equipment for wastewater treatment, that require significant capital investment. The private sector is also able to draw on substantial experience in the operation of treatment facilities and take advantage of wholesale prices of supplies and materials needed for a facility’s successful operation. The private company can frequently use its management expertise to stabilize user fees for the time period of the privatization agreement.

Cost reduction– Often the opportunity to realize cost savings is the primary reason that local governments are attracted to privatization. In many cases, private ownership/operation makes sense because it lowers costs. Depending on the type of privatization selected, surveys indicate the private treatment systems can operate at costs savings compared to public treatment systems. Capital cost savings can be substantial when the private partner uses advanced technology coupled with streamlined procurement and construction practices. Local governments that are able to identify and implement the cost-saving management techniques that would be undertaken by a private company may be able to reduce costs as much or more than the private sector. This can occur because the public sector has several cost-related advantages over the private sector. First, the public sector does not have to make a profit on operations and capital investments. Second, the public sector has better access to tax-exempt debt financing that results in lower borrowing costs for capital projects. It may also be possible to combine the advantages of private ownership/operation and public ownership.

Environmental benefits– Some government facilities may have problems complying with discharge permit limits because of needed capital improvements, maintenance costs that exceed budgetary allocations, or difficulty in maintaining skilled personnel. Where local governments have had difficulty meeting permit limits, privatization may result in real environmental benefits. Private companies can readily make capital investments under the conditions of the service contract and dedicate highly skilled personnel to ensure efficient operation and compliance with facility discharge permit requirements.

Access to capital– One of the major benefits of privatization is that it provides access to private sector capital. This may be an attractive feature of privatization for communities with limited access to capital markets for a variety of economic or planning reasons. However, as with public financing, the use of private capital will require that user fees are increased sufficiently to recoup the capital investment plus interest. When a privatization arrangements transaction includes capital investments in the form of an up-front transfer of funds (e.g., transfer price in an asset sale or concession fees in connection with lease or a concession operations a lease arrangement), it such investment can be analyzed viewed as a loan

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from the private sector to the public. Up-front fund transfers from the private sector, or "facility-equity" loans, that are part of a privatization arrangement mean transactions ultimately will require the local municipality and/or its local wastewater users must to repay the up-front such funds plus interest to the private firm. An increase in user fees can result when the transfer price or concession fees effectively replaces and exceeds the previously outstanding local debt on the wastewater treatment facilities. In those cases, in effect because of the "equity" that may be said to be is taken out from the facility.

Types of Privatization

Municipalities seeking public-private partnerships have a range of options to consider from the status quo of continued municipal ownership and operation to complete private ownership and operation. Often a local government will evaluate the expected cost of continued public operation with various privatization proposals. Currently the most widely discussed types of wastewater privatization include contract operations, leases, and asset sales and those transactions which are termed "disposition agreements" which include asset sales, leases and concession operations in connection with which a "concession fee" as defined below is paid..

The specific application of each privatization type will vary by location, since local governments do not have the same conditions and requirements. For example, some communities may find privatization attractive because they are having difficulty meeting permit requirements due to lack of skilled personnel or extremely challenging water pollution treatment conditions. Other communities may wish to evaluate privatization when undergoing major facility expansions or rehabilitation in hopes of achieving greater economies by attracting competitive facility design, construction and operation bids from the private sector. Because privatization situations are not identical, this guidance focuses on a presentation of the general structure of widely used types of wastewater privatization and the factors leading to the selection of a privatization type. The determination of whether a privatization agreement is classified as a contract operations agreement, on the one hand, lease, or sale, lease or concession operation sale type of agreement, on the other hand, for the purposes of EPA review and approval of privatization agreements for grant funded wastewater facilities is based on the overall function of the contract as defined in its specific conditions. The nomenclature used by the local government to describe the privatization agreement does not influence the EPA’s classification of the agreement this guidance, not state legal nomenclature or technical legal requirements..

Contract operations– For many years municipalities have used the flexibility of contracting with private entities for providing selected governmental functions activities ranging from janitorial services to vehicle fleet management or equipment maintenance. Municipalities have found that contracting can be a good way to obtain services needed for a limited period of time, acquiring specialized skills not available in the municipal pool of employees, or as a way of introducing competition into the governmental services arena.

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In the area of water pollution control, municipalities have employed many different levels of contract operations. In full contract operations, the private entity manages, operates and maintains the wastewater treatment facility, collection system, and/or distribution system, in its entirety. All aspects of the plant’s operation and maintenance are performed by the private entity. The collection of user fees can also be assigned to the private entity, while even though the authority for establishing user rates is retained by the public entity.

In partial contract operations, the private entity operates only certain areas of the facility. For example, a private entity can be contracted to haul sludge on an as needed basis, or maintain a plant’s centrifugal force extractors for a specific time period. The private entity has its obligations specified and limited through the terms of the contract. Normally the contract will specify a fixed fee for the specific services. Typically the contract fees increase annually with inflation or by another index.

With contract operations types of arrangement, the facilities are operated for a fixed length of time. Until recently, Internal Revenue Service "management contract" rules for wastewater and water facilities financed with tax-exempt municipal bonds allowed a maximum of five years for contract operations without affecting the status of the municipal tax-exempt bonds. Private entities and local governments generally viewed this term as too short and limiting the economic benefits that could result from longer term contract arrangements. For example, with the assurance of a longer-term contract, private entities are able to make a long-term commitment of expert staff or equipment to effectively operate and maintain a facility. Recent rule changes from the IRS (January 1997) have addressed this concern by allowing "management contracts" for wastewater treatment facilities of up to 20 years under specific contract conditions.

Contract operations arrangements between private entities and local governments that received EPA construction grants do not require Agency review and approval prior to signing the contract even if the facility had received an EPA construction grant. The contract operations agreements may, without being deemed concession operations transactions subject to EPA review under this guidance include cash transfers from the private entity to the municipality for the documented transaction costs the municipality incurs to establish the agreement or for an amount of less than one percent of the present worth value of the contract. They may also include capital investments arranged or made by the private entity, provided the resulting assets investments remain the sole property of the local government when construction is complete and the contractor would not have any claim on the facilities as a result of constructing the capital investment. it's involvement in asset finance. Capital investments generally are expenditures for the purpose of improving operational efficiencies, and increasing the capacity or treatment levels of the facility. Any such private capital investment arrangements should be documented fully. The contract operations agreements could They may also provide for local government reimbursement of the contractor’s private entity's unrecovered capital investment in the event of premature contract termination.

A contract operations form of privatization agreement usually requires the private entity to operate and maintain the facilities for a specific time period (See Figure 1). Maintaining the facilities includes the repair, upgrade, or replacement of equipment so

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the facilities will continue to perform their originally intended purposes. Some local governments limit a private entity’s equipment replacement costs under the contract to a specific dollar amount with the local government funding the costs above the specified amount. When the contract does not have an upper limit on equipment replacement costs, the private entity must carefully evaluate facility maintenance records to accurately establish its service fee for the contract.

Contract operations agreements are not considered subject to review by EPA under these Guidelines can provide for if the contractor payments to municipalities of either represent the documented, auditable contract transaction costs or an amount equal to one percent of the present value of the contract. When a cash transfer exceeds these amounts the contract is considered a lease under EPA regulations and E.O. 12803. A lease type of privatization agreement requires Agency review and approval prior to signing the contract. Under EPA’s construction grant regulations, a concession type Receipt by a municipality of a non-operating revenue payment, greater than this amount is deemed to subject the concession operations agreement to Agency approval results in the private company encumbering the title to the facility as a part of EPA's overall construction grants review to prior to agreement execution, whether the payment is up-front or periodic in nature.

A privatization agreement that involves up-front or periodic payments to the government may be considered a contract operation type arrangement by some parties, however, EPA views these types of agreements as leases that must receive Agency approval.

Under contract operations, a local government will maintain unencumbered ownership of the facility at all times. The local government will retains control over and ultimate responsibility for all capital investment in the wastewater facility, setting rates, collecting user fees, and enforcement of the municipal industrial pre treatment program (MIPP). The local government will maintains primary responsibility for all interactions with the federal and state regulators. The private partner is will be paid a service fee to cover the costs of operation, maintenance, equipment replacement and capital investments and other related services as specified in the contract. Performance is will be maintained through close contract monitoring by the public partner and strict contract clauses that stipulate the actions to be taken in the event of nonperformance by the private entity. The Such performance clauses usually includes financial penalties.

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Leases– Historically, leases have been popular tools for local governments. The most common form is generally called an operating lease. Operating leases have provided governments with a way to obtain long-term use of equipment ranging from office equipment such as copying machines and desk top computers to heavy machinery for public works departments. Under this form of a lease the private leasing company, the lessor, purchases equipment and leases it to the government, the lessee. The lessor receives tax benefits related to depreciation of the equipment while the lessee is not required to treat the lease payment as debt, as would occur if the equipment were purchased.

Not all leases are operating leases. Each lease has different terms and conditions. The terms define the agreement and they vary from lease to lease. Under EPA construction grant regulations and E.O. 12803, all types of leases require EPA review and approval before a local government may enter a lease agreement when EPA grant funds were used to finance the wastewater facility. Leases may result in some type of non-operating revenue up-front, or periodic payments to the local governments. These payments are here termed "concession fees," which the private entity pays for the right to operate a facility. The fees are considered a form of lease payments from the lessor. The Such concession fees generally are generally used by the public owner for debt repayment, capital improvements or general tax relief. Yet another form of lease is the "design, build, and operate lease." In this another scenario, the lessor designs and constructs a facility on behalf of a public owner. These agreements usually provide that ownership of the facility will reside with the public entity, but the operation of the facility will be performed by the private company that builds it. The builder, by prior agreement, becomes the facility’s lease operator.

In addition to operating leases, tax-exempt capital leases have been widely used by state and local governments and have also become common in the industry. Tax-exemptSuch leases are used by local and state governments as a way to purchase equipment or buildings. Several of the key reasons cited for use of tax-exempt leases are: 1) leases are a way to purchase equipment when local debt restrictions or the need for local voter approval make it cumbersome to obtain the required equipment or facilities, 2) leases do not

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have the transaction costs that are experienced when issuing local bonds. Under the tax-exempt lease, the local government makes lease payments that are defined as principal and interest to the lessor. Under federal tax law the interest portion of the payment is viewed treated as tax-exempt so lessors are willing to charge a lower interest rate to lessees. This tax advantage results in lower costs for the local or state governments.

The lease concept applicable Concessions operations approach to privatization of EPA funded wastewater treatment facilities differs from operating and tax-exempt lease structures. This type of wastewater lease structure establishes the contract terms for the local government or authority, which is, the owner of the facility, to enter into an agreement for operations ofa lease agreement of the a wastewater facility with a private partner pursuant to which the The private partner, as the lessee, frequently pays the local government a type of lease payment for the right to operate the facility for a specified period of time. The lease payment may be a one time, up-front payment, or periodic payments over the life of the lease. These payments are referred to as "concession fees." The local government then pays the private partner an annual service fee to operate and maintain the facility. This annual service fee is comparable to the service fee paid under contract operations. However, the this service fee under a lease will incorporate includes an annual payment on the debt incurred by the private partner for concession fees. The lease arrangement allows the local government to retain ownership responsibility over wastewater rate setting, collection of user fees, and the municipal industrial pretreatment program. Unless the concession fees fall below the threshold specified above, this type of arrangement, will be deemed subject to EPA review under these Guidelines.

The Clean Water Act (Title II) established EPA’s construction grants program and specifies that grants should be awarded to "publicly owned" treatment works. The term "publicly owned" has been established to mean 100 percent ownership by a public entity. When a private entity invests in a "publicly owned" federally grant assisted treatment works, via a sale, lease or concession operations agreement transaction the action triggers the compensation requirements of EPA’s construction grants regulations. Unless EPA provides a grant deviation under those requirements. E.O. 12803 provides guidance as to the amount of compensation to which EPA is entitled under these circumstances.

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OMB promulgated Circular A-102 to ensure consistency and uniformity among federal agencies in the administration of grants to state and local governments. One area of standardization is the uniform treatment of property acquired in whole or in part with federal funds, or whose cost was charged to a project supported by a federal grant. The uniform standards include a prescription for the use and disposition of property acquired under a grant. EPA administers these uniform administrative requirements through its general grant regulations at 40 CFR Parts 30 and 31 [citation].

OMB Circular A-102, Attachment M, requires that any federal grantee assure EPA that "it will not dispose of, or encumber its title or other interests in the site and facilities during the period of federal interest or while the government holds bonds, whichever is longer." When local governments applied for EPA grant assistance to fund local wastewater treatment works, they agreed not to dispose or encumber the proposed facilities during the period of federal interest. This means that property acquired under a grant can not be sold or pledged as collateral in the event the grantee needs to refinance the grant funded facility. This condition limits the grantee’s ability to draw on the federal equity invested in the facility to raise additional capital during the period of federal interest. By giving this assurance the recipient agrees to retain the financial

structure in place at the time of the grant award and relinquishes its option to financially restructure. This ensures the federal agency that the financial structure it approved at the time of grant award will not be changed, without a grant deviation.

OMB Circular A-102, Attachment N, requires that the "title to real property shall vest in the recipient subject to the condition that the grantee shall use the real property for the authorized purpose of the original grant as long as needed." This rule effectively limits the grantees use of its federally funded property, or discrete portions of that property, to its originally authorized purpose.

These rules regarding the deposition of federally funded property pose barriers to lease, and sale and other disposition types of privatization agreements for local governments which received EPA construction grant funds. These types of transactions are viewed all treated as dispositions of federally funded property under OMB rules, because they temporarily or permanently transfer the facilities title or use the title or revenue derived from facility operation as a form of collateral for funds received by the municipality.

Executive Order (E.O.) 12803 was issued in 1992 to simplify the disposition of the federal interest in grant funded projects. The E.O. serves as a means for allows the federal government to dispose of its interest in the wastewater facilities funded with federal construction grants and directs EPA to subordinate the federal financial interest in the facility to those of the local and state governments. and allow the federal government to dispose of its interest in the wastewater facilities funded with federal construction grants. Therefore, when EPA approves a lease or sale or other concession operations privatization agreement, the Agency relinquishes its future economic interest in the federally funded portion of the facility. However, the Agency still retains its interest in the NPDES and RCRA permit requirements on the facilities.

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A contract arrangement involving private company cash concession payments must undergo review and approval by EPA to determine compliance with the specific EPA grant requirements and Executive Order 12803 prior to the local government signing a lease agreement. Lease arrangements of this type were approved in May 1997 for Cranston, Rhode Island and November 1997 for Danbury, Connecticut.

The duration of the lease or contract operations arrangement may be affected by the presence of outstanding tax-exempt municipal debt on the wastewater treatment facility. If the local government used tax-exempt municipal bonds to finance any portion of the leased facility, then the term of a service contract may will be restricted by federal IRS tax regulations. just as they limit the term under a contract operation.

If the local government has no outstanding wastewater facility tax-exempt debt, or pays off wastewater facility debt prior to entering into the lease agreement then the term of the lease or contract operations arrangement can be longer since the IRS requirements do not apply. It may be possible in connection with the transaction for a local government to retire outstanding debt out of available financial resources or a lease concession payment that is used to retire debt. The implicit result is essentially of such refinancing of outstanding debt may thus be replacing by swapping tax-exempt debt service with for payments to the private partner which include charging for that reflect the private "investment" in the local government. This approach may be beneficial to the local government if the private partner is able to guarantee lower annual wastewater treatment costs for a longer time period than could be expected under continued governmental operation, or may otherwise be necessitated by exigencies surrounding the local government's condition.

Asset sales– Asset sales have received a great deal of attention as a result of E.O. 12803 - Infrastructure Privatization. Under an asset sale (Figure 3), a local government sells a wastewater facility to a private partner. Revenue Proceeds from the sale of the facility can be used to retire outstanding wastewater facility debt, for infrastructure investment, or for general property tax relief. When the local government retains the responsibility for wastewater user fees and pretreatment standards, the sale transaction between the private partner and the local government would generally includes a multi-year service contract under which the private partner is paid an annual service fee for treatment

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of the wastewater. When the private company has complete control over all aspects of the wastewater treatment facility, it is free to modify the equipment or treatment processes as necessary to reduce costs and/or improve performance.

When the complete wastewater operations are under private ownership, the local public utility control boards usually approve user fees. The private costs for capital investments are likely to be reflected passed on to the public in the form of higher fees depending upon the contractual allocation of any future private efficiencies. A partial asset sale and lease agreement occurred in June of 1995 under E.O. 12803, when the private partner became responsible for the operations of the Franklin Area Wastewater Treatment Plant (Franklin, Ohio) owned by the Miami Conservancy District. A complete sale of all wastewater assets to a private entity was approved in August of 1997 for Fairbanks, Alaska. In Fairbanks, the private entity has total responsibility for wastewater services.

The transfer purchase price paid for a wastewater facility by a private entity represents an investment in the facility by the private partner. The private owner will need to recoup its investment plus interest through the service or user fees it charges to operate the facility. As a result it is inappropriate to view an asset sale as a way to free capital for other investments at no cost to the municipality. It is, in fact, another financing source available to local governments comparable to individual homeowners borrowing against the equity in their home whose cost must be assessed objectively.

A simplified example helps to illustrate this point. If a local government sells a wastewater facility for a price of $1,000,000 and the facility has outstanding debt of $400,000, the government will receive net cash of $600,000 from the sale. However, a private partner will require repayment of its total $1,000,000 investment plus interest. So, over time, as part of the annual operating or user fee payments, the private partner will receive repayment of its the $1,000,000 investment plus interest.

In summary, any payment a local government receives from the sale or lease of a wastewater infrastructure 

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asset is like a loan from the buyer or lessee which must be repaid with interest by the wastewater users in the form of additional user fees. Therefore, the value of any concession fees or sales price which exceeds the current debt on the wastewater infrastructure represents additional debt the a municipality's wastewater users and/or the municipality itself must repay.

If Depending on the facts if a local and state government wants to recoup all of its initial investment in a facility and sets a transfer price or concession fee to reflect that amount, the resulting annual service fees to the buyer or lessee or concession fee payer could be very large and could result in significant increases in user fees for all the wastewater treatment users.

P R I VAT I Z AT I O N