October 3, 2003
Public Goals, Private Means: Why the Private Sector is Uniquely Capable of Providing Water and Wastewater Services to Ontario’s Municipalities
Presented to “Public Goals, Private Means” Research Colloquium
Faculty of Law, University of Toronto, October 3, 2003
Sponsored by Government of Ontario Panel on the Role of Government
Presented in conjunction with
Revisiting Water and Wastewater Utility Privatization
If I were using Power Point, I’d be tempted to project two numbers onto the screen during my entire talk. The first would be 407. That’s the number of municipally owned water treatment plants that failed Ontario inspections last year. It’s an astonishing figure. More than two years after the Walkerton tragedy, 407 water plants – 61 percent of our plants – were out of compliance with provincial laws and regulations. Some were still not training or certifying their operators. Some weren’t doing enough sampling. Some hadn’t mastered disinfection. And not surprisingly, some were producing unsafe water.
The other figure that I’d project onto the screen is 101. That’s the number of sewage treatment plants that violated provincial laws or guidelines in 2001. We don’t have the data for 2002 yet, but we do know that the trend has been worsening. We had 101 violators in 2001, 92 the previous year, and 82 the year before that.
That’s the context in which we should be discussing privatization. Those are the problems that need to be solved. The question is: Can privatization help solve them? If so, how? And perhaps more interesting, why?
I should mention at the outset that I use the word “privatization” quite broadly. As you know, the term can encompass a whole range of private-sector involvement. Most of what I’ll say will apply primarily to long-term operating contracts and to full privatization – the sale of assets.
My research into privatization in other jurisdictions has convinced me that some form of privatization is, in fact, key to solving Ontario’s water and sewage problems. Yes, some problems could be solved without privatization. And no, privatization alone is no panacea. But privatization combined with public regulation does have unique and inherent advantages over public provision. I want to talk about four of these. First, the private sector can provide desperately needed capital. Second, the private sector brings with it a great deal of expertise. Third, the private sector has incentives to operate systems efficiently. And fourth, the private sector is more accountable than the public sector.
Let’s start with the issue of capital investment. It’s clear that our water and wastewater systems need a lot of investment. Exactly how much is not so clear. We know surprisingly little about the state of our infrastructure – especially the underground pipes. Estimates of capital needs are based on a good deal of guesswork. So they vary quite a bit. But virtually everyone agrees that we’re talking about many billions of dollars. Several years ago, the provincial environment ministry estimated that $16 billion would be needed for water and sewage infrastructure over ten years. The Canadian Water and Wastewater Association came up with a higher estimate: $32 billion over 15 years.
This need for investment has spurred arguments for privatization for more than a decade. These arguments haven’t just come from Conservatives. They were being made when the NDP was in power. Back in 1991, the MISA Advisory Committee recommended public-private partnerships as one way to finance water and sewage improvements. In 1993, the NDP government changed the Municipal Act in order to facilitate private investment. It did so because it was concerned about the gap between public outlays and capital needs.
In this regard, Ontario has been quite typical of other jurisdictions. The need for investment in infrastructure has driven privatizations around the world. Certainly in England and Wales, where the water and sewage systems were sold off in 1989, this was a major factor. The systems had to be brought into compliance with new European standards. The government estimated that £24 billion would have to be invested over ten years to accomplish that. For both political and financial reasons, it wanted the investment to come from the private sector rather than the public sector.
The new private water companies actually surpassed investment expectations. They invested more than £33 billion in the first decade after privatization. By the end of 2005, they will have invested £50 billion – that’s the equivalent of more than Cdn$110 billion. As one official from the Department of the Environment said, “You just couldn’t contemplate that kind of expenditure in the absence of privatization.”
Closer to home, we have an example in Moncton. In the 1990s, Moncton was desperate for a water filtration plant. But it couldn’t afford the upfront investment, and it couldn’t get provincial or federal funding. So it turned to the private sector. It held a competitive bidding process, USF Canada won, and the firm financed, designed, built, and now operates a state-of-the-art plant.
So that’s one reason for municipalities to consider privatizing: The private sector is a potential source of capital that can be invested in our crumbling infrastructure. And it’s a good source of capital. Even if public money were available – and there’s no indication that it is – there are still several reasons to go for the private money.
One has to do with opportunity costs. There are many competing demands for our public funds. And those funds are limited. What we spend on water infrastructure we can’t spend on health care or education. Why spend public money on water when the private sector is willing and able to foot the bill? Why not free up public money for other uses?
Another reason for using private rather than public money is that doing so transfers financial risks to the private sector.
Another reason to go with private capital is that it’s likely to be used more efficiently than public capital. I’m talking about capital efficiencies here, and not about operating efficiencies – I’ll deal with them in a minute. Both lenders and firms play a role in promoting efficiencies. Lenders of private capital understand that their capital may be at risk. So they apply their own due diligence.
And of course in a competitive environment – or in a properly regulated environment – private firms have incentives to keep capital costs down. In Moncton, USF Canada built the new water plant for at least 25 percent less than the city was planning to spend. It shaved between $8 million and $10 million off projected costs. It did so in part by choosing a kind of filtration that allowed it to greatly reduce the size of the building itself.
The final reason to go with private capital is to reduce the conflicts of interest that currently prevent the provincial government from enforcing its laws governing water and sewage. I’ll come back to this issue in a few minutes, when I’m talking about accountability. For now, let me just say that complying with laws can be expensive. When systems are financed publicly, the government understands that if it enforces the law and requires costly improvements, some level of government will have to foot the bill. Recently it’s been the provincial government. Through various grant programs over the years, it has paid up to 92.5 percent of the cost of capital improvements. The threat of financial responsibility is bound to have made it think twice before enforcing the law. Indeed, a former official from the environment ministry told the Walkerton Inquiry that before making demands, the government has always taken costs into consideration.
Those, then, are the four primary reasons to go with private capital: To meet investment needs. To offload risk. To increase capital efficiency. And to reduce regulatory conflicts.
What about the operations side of things? Why go with a private operator?
One argument for privatizing operations is that doing so will inject expertise into our systems. Of course, privatizing doesn’t guarantee that this will happen. When Hamilton contracted out operations of its water and sewage treatment in 1995, it chose a firm with virtually no expertise. Indeed, one of its reasons for privatizing was to aid a fledgling local company – to give it experience so that it could build a business. That wasn’t such a great idea.
In any case, when expertise is wanted, there are several firms out there that are in a unique position to provide it. The large international firms have far greater expertise than any Ontario municipality. Some of them have more than a century of experience. Some have more than a hundred million customers around the globe. These firms have thousands of employees whose expertise can be harnessed to solve local problems. They invest small fortunes in research and development. In 1999, the world’s two largest water companies invested almost US$200 million between them in R&D in the water sector.
It was this kind of experience and expertise that persuaded Indianapolis to privatize the operation of its sewage system. The director of that city’s public works department said, “It’s just a different league. These guys have resources our guys could only dream of.”
Expertise can certainly be important. But water treatment isn’t exactly rocket science. In many cases, operators don’t need a century of experience behind them. What they do need is incentives to do their job well.
Incentives to perform well inhere in a competitive, regulated environment. The competition to obtain contracts rewards companies with good reputations – companies that have performed well in other communities. The desire to renew contracts keeps companies focussed on good performance. Municipalities can enhance these incentives by structuring contracts to reward good performance and to penalize bad performance. The Milwaukee sewage contract includes bonuses if the operator keeps average concentrations of BOD or suspended solids below a certain limit and penalties if it exceeds specified limits. This has given the operator a real incentive to perform well. In each of the four years since the contract was let, the firm has earned $50,000 bonuses.
Competition for contracts also creates incentives to operate efficiently and thus to reduce the costs of providing service. As long as the quality of service is regulated, efficiencies don’t come at the expense of good performance. Instead, they’re achieved through innovation and through the elimination of waste. Private firms are dis-inclined to pay unnecessary workers – they tend to reduce staffing levels. They may insist that their workers cross-train or multi-task. They may link compensation with performance. The larger companies benefit from economies of scale. And they have the resources to innovate. All of these factors translate into lower costs.
Of course, privatization itself doesn’t guarantee the cost savings. The savings come from competition, incentives, or, in some cases, regulation. If those are missing, the savings may be missing. Hamilton, you’ll remember, gave its water and wastewater contract to a local firm. It was a sole-sourced agreement – no competition. And that showed. The original contractor promised savings of just three percent.
But when the process has been approached right, the cost savings have been enormous. In Houston, contracting out water plant operations brought savings of 43 percent. In Seattle, the contract to design, build, and operate a water filtration plant was priced at 40 percent below the city’s benchmark. In Indianapolis, privatizing sewage treatment reduced costs by 42 percent. Milwaukee expects to save about 30 percent.
Cost savings of that magnitude would make a tremendous difference to water systems here in Ontario. One firm has estimated that it could save Toronto between $95 million and $110 million every year if it managed our water and wastewater systems. Money that’s currently being used for operations would be freed up for capital expenditures. That’s a persuasive argument for privatization.
I’ve argued to this point that the private sector can provide needed capital, and that it has the tools and the incentives to operate our systems effectively and efficiently. I want to turn now to the other major advantage of privatization: accountability. A private owner or operator is inherently more accountable than a public owner or operator. It’s more accountable to provincial regulators, to the public, to municipal governments, and to the market.
I want to spend some time on this, in part because I think it’s the most compelling reason to privatize, and in part because it seems to be the hardest for many people to grasp. Canadians have, in great numbers, embraced what I call the myth of public-sector accountability. In July, the University of Toronto’s Munk Centre published a handbook that perfectly expressed this myth. It was entitled Good Governance in Restructuring Water Supply, and it was a joint effort with the Federation of Canadian Municipalities. According to this handbook, when a water utility is owned and operated by a municipal government, “clear and direct accountability exists through municipal council.” The handbook lists a number of sanctions against public utilities that fail to maintain services: state authority backed by coercion; the political process via elections; and litigation. In contrast, the handbook suggests that under delegated management, “accountability to consumers is reduced, particularly in the case of long-term contracts.”
Well, public-sector accountability may sound good in theory, but it sure doesn’t work in practice. Municipal politicians, managers, and operators are rarely held accountable for the performance of their water systems. They aren’t held accountable by regulators, by voters, or by the courts. Let’s take regulators first.
Remember those two figures that should be projected onto the screen? The 407 non-compliant water plants? The 101 non-compliant sewage plants? No regulator is holding them accountable. The sad truth is that our regulators have always tolerated municipal non-compliance. Don’t believe for a minute that the absence of enforcement is anything new. Or that it reflects conservative ideology, or budget cuts, or staff cuts at the environment ministry.
Municipal water plants have been out of compliance with provincial standards ever since we started monitoring them. Between 1992 and 1994, the government inspected 86 percent of the water plants in the province. At that time, inspectors found inadequate sampling at more than half of the plants they looked at.
Other studies in the late 1980s and early 1990s found a host of other problems. One found that at least half of the plants it looked at had problems with flow measurement, chemical selection and application, and turbidity monitoring. Another report identified operator expertise as a major problem at many water plants. It noted that many operators “do not understand the fundamentals of water treatment.”
Despite these well-documented risks to public health, the province has almost never enforced the law. It has almost never prosecuted municipalities, water-managers, or operators.
No one seems to know how many prosecutions there have been over the years. Apparently the government doesn’t keep track of its prosecutions by sector. We asked several witnesses at the Walkerton Inquiry about this subject. One ministry investigator could remember only two prosecutions. Another former investigator could remember one more. The acting program manager at the investigations and enforcement branch thought that there may have been 20 in the last decade – or maybe, he said, even less than ten. In short, we may be talking about one or two prosecutions a year – even though there were hundreds of targets.
Recently, in response to the Walkerton tragedy, the environment ministry has, to its credit, issued more orders against non-compliant water plants. But charges and fines are still the exception to the rule. In the first eight months of this year, the ministry announced charges relating to just four water systems and fines relating to just 11 systems.
It’s the same story with sewage treatment plants. Between January and August of this year, the ministry announced charges relating to just three sewage operations, along with one lone fine regarding a sewage facility. This has been the pattern for years. As with water, we’ve had wide-spread non-compliance, and a dearth of prosecutions, regardless of the party in power. In 1989, under the Liberals, 110 sewage treatments plants failed to meet provincial standards. That year, the government brought enforcement actions against just two plants. In 1991, under the NDP, 91 plants failed. How many charges were laid? Zero.
The government’s consistent failure to enforce the law exposes an inherent flaw in the system. The government simply cannot properly regulate a system that it also finances and, in some cases, operates. These different roles inevitably conflict with one another.
I talked about the financial conflict a few minutes ago. But there’s another conflict as well – an operational conflict. For years, the environment ministry owned and operated hundreds of water and sewage plants. The province no longer owns the plants, but it does continue to operate them. It does so through the Ontario Clean Water Agency, or OCWA. OCWA and the environment ministry are closely linked. OCWA’s employees initially came from the ministry. Senior management travel between the two organizations. And the ministry oversees the agency.
Unfortunately, OCWA has not been doing a very good job. I don’t have current figures, but two years ago, 41 of OCWA’s water plants didn’t meet provincial standards. And between 1998 and 2000, 56 of its sewage plants violated provincial rules. Obviously, it would have been awkward for the ministry to prosecute the agency for these violations. After all, it would have been prosecuting itself.
The only way to resolve this conflict is to get the provincial government – and its so-called children, the municipalities – out of the business of operating and financing water systems. In short, privatize. Privatization will enable the government to focus on its core responsibility: regulating our systems.
This is a point I cannot stress enough. People often associate privatization with deregulation. But the privatization of water utilities does not in any way imply deregulation. On the contrary, it goes hand-in-hand with a new focus on regulation.
Norm Sterling, the former environment minister, confirmed this at the Walkerton Inquiry. He said that privatization would mean better enforcement of regulations. He said that it’s easier for the government to regulate the private sector. He said that there’s no potential conflict of interest and less reluctance to prosecute.
Ontario’s limited experience with privatization confirms this. In Hamilton, enforcement has gotten much tougher since privatization. Hamilton’s sewage treatment plants have a long history of violations. They made eight appearances on non-compliance lists in the eight years before privatization. They were not prosecuted once. Hamilton contracted out operations in 1995. The plants continued to experience problems, but there was a sea change in people’s attitudes towards those problems. The union became extremely critical, and pressured the ministry to enforce environmental laws. Eventually, the ministry acted: It laid 22 charges. It is undeniable that both the union and the ministry are holding the private operator to higher standards than those to which they held its public predecessor.
The same thing has happened in other jurisdictions, most notably in England and Wales. Before privatization, the government understood that it was in a conflict of interest that prevented it from enforcing tough standards. In its words, it was both the poacher and the gamekeeper. Privatization changed that. It separated the operator from the regulator. One regulator identified this separation as the most significant gain of privatization.
Since privatization, the system of water regulation in the UK has become one of the toughest in the world. A new, strict enforcement policy emphasizes investigations and prosecutions. The results – in terms of both drinking water and sewage treatment – have been very impressive.
Now, we shouldn’t fool ourselves into thinking that privatization will solve all regulatory problems. We know that successive governments have tolerated private pollution as well as public pollution. In eliminating the conflicts of interest that discourage regulation and enforcement, privatization will increase the odds of accountability to government. But it won’t guarantee anything. And that’s why it’s important to have another level of accountability: accountability to the public.
The public is able to hold private water providers more accountable than public water providers. Legal liability – a form of accountability – is different for those who work in private and municipal systems. One major difference in the liability of public and private providers is that governments are immune from tort liability for the consequences of their policy decisions. Under that umbrella, courts have ruled that governments shouldn’t be liable for the results of decisions based on economic expediency. Budgeting is thought to be a matter for the political process, and not for the courts. This doesn’t have any parallel in the private sector. A private water company can’t defend itself by arguing that it had a policy not to repair pipes or that it had decided not to budget for repairs that year.
Another difference between public and private providers may lie in the remedies available to those who sue them. The courts cannot grant injunctions against the crown or its servants. I don’t know whether this protection would or would not extend to OCWA. It would be worth looking into.
There’s one other important difference in the liability of public and private providers, and that’s a difference in the consequences of liability. The consequences of being found liable for a particular failure are often more serious in the private sector. The individuals who are responsible are more likely to lose their jobs. The companies are more likely to feel real financial heat. Damages levied against them will come out of their profits. If the damages are big enough, they could threaten the company’s very existence. Because private decision makers will bear the costs of their decisions, liability has a great deterrent value. That deterrent is diminished in the public sector. Liability doesn’t personally threaten public providers. Public decision makers don’t usually foot the bills for their mistakes. Municipalities offload financial responsibility to their taxpayers. And OCWA is backed by the province’s financial guarantee: The government will pay any judgment against it from the Consolidated Revenue Fund. Because the liability is less direct, the public sector’s accountability to the public through the courts is reduced.
Privatization increases accountability in other ways, as well. It increases accountability to municipalities through the contract mechanism. Enforceable contracts with specific performance criteria provide municipalities with powerful tools to compel compliance. Contracts can guarantee water quality, or maintenance levels, or capital expenditures. They can require financial assurance. And, as I mentioned a moment ago, they can include financial penalties for non-compliance.
In a privatized system, the market itself provides yet another form of accountability. When a company performs poorly, stock prices fall. Investors are punishing the company – they’re holding it accountable. Market accountability works on a larger scale as well. Clients and potential clients hold irresponsible companies accountable by refusing to work with them. As the president of Azurix once said to me, “If you are negligent, you are history.” A former senior official with the environment ministry said the same thing at the Walkerton Inquiry. Private firms, he said, would “be put out of business” if they provided unsafe water. He asked, “If you were a customer, would you buy their water from them?” The punishment of being put out of business doesn’t threaten municipal or provincial service providers. And that makes them less accountable.
Those, then, are what I think are the four best reasons to privatize. Privatization will provide capital investment, expertise, efficiency, and more complete accountability.
We’re faced with an obvious question: If privatization is so clearly beneficial, why don’t we see more of it? Of course, we’ve seen a huge amount of it elsewhere in the world. England is now completely private. Private water firms serve almost 80 percent of the French and 50 percent of the Spanish. There are about 30,000 privately owned water or sewage systems in the United States. Another 2,400 communities in the US have contracted out operations. Seattle, Indianapolis, Milwaukee, Houston, Phoenix – privatization is almost commonplace south of the border.
But not in Ontario, and not in Canada. In Canada, in fact, we’re seeing something of a retreat from privatization. Vancouver had been planning to have a private firm design, build, and operate a water filtration plant. It cancelled those plans in 2001. Kamloops made a similar decision. Last year, Moncton shied away from having a private firm operate its distribution and collection system. This summer, Winnipeg decided against a private option for a water plant. And this summer, Halifax announced that it was cancelling plans to have a private firm design, build, and operate three new sewage treatment plants.
Here in Ontario, we haven’t seen this retreat, but we haven’t seen any progress in the last two years either. Hamilton privatized back in 1995, Haldimand-Norfolk in 1998, Goderich in 2000, London in 2001. And then, we seem to have stalled.
What’s going on? Obviously, different municipalities have had different reasons for staying away from privatization. But I think it generally boils down to their weighing the costs of not privatizing against the costs of privatizing. And I think that they’re realizing that the costs of not privatizing are pretty low. They’re artificially low – but that’s not the point. The point is that most municipalities are quite comfortable with the status quo. They’re allowed to flout laws and regulations with impunity. They’re given grants – free money – for capital improvements. In other words, they haven’t had much of an incentive to seek private expertise or capital. Why bother?
Why bother indeed, especially when the political costs of privatization can be so high. CUPE, the Council of Canadians, and the CBC have been very successful in raising the costs of privatizing. CUPE is an especially formidable opponent. It’s extremely well-organized. It’s very good at getting its message out. Never mind that it doesn’t have its facts right. As one discouraged water company executive said to me recently, this has become an environment where “logic and facts don’t matter.”
Instead of facts, the debate these days is turning on feelings. Especially one’s feelings about water and profit. Water, it is said, is a precious resource – the source of life itself. Water must not be entrusted to for-profit corporations. Tainting water with the profit motive would be unethical. This kind of pap isn’t just coming from Maude Barlow – it’s coming from our universities.
And it’s complicating life for municipalities. A municipality that wants to privatize is put in the position of having to defend the profit motive – having to defend capitalism itself. Councillors aren’t looking for that kind of debate. And it’s not the kind of debate they should be having. They should be discussing their infrastructure needs. They should be discussing the private sector’s performance elsewhere. They should be discussing what mechanisms are required to secure good performance in their own community. They should be discussing concrete problems and concrete solutions – and not wasting their time on how people feel about profit. Gary Podesto, the Mayor of Stockton, California, offered that advice before his city voted to contract out water and wastewater operations. He said, “This can’t be a decision of the heart. It must be a decision of the mind.”
Let me end with a few words of advice for our new government. I’ve seen no indication that the Liberals are interested in pursuing privatization. But let’s assume for a minute that the new government comes to understand the magnitude of the problems faced by our water and sewage systems. And let’s assume that it comes to understand that the private sector can play an important role in solving those problems. What then, can it do to encourage privatization? The decision to privatize is, quite rightly, a municipal decision. What role can the province play?
First of all, the province can stop making the status quo so comfortable for municipalities. It can start enforcing our laws and regulations. It can remove liability limitations. It can cut grants and subsidies to municipal water and sewage systems. And it can disband OCWA.
The province can also show some leadership around the issue of privatization. Mike Harris’s Conservatives supported privatization. Back in 1996, Cabinet actually endorsed greater private participation in the financing and delivery of water and sewage services. But it was the best kept secret in town. It was never acted on. At the Walkerton Inquiry, we asked Norm Sterling if there had been any encouragement of any private sector involvement. He answered, “Not that I’m aware of.”
There is plenty the new government can do to facilitate privatization. It can educate municipalities about potential benefits. It can prepare model Requests for Expressions of Interest and Requests for Proposals, along with information to guide municipalities through the bidding process. It can distribute model contracts. It can prepare case studies to illustrate how different approaches to privatization have worked – or failed – in different circumstances.
Examining the failures is actually very useful. It’s important for municipalities to understand what went wrong, and why, and what can be done to avoid similar problems in the future. It’s hard to get privatization right. It’s not going to happen automatically. Sure, some of the elements of a successful privatization seem obvious: Competition. Good regulation. A thorough, unambiguous, and enforceable contract.
But other elements haven’t been so obvious. We’re learning about them through the failures – through the disintegration of the Halifax agreement, the failure of Atlanta’s water privatization, and a couple of fiascoes in the developing world. For example, several of these failures teach us the importance of doing thorough due diligence – of getting good, solid information about the state of a system. They teach us the importance of assigning a risk to the party that has most control over it and the greatest ability to reduce it. They teach us other lessons as well. The value of making one party responsible for both operations and capital improvements – to keep buck-passing and finger-pointing to a minimum. The value of a political champion. The hazards of political interference – especially in pricing. The hazards of pursuing an imperfect contract – of relying on ambiguities, or future change orders, to make it work.
We still have much to learn about privatization. Doubtless, other jurisdictions will continue to teach us important lessons. But some things we just have to learn through experimentation. We don’t have the luxury of waiting. Remember those numbers that should be projected onto that screen: 407 and 101. Combined, they give us 508 reasons to privatize now.