Drawing up the franchise agreement

Chapter Summary

Expectations

401
We expected that the Council would have ensured that the franchise agreement:

• Includes clauses with –
  • incentives for the franchisee to enhance network performance (by reducing water losses and minimising infiltration into the wastewater network), and to meet environmental, water conservation and efficiency objectives; and
  • provision for the franchisee to bear the costs of water lost in the network between the bulk supply intake and consumers’ meters.
• Allows the franchisee to supply water to a variety of quality, quantity and pressure standards (within minimum regulations) to different users if required.
• Requires the costs for legal or other professional advice associated with resource consent applications to be borne by the franchisee.
• Requires the franchisee to meet all legal or third-party water and wastewater quality standards, and to bear the associated costs.
• Defines clearly all legal responsibilities between the two parties for matters such as: access to properties, trade waste bylaws, issues concerning the Public Works Act 1981, and other responsibilities imposed by the Local Government Act.
• Sets up specific performance measures for maintenance and renewal of, and additions to, the water and wastewater networks.
• Requires the franchisee to prepare a set of procedures to deal with a range of extreme events/Acts of God. The Council should itself have a set of such procedures.
• Requires the franchisee to:
  • supply the service to a set of minimum standards; and (if warranted)
  • establish a customer charter, after consultation with its customers, setting out detailed service standards.
• Includes a mechanism for regulating the prices charged to customers.
• Includes provisions to encourage the franchisee to provide a system of price differentiation for different classes of consumer.
• Requires the franchisee to establish rules for customer bonds.
• Provides for standards for monitoring the accuracy of water meters.
• Includes:
  • definitions of poor performance and non-performance by the franchisee; and
  • mechanisms to deal with those circumstances.

Findings

402
The franchise agreement contains provisions relating to all of our expectations.

403
Council officers told us that the franchise agreement is deliberately worded to encourage an innovative approach to service delivery. At the same time, they feel that the wording is directive and capable of clear interpretation to reflect the standards existing at any time.

404
The franchise agreement met the majority of the objectives which it was set up to achieve. (See paragraphs 235-239.)

405
The price of water and wastewater is fixed for the first two years of the franchise. After July 1999, United Water can charge the Auckland Average Price for water. If United Water does choose to do this, it will mean an increase in the price of water for Papakura residents who before the franchise agreement paid the lowest price for water in the region.

406
The price structure provides an incentive for United Water to minimise network losses.

Recommendations

407
We recommend that, when a local authority is drawing up a franchise agreement, it should:

• Ensure that the agreement is designed to meet the objectives for delivery of service.
• Have regard to the expectations set out in the Appendix on pages 59-63. In particular, it should give consideration to:
  • identifying the long-term interests of the ratepayer and structuring the agreement to protect them;
  • price control; and
  • the authority’s role and responsibilities to monitor customer satisfaction, service quality, asset maintenance, and non-performance by the franchisee.
• Set clear standards to ensure that the franchisee knows what it is expected to do, and to provide an objective basis for managing the agreement to the level of assurance required.
• Ensure that the agreement requires the franchisee to set up a customer charter which covers a specified range of issues. The charter should have regard to the customer agreement guidelines issued by the Association of Local Government Engineers of New Zealand (ALGENZ).⁹

Network Losses

Expectations

408
We expected that the Council would have ensured that the franchise agreement includes clauses with:

• incentives for the franchisee to enhance network performance (by reducing water losses¹⁰ and minimising infiltration into the wastewater network), and to meet environmental, water conservation and efficiency objectives; and
• provision for the franchisee to bear the costs of water lost in the network between the bulk supply intake and consumers’ meters.

Findings

409
The franchise agreement contains clauses and a pricing formula which encourage United Water to reduce water losses from the water supply network and infiltration to the wastewater network. The pricing formula is such that all water that is lost must be paid for by United Water. This is a direct incentive for United Water to improve the networks and reduce losses.

410
The agreement also includes a clause which requires United Water to be “vigilant” in checking for leakage, and to take preventative steps promptly.

Variable Quality, Quantity and Pressure Expectation

411
We expected that the Council would have ensured that the franchise agreement allows the franchisee to supply water to a variety of quality, quantity and pressure standards (within minimum regulations) to different users if required.

Findings

412
The franchise agreement allows United Water to supply different qualities or quantities within the boundary of specified third-party standards.

413
United Water will supply on alternative bases if the market demand is sufficient.

Resource Consent Costs

Expectation

414
We expected that the Council would have ensured that the franchise agreement requires the costs for legal or other professional advice associated with resource consent applications to be borne by the franchisee.

Finding

415
The franchise agreement provides that all costs associated with resource consents are the responsibility of United Water.

Third-party Standards

Expectation

416
We expected that the Council would have ensured that the franchise agreement requires the franchisee to meet all legal or third-party water and wastewater quality standards, and to bear the associated costs.

Finding

417
The franchise agreement specifically requires United Water to meet and pay for compliance with all relevant third-party standards.

Legal Responsibilities

Expectation

418
We expected that the Council would have ensured that the franchise agreement defines clearly all legal responsibilities between the two parties for matters such as: access to properties, trade waste bylaws, issues concerning the Public Works Act 1981, and other responsibilities imposed by the Local Government Act.

Findings

419
The franchise agreement requires United Water to do everything necessary to comply with legislation. For those elements for which it cannot transfer responsibility, the Council will undertake compliance on behalf of United Water.

420
The agreement also indemnifies the Council for any loss which it may suffer as a result of a breach by United Water.

Maintenance Performance

Expectation

421
We expected that the Council would have ensured that the franchise agreement sets up specific performance measures for maintenance and renewal of, and additions to, the water and wastewater networks.

422
The success or failure of a long-term franchise is influenced significantly by the franchisee making adequate provision to ensure that the networks are maintained in good condition. For this reason, a sound asset management strategy for maintenance and renewal of, and additions to, the networks is of central importance to long-term protection of the interests of ratepayers and users. There are key issues of equity, environmental protection, and water conservation which are dependent upon the franchisee maintaining the networks to the required level.

Findings

423
The franchise agreement addresses this expectation with requirements that United Water must:

• Maintain the assets to an overall standard better than the initial condition.
• Extend, modify, replace and repair the assets in order to provide an effective potable water and wastewater service.
• Keep the system in good operational order, repair and condition having regard to the initial condition.
• Ensure a minimum of a B grade standard for water distribution networks as prescribed by the Minister of Health.

424
The franchise agreement requires both parties to agree on the initial condition. This is being established by United Water as part of its preparation of an Asset Management Plan in accordance with a methodology set out in the agreement. If there is disagreement as to the establishment of the initial condition, that can be resolved under the dispute resolution conditions of the agreement.

425
Council officers told us that the condition of the assets was assessed as part of the due diligence process by all tenderers, and that all of them found the assets to be “in a median condition for a system of its age and type”. The officers also told us that extensive historical data indicated that there was no deferred maintenance.

426
The franchise agreement requires United Water to produce a report every five years on the condition of the assets, which the Council may have audited by someone independent of the company. The Council’s view is that the regular five-yearly audit is appropriate to confirm assumptions and expectations of the condition of the systems and more frequent assessment of the assets are unnecessary:

• because of the costs of such a review; and
• because of the nature of the assets (pipes, valves and other components of the infrastructure have characteristics as to their wear and tear, deterioration, etc which are well known to engineers).

427
The Council can require United Water to produce all records, plans and documents which the Council requires for the purpose of ensuring their compliance with the terms of the agreement. In addition, United Water must report all changes to the system within one month.

428
Because the Council had no Asset Management Plan in place when the franchise began, performance measures for the maintenance of the assets will not cover the first year (1997-98) of the franchise.

429
The Council told us that if a major problem was to arise it would become readily known to them by way of public complaint or through the reporting procedures contained in the agreement.

Conclusion

430
Given that –

• the initial condition of the assets has yet to be determined;
• an Asset Management Plan will not be available until June 1998; and
• no substantial maintenance has yet been carried out under the franchise agreement –

we cannot at this time judge whether the requirement in the franchise agreement for a five-yearly audit will provide satisfactory assurance that the assets are being suitably maintained. This is an issue that we will look at again in our follow-up audit.

Commentary

431
Local authorities should assure themselves that contracts for service delivery of this nature require the franchisee to invest sufficient ongoing capital and technical expertise for:

• preservation of the assets;
• performance of the service to required standards; and
• provision of capacity to meet future demand.

432
Local authorities should define the standards to which assets have to be maintained. Clear standards ensure that the franchisee knows what is expected of them, and provide an objective basis for managing the agreement. Standards that are unambiguous reduce the potential for dispute between an authority and a contractor over interpretation of satisfactory performance.

433
The existence of an Asset Management Plan before establishing the franchise provides a platform for local authorities to set realistic standards in the franchise agreement for maintenance, additions to the network and customer service.

434
The agreement should require the franchisee to comply with industry standards in its methodology or condition and performance assessment. Such standards are currently only in their infancy in New Zealand. However, it is inevitable that, over the period of the Papakura agreement for example (30-50 years), detailed standards will develop. If a local authority wishes to be able to more effectively benchmark the activities of the franchisee, it should require the franchisee to meet such industry standards as they are developed.

435
Local authorities should ensure that the franchise agreement contains sufficient detail about the proposed asset management system that will be used. Some very sophisticated systems are now available which will provide a comprehensive and essential management tool for asset management. The New Zealand water industry, through the auspices of ALGENZ and the New Zealand Waste Water Association, is promoting the use of a single system to form the basis of meaningful industry benchmarking.

436
An agreement containing only broad standards increases the risk of dispute over the interpretation and implementation of maintenance standards. “Descriptive” grading systems (such as those detailed in the Papakura agreement) are vulnerable, to some extent, to the subjectivity of the assessor.

437
Asset assessment is an ongoing process, with assumptions and decisions on asset condition being made on a continual basis. The longer the periods between auditing the condition of the asset, the greater the risk that the same individuals will not carry out each assessment. This dilutes the quality assurance which monitoring can provide.

438
Clear and specific definitions of maintenance performance are a more objective means for managing and enforcing the terms of the agreement.

Extreme Events

Expectation

439
We expected that the Council would have ensured that the franchise agreement requires the franchisee to prepare a set of procedures to deal with a range of extreme events/Acts of God. The Council should itself have a set of such procedures.

440
Local authorities should ensure that all responsibilities and procedures for both parties are clear for a range of extreme events – earthquake, drought, flooding, fire, dam failure and company failure¹¹. This is in the interests of both parties.

441
Depending on the terms of the franchise agreement, local authorities will still need a set of guidelines and procedures for responding to a range of extreme events – because they will have residual responsibilities in the franchise situation.

Findings

442
The franchise agreement requires United Water to produce a Disaster Recovery Plan by 30 June 1998. The plan is to be reviewed and updated as necessary every five years.

443
The Disaster Recovery Plan is required to contain:

• Risk analysis of possible loss or damage.
• Analysis of insurance required.
• Plans for disaster relief and temporary service.
• Short-, medium- and long-term reconstruction plans.

444
Company failure is an event that can be dealt with under the termination clause of the agreement.

445
No contingency procedures are currently in place.

Commentary

446
Good management practice and the requirements of section 247D(d) of the Local Government Act mean that local authorities should assess and account for these types of risk when considering the advantages and disadvantages of the alternative approaches to service delivery.

447
Local authorities should give due consideration to the seismic performance of any structures when assessing serviceability and prioritising investment needs. In similar exercises undertaken in other parts of New Zealand, one of the principal justifications claimed for asset replacement or upgrade has been the assessed inability of key components to adequately resist earthquakes. Water reservoirs and their connections, pump stations, tanks, pipe bridges and mechanical equipment are particularly vulnerable.

Customer Service Standards and Customer Charter

Expectation

448
We expected that the Council would have ensured that the franchise agreement requires the franchisee to: supply the service to a set of minimum standards; and (if warranted) establish a customer charter, after consultation with its customers, setting out detailed service standards.

Findings

449
The franchise agreement states a range of customer service standards in general terms, but United Water’s practice is to establish a charter defining the relationship between the supplier and the customer.

450
The franchise agreement requires United Water to establish an agreement with its customers (a customer charter).

451
The customer charter provision was included at the suggestion of United Water and was supported by the Council.

Commentary

452
As an alternative to the franchise agreement specifying detailed customer service standards, the agreement could contain a clause to require the franchisee to set up a comprehensive customer charter that meets minimum standards specified in the agreement. Any charter should have regard to the ALGENZ Customer Agreement Guidelines for Water Services.

453
A customer charter provides more flexibility for agreeing and updating customer service standards than specifying such standards in the franchise agreement.

454
Local authorities should consider specifying a range of clearly defined unambiguous service delivery standards, performance standards or customer charter standards within an agreement designed to reduce the potential for disputes over interpretation of satisfactory performance (see also paragraphs 483-496).

Price Regulation

Expectation

455
We expected that the Council would have ensured that the franchise agreement includes a mechanism for regulating the prices charged to customers.

456
Given the monopolistic nature of a public utility franchise, controls need to be in place to prevent unreasonable price increases for customers.

Findings

457
Before the franchise agreement, the Council’s service charges for water and wastewater were the lowest in the region.

458
Within the agreement, there are two pricing mechanisms – one for water supply and the other for wastewater disposal. The United Water component of the price – the service charge – is fixed for the first two years of the franchise (i.e. until 1 July 1999).

459
Water consumers pay two charges (see Figure 4 on page 42):

• a supply charge, based on metered consumption to cover the cost of the treated water which United Water buys from Watercare; and
• a service charge, determined by United Water to pay for delivery of water and maintenance of the water supply network.

460
Similar charges are imposed for sewerage (see Figure 5 on page 42):

• a reception and treatment charge, to cover the bulk removal and treatment costs incurred from Watercare; and
• a service charge, determined by United Water for maintenance of the wastewater network based on 80% of metered water.

Figure 4
Changes to Water Charges

All charges are based on cents per cubic metre.

Figure 5
Changes to Wastewater Charges

All charges are based on cents per cubic metre.

461
After July 1999, United’s charges are restricted to being at or below the Auckland Average Prices for water and wastewater services.

462
The bulk supply component of the price for both water and wastewater disposal is passed directly from the wholesaler, Watercare in this case, on to the consumer. United Water does not charge any additional handling or administration fee. There is also a requirement for United Water to do all things necessary to ensure that the price of bulk water supply is at all times minimised. Should other competition come into play, then the agreement provides that the charge to be made is the average charge by Watercare and any other wholesalers.

463
One of the Council’s stated objectives of entering into the franchise was to protect the interests of its ratepayers by locking in the current low cost regime (December 1996). If, in 1999, United Water does charge the Auckland Average Price for its service, it will mean an increase of prices for all Papakura consumers from the lowest in the region to the Auckland Average Price.

464
We were told that the Council believed that:

• While the prices were the lowest in the region before the agreement, this was a fragile situation, as the small scale of the Papakura system precluded the economies of scale available to larger local authorities. Consequently, there was no guarantee that Papakura would remain at the lowest-price.
• It is now able to guarantee that Papakura prices will always be at or below the Auckland Average Price.
• By introducing an additional company (United Water) into the region the Council had introduced competition into the regional water supply and wastewater industry.
• United Water could take up the business opportunity available to develop an alternative water supply and/or wastewater treatment plant in Papakura and perhaps supply these services at a cheaper rate than Watercare.
• This could then encourage Watercare to improve the efficiency of its operations and pass any economies on to consumers in the form of lower bulk charges.
• While it cannot dictate the charging policy of bulk water supply through the agreement with United Water, there are legal remedies in the regulatory arena controlling monopolies. In this regard water and wastewater charges are no different from other natural monopolies such as the supply of energy and telecommunication services. As a matter of public policy, the general law as expressed in the Commerce Act 1986 should prevail and govern the charging methodology of bulk suppliers.

Conclusions

465
The franchise agreement meets our expectation of including a mechanism for regulating the prices charged to customers.

466
However, we have some concerns about the pricing mechanism. These are that:

• Although the two-year price freeze in the agreement keeps the service charges low until July 1999, it is uncertain whether this position will be maintained after that time when United Water can increase charges up to the Auckland Average Price. Our concern is that such a price movement would fail – in the longer term – to meet the Council’s objective to protect the interests of its ratepayers by locking in the current low cost regime.
• The agreement provides no protection against the potential inefficiencies of other councils in the Auckland area that are reflected in their price for water and, consequently, in the Auckland Average Price.
• The agreement provides no protection against United Water’s ability to influence the Auckland Average Price should it secure a contract to deliver water and/or wastewater service to one or more of the other local authorities in the area.
• The agreement does not require United Water to develop alternative water supply or wastewater treatment systems; nor to pass on any benefits should it choose to do so. Therefore, the extent of any efficiency gains to be derived from the innovative approach available to the company (and the resulting introduction of competition into the market) remains a matter for speculation.

467
Consequently, we find it difficult to assess whether consumers will obtain any benefit from increased efficiencies in service delivery – which the franchise agreement allows for, and which the Council hopes will be gained. The “average price” may well be appropriate to allow the necessary investment for the maintenance and improvement of the asset over the long term, but at this time we cannot judge if this is the case. The concerns outlined in paragraph 466, and what benefits the consumers may obtain from the franchise agreement, are issues that we will consider as part of our follow-up audit.

Commentary

468
The condition of the assets is directly linked to the profitability which any pricing structure will provide for a franchisee. Council officers told us that the due diligence carried out by the tenderers indicated that the water and wastewater network was in neither a very good nor a poor condition but is “median”. The officers also told us that there was no deferred maintenance and that appropriate capital investment had been made in the system.

469
In developing a pricing structure for a franchise agreement, local authorities should take into account the need to balance a number of issues. Authorities need to consider the long-term capital investment that will be necessary by a franchisee, balanced against any short-term agreements about the unit retail price for water. Regional variations relating to the nature and size of the system will also affect the types of running costs involved, which in turn will affect the determination of an appropriate pricing structure.

470
An appropriate pricing structure, and how it meets the full range of service delivery expectations and long-term interests of the community, will be central to the success of any franchise agreement. Local authorities should be careful that in attempting to control price at too low a level they are not disadvantaging long-term users of the service.

Price Differentiation

Expectation

471
We expected that the Council would have ensured that the franchise agreement includes provisions to encourage the franchisee to provide a system of price differentiation for different classes of consumer.

472
There is a range of potential benefits for both water users and the franchisee in setting up a system which allows price variation. The franchise agreement should not preclude this option.

Findings

473
The franchise agreement allows for price differentiation between classes of consumer after two years.

Customer Bonds

Expectation

474
We expected that the Council would have ensured that the franchise agreement requires the franchisee to establish rules for customer bonds.

Findings

475
The franchise agreement has no provisions covering customer bonds.

476
However, arrangements for customer bonds are covered in the customer contract.

Commentary

477
This expectation could be met within the terms and conditions of a customer contract or charter if that approach was preferred.

Accuracy of Water Meters

Expectation

478
We expected that the Council would have ensured that the franchise agreement provides for standards for monitoring the accuracy of water meters.

Findings

479
The franchise agreement allows for water meters to be treated as accurate, but requires United Water to check the accuracy at the request of customers.

480
The customer contract provides that water meters will be regularly checked by United Water.

481
A customer who requests a check is charged a testing fee if the meter reading is found to be accurate. No charge is made if the meter reading is found to be inaccurate.

Commentary

482
The specific terms and conditions of a customer contract or charter are also an appropriate mechanism to deal with this issue, as part of the day-to-day operation of the service.

Poor Performance and Non-performance by the Franchisee

Expectation

483
We expected that the Council would have ensured that the franchise agreement includes: definitions of poor performance and non-performance by the franchisee; and mechanisms to deal with those circumstances.

484
It is important that local authorities have appropriate means of legal redress in the event of the franchisee failing to meet the terms and conditions of the franchise agreement. In addition, the public should be protected from business failure by the franchisee.

485
Both parties should have the benefit of clear definitions of what constitutes poor performance or non-performance by the franchisee, and the penalties accruing should the circumstances occur. Such definitions provide an objective basis for managing the franchise agreement and help to minimise the potential for dispute between an authority and the franchisee over interpretations of satisfactory performance.

Findings

486
The franchise agreement gives the Council the right to monitor water quality, asset management, prices charged, and service performance.

487
The franchise agreement requires United Water to:

• Operate the assets in an efficient and effective manner so that customers serviced by the assets, and paying for such services, may expect a level of service and quality of supply in accordance with accepted industry standards prevailing at the relevant time in the Auckland Area.
• Ensure a continuity of supply of good quality, wholesome, potable water to Papakura District.
• Use its best endeavours to maintain good working relations with customers, fellow citizens (both corporate and individual) and regulating authorities.

488
The Council’s view is that:

• these provisions, along with other obligations, are broad and comprehensive;
• the nature of the agreement is one where it is expected that interpretation will change from time to time to reflect the social and legal environment within which the agreement is operating; and
• the wording is directive and capable of clear interpretation reflecting the standards existing from time to time; and that, as a result
• it is undesirable to prescribe standards that are likely to become inappropriate and render nugatory consumer law and monopoly practices controlled under the Commerce Act 1986 or general community expectations that are likely to change over the life of the agreement; and
• all aspects of the franchise agreement can be changed by mutual agreement at any time during the franchise. Council officers told us that the franchise agreement was likely to evolve as the relationship with United Water matured, and that the detail of the contract in 5 years’ time could be quite different from its current form.

489
The Council’s view is that the dispute resolution processes set out in the franchise agreement is a mechanism by which the Council can clarify or address low level issues and resolve poor or non performance issues.

490
In the event of poor performance or non-performance by United Water the “disciplinary” provision in the agreement is a termination clause. This can be invoked principally on the grounds of non-compliance with agreed obligations or the directions of an arbitrator following the dispute resolution process.

Conclusions

491
The agreement meets our expectation that there will be a definition of poor performance and non-performance, and that there is a mechanism to deal with those circumstances.

492
The Council’s approach was, wherever possible, to encourage innovation, negotiation, partnership and self-regulation, rather than being over-prescriptive about management and control. There are known difficulties in proving poor performance within a facilities management contract, and in terminating a contract when poor performance is sufficient to compromise customer satisfaction but not bad enough to invoke termination procedures.

493
We cannot assess:

• how effective the “broad” approach taken by the Council will be; or
• the potential benefits or disadvantages of letting a 50-year contract and then continuing to renegotiate it throughout its term.

We will look at these issues as part of our follow-up audit.

494
The terms of the customer charter oblige United Water to monitor its service performance for individual customers, and to provide redress for failure to meet certain standards. While this requirement is a commendable feature in its own right, we believe that it is no substitute for what is needed to protect the interests of the Council, ratepayers and consumers generally.

Commentary

494
Excessive monitoring would defeat the purpose of setting up a franchise agreement like the Papakura agreement which is intended, as far as possible, to be self-monitoring. While self-monitoring may be a desirable feature, the ultimate monitoring responsibility will always lie with the local authority.

495
In identifying key factors that will indicate poor performance or non-performance and allow the authority to enforce its requirements, a balance needs to be struck between obtaining sufficient assurance minimising day-to-day interference or regulation of the franchisee.

496
Other alternatives – such as specific performance requirements and sliding scales of penalties – offer more specific, directive and enforceable options. These can be regularly reviewed to ensure their relevance to accepted standards at the time. They could also be linked to any customer charter that builds a direct relationship between the franchisee and the customer while ensuring that primary liability lies with the franchisee.

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9: Customer Agreement Guidelines for Water Services, December 1997.

10: Losses are defined as the total water received from the bulk supplier less water used for scouring, firefighting and recorded on customers’ meters. Losses are also referred to as “leakage” and“unaccounted water”.

11: By company failure, we mean insolvency or any form of company collapse.

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