A NOVEL APPROACH TO THE OUTSOURCING OF OPERATIONS AND MAINTENANCE SERVICES IN THE WATER SECTOR

A NOVEL APPROACH TO THE OUTSOURCING OF OPERATIONS AND MAINTENANCE SERVICES IN THE WATER SECTOR Jeff Rigby 1, Neville Pearce 1, Mike Duell 2, Paul Collier 2, Meredith Gibbs 3, Damien O Brien 4 1. Coliban Region Water Corporation, Bendigo, VIC, Australia 2. Beca, Melbourne, VIC, Australia 3. Ashurst, Melbourne, VIC, Australia 4. Everything Infrastructure Group, Melbourne, VIC, Australia ABSTRACT Coliban Region Water Corporation (Coliban Water) has been outsourcing a variety of business functions through different contract models for over 15 years. In 2011, Coliban Water began reviewing its business functions and considering whether each function should be delivered by Coliban Water or by an external partner - insourced versus outsourced with the ultimate objective of delivering additional value to Coliban Water s customers. The review was also scheduled in preparation for the expiry of its primary frontline Operations and Maintenance (O&M) services contract in 2013. This paper reviews the methodology utilised and summarises the lessons learned. The results could benefit other water authorities considering outsourcing business functions. INTRODUCTION Coliban Water provides urban and rural water and sewerage services to the North-Central region of Victoria with a resident population of approximately 140,000 people. Coliban Water has been providing some of these services through different procurement and contracting models ranging from full outsourcing to partial outsourcing for the past 15 years. This experience includes the outsourcing of frontline O&M business functions under a ten year contract that expired in June 2013 and two Build Own Operate Transfer (BOOT) contracts that can into operation in the early 2000s. Starting in 2011, Coliban Water undertook a business model review principally to identify the best method of delivering value to its customers. The timing of the review was also key to preparing for the conclusion of three then current O&M contracts, one of which was the ten year services contract referenced above. While all business functions were reviewed through the process, the focus of this paper is the O&M business functions and the methodology utilised by Coliban Water and its advisors to undertake this review and convert it into an awarded contract with an aligned O&M service provider. Coliban Water s advisors were Beca Technical, Ashurst Legal and Everything Infrastructure Group Advisory Commercial. STRATEGIC DRIVERS The Board of Directors of Coliban Water (the Board) set the strategic drivers to be achieved through the busines model review in the following seven "Guiding Principles": 1. Promote innovation to create value and share that value created between Coliban Water, the contractor and the community; 2. Define a KPI regime that is aligned with Coliban Water s objectives and clearly drives the behaviour required from the contractor make these measureable and enforce the KPI regime; 3. Create financial flexibility consider the use of both fixed costs and variable costs to allow flexibility for variability in inflows etc; 4. Ensure the development of a contract that is easy to understand, easy to administer and clearly outlines expectations of the contract must be reflective of the spirit and intent of the agreement; 5. Ensure expectations of the contractor are clear this includes branding, performance, reporting requirements etc; 6. Consider Coliban Water s greater business objectives and make sure these are reflected in the contracts i.e. consider sustainability and financial viability etc.; and 7. Coliban Water should maintain the ownership and retention of all intellectual property capital created by its activities and functions, ie build the capability of the organisation. The Guiding Principles were applicable to both the consideration of all business functions and specific O&M business functions. To demonstrate this point, the key O&M strategic drivers are nominated alongside the corresponding Guiding Principles. Retain knowledge of the treatment and reticulation assets within Coliban Water Guiding Principle 7; Nominate maintenance standards that were representative of the fact that asset lifespans are far in excess of the contract lifespan Guiding Principle 6; and

Build in flexibility into the O&M contract that allows Coliban Water to remain agile to changing external conditions Guiding Principle 3. In addition to the Guiding Principles, Coliban Water's prior experience of outsourcing was also relied upon to provide guidance. This experience includes BOOT contracts, O&M contracts, Design and Construct (D&C) contracts and general labour hire contracts. Under the direction of Managing Director Jeff Rigby, Coliban Water then formulated a matrix presented in Figure 1 that encapsulated various and relevant contract models and framed them in a continuum according to their level of risk transfer, ability for Coliban Water to control the strategic direction as well as other matters. The majority of Coliban Water s experience in previous outsourcing contracts was with BOOT and regulate style contract models that provided for a high level of outsourcing and risk transfer to the service provider. However, this approach left Coliban Water with relatively low levels of control over how services would be delivered to its customers and its infrastructure assets managed. The business model review identified that one of its revised objectives was to retain strategic direction and involvement in delivery of the services and management of assets, while leveraging the skills and knowledge of an experienced service provider. This objective was particularly pertinent for services that involved customer interaction. This required an O&M services contract model that moved away from its existing contract model (fixed fee for all services) and enabled Coliban Water to have a greater degree of control over how and when services would be delivered. At the strategic level, Coliban Water identified that its ideal contract style fell within the "supervise" category. Prior to committing to an effort-intensive procurement process, a review of the existing primary O&M Contract against the Guiding Principles was also undertaken. The review demonstrated that the existing O&M contract did not align to the Guiding Principles. BUSINESS FUNCTIONS With the strategic drivers clearly articulated and with the knowledge that the primary O&M contract would not be rolled-over in its current form, the next step in the methodology was to determine whether each business function within the organisation should be outsourced or insourced. This determination was achieved, in part, by first identifying each business function within the organisation, from the provision of information technology services, customer service through to management of reservoirs. Then, each business function was assessed using a framework that was based on the Guiding Principles and in particular; customer value, risk, level of control and market appetite. The result was a recommendation for each business function to be either outsourced or insourced. Where the recommendation was to be outsourced, the level of outsourcing was also referenced in line with the matrix continuum (Figure 1). Broadly, the outcome of the assessment was to change from outsource to insource for customer-facing business functions and to continue to outsource O&M business functions, with the majority of O&M business functions to be outsourced through a supervise style model. However, some business functions such as biosolids disposal and meter reading were recommended to be outsourced through a direct approach model. The next step in the methodology was to consider various packaging options for the business functions that were to be outsourced. All business functions delivered through one contract; O&M business functions split out from the administrative business functions; or Further separation through splitting O&M business functions: o Geographic splits eg, North and South regions o Function splits eg, networks and treatment. To assess the suitability of the proposed packaging options, a number of different types of assessments were undertaken: 1. A market sounding exercise was undertaken to assess the appetite of potential contractors particularly around the financial size of the contact and the types of the business functions where delivery by the market was preferred; 2. A financial model was developed for O&M business functions in order to develop baseline costs for all O&M activities as well as for the different packaging options. The financial model was referred to as the Industry Comparator and was based on a Public Sector Comparator; and 3. Individual Best Value Assessments were undertaken for the business functions proposed to be repatriated from the contractor and returned to Coliban Water. With regards to the O&M business functions, the various assessments demonstrated that the best value would be obtained by tendering the O&M business functions as a single package under a supervise contract model see Figure 1. In summary, this step of the methodology delivered Coliban Water a clear scope and contract model.

Table 1: Outsourced scope, previous and new arrangement. Note: services marked with * were continuing arrangements under separate contracts. Outsourced service Previous New arrangement arrangement Asset management Previous provider Coliban Water Urban water networks Previous provider Lend Lease Urban sewer networks Previous provider Lend Lease Water Reclamation Plant - Kyneton Previous provider Lend Lease Water Reclamation Plant Castlemaine Previous provider Lend Lease Water Reclamation Plant Echuca * WIG WIG Water Reclamation Plants All others Previous provider Lend Lease Water Treatment Plants Echuca, Castlemaine & Kyneton * Veolia Veolia Water Treatment Plants All others Previous provider Lend Lease Rural Water Networks Previous provider Coliban Water Billing, Revenue Collection, Meter Reading Previous provider Coliban Water IT Support Previous provider Coliban Water Headworks Coliban Southern Reservoir System Coliban Water Coliban Water Headworks Goldfields Super Pipe (JV with CHW) * Veolia Veolia In addition, the Industry Comparator was developed which had further benefit during tender evaluation phase. The Industry Comparator provided a baseline cost for the services using a technical assessment of the O&M requirements of each asset. The Industry Comparator also included costings for management, consumables, travel and grouping efficiency and quantified contract risk profile in line with the supervise model. It thus could be sliced and diced to match the different proposals received from the tenderers. During the contract term, the Industry Comparator could then be used as an annual maintenance plan given that it was built from Coliban Water s master asset list. CONTRACT MODEL With the scope and contract approach nominated, Coliban Water turned to its advisors to develop the contract document in line with the Guiding Principles. The methodology adopted was to conduct a series of workshops with key Coliban Water staff and management to capture lessons from the past and to articulate Coliban Water's aspirations for a successful relationship with the service provider at a practical level. The following sections reference Figure 2 which diagramatically represents the contract model. One of the key strategic drivers was that Coliban Water retained strategic direction and involvement in delivery of the services while leveraging the skills and knowledge of an experienced service provider (Guiding Principles 6 and 1 respectively). In addition, one of the key lessons identified through the workshops was that Coliban Water required a contract structure that would retain competitive tension with the service provider and avoid the pitfalls of "client capture". These dual objectives were achieved by the annual work plan process and fee structure a mixture of lump sums, schedule of rates and pass through consumables. Coliban Water retains responsibility for developing an annual work plan covering all planned maintenance services. The service provider must deliver the annual work plan within the relevant financial year to required service standards. In practice, Coliban Water retains the ability to direct the service provider regarding delivery of the work packages identified within the annual work plan. Tenderers were required to bid for a lump sum to deliver the annual work plan for the first year of the contract but also to provide costings for individual tasks within the annual work plan. Each year, the annual work plan is reset by Coliban Water after consultation with the service provider and the service provider must provide a revised lump sum for the relevant annual work plan. Coliban Water is able to refer to the individual costings for work packages provided as part of the RFT response as a basis for considering and negotiating the revised lump sum for following years of the contract. Due to the relatively high level of direction retained by Coliban Water, the contract expressly provides that Coliban Water retains all asset risk. These objectives were also achieved by making the contract non-exclusive and providing for a term of four years with two options to extend for a further five years. The initial four year term was required to achieve alignment with the future timing of the Essential Services Commission regulated price setting and Water Plan process. The options to renew would only be exercised by Coliban Water if the service provider was delivering a high level of service performance and there was a productive and effective relationship with Coliban Water. For reactive (and planned corrective) maintenance, the service provider is paid for work completed on the hourly rates negotiated at the commencement of the contract and which are adjusted for CPI increases during the contract term. However, the service provider is discouraged from gaming planned maintenance and reactive maintenance by

being subject to a reactive maintenance "budget". This is a pain-share, gain-share mechanism under which the service provider bid a set percentage of the planned maintenance lump sum as the "budget" for reactive maintenance. Coliban Water and the service provider share 50/50 in any overrun or underrun of the "budget". This provides an incentive for the service provider to keep up its planned maintenance schedule so that it underruns the reactive maintenance budget and therefore shares any savings. This also meets the objective of sharing benefits of any innovations between Coliban Water and the contractor (Guiding Principle 1). As per the description above, if there is an overrun on the "budget" the service provider is only paid 50% of all work in excess of the budget. This represents a significant risk to the contractor given the difficulties of predicting reactive maintenance events, and that the cost implications of a large reactive maintenance event could blow the budget. As such, only the first $25,000 of each is event is counted for the purposes of determining the budget (the service provider is still paid the full amount, subject to the pain-share gain-share mechanism). Lessons learnt workshops revealed that the previous fixed fee model had provided both benefits and disadvantages to Coliban Water. In particular, while fixed price gave budget certainty, during the drought around 2005 when water treatment throughput was low, there was a perception that that there was a windfall gain under the previous O&M contract with limited benefit to Coliban Water s customers. To account for the relatively high degree of regulation of operations services and large impact of climatic variability, the new O&M contract transfers the labour risk to the service provider (lump sum) while the risk for consumables such as chemicals and electricity is retained by Coliban Water. This model also reflects the fact that Coliban Water does not require as much strategic direction and control over these services as compared to planned maintenance services. Alternatives to this model were considered and discounted: Providing for Exceptional Events, such as Blue- Green algae outbreaks, to be at Coliban Water's risk (ie outside lump sum) was discounted to due to the complexity in defining what was, and what wasn t, an exceptional event; and Charging on a throughput rate was discounted as this would introduce a conflicting driver between Coliban Water s responsibility for asset maintenance versus the service provider s responsibility for operations. The contract model provides for the payment of a monthly Management Fee based on a percentage of all payments for planned maintenance, reactive maintenance and operations services. This is intended to cover all corporate overheads including administration, management costs and other related costs, together with profit margin. Four key result areas (KRAs) were identified for the performance incentive mechanism: safety, budget, compliance and joint outcomes. The budget incentive included the reactive maintenance painshare, gain-share "budget' mechanism described above. The three remaining KRAs operate as separate incentive pools made up of amounts withheld from the monthly Management Fee based on the percentage of the service provider's annual profit that it was required to bid for this purpose, with a minimum of 5% of profit to be put into each incentive pool. Payment of the incentive pools is made annually based on the percentage achievement of negotiated KPIs in each KRA pool. KPIs may be re-set at the end of each contract year by agreement of the parties. The KPIs align with Coliban Water's safety and key compliance measures and strategic objectives, such as building the capability of the organisation (Guiding Principle 7). In addition, the contract model also included provisions for extra services, emergency services, transition and mobilisation lump sums, default and termination, and formal instructions to the service provider from improvement notices through to major non-conformance notices. PROCUREMENT PROCESS The procurement process (see Table 2) was comprehensive and is relatively representative of the standard used throughout the water industry. Points of difference are discussed below. As previously mentioned, market sounding was undertaken by a third party without identifying Coliban Water to the potential O&M service providers. This had the benefit of gauging market interest in outsourced O&M business functions and helped inform the potential packaging options. The EoI responses confirmed that there was strong market interest and that a single contract model was preferred. Six parties were shortlisted to proceed through the procurement process. Given that two out of the six shortlised parties were incumbents it was critical that a level playing field was afforded to all shortlisted candidates. This was achieved by a number of means: Coliban Water and its advisors designed and implemented an interactive tender process so that those potential service providers less familiar with Coliban Water's business had the opportunity to learn and understand Coliban Water's fundamental business drivers, as well as the specifics of the proposed O&M services contract. This was achieved through various

Table 2: Procurement process and timeline Phase Period Market sounding March 2012 April 2012 Expression of July 2012 interest Shortlisting of August 2012 service providers Request for November 2012 February Tender 2012 Contract January 2012 comments Evaluation and February 2012 March 2013 negotiation Award April 2013 Transition April 2013 June 2013 Contract Commencement 1 July 2013 information sessions (techncial, commercial and legal), a data room, site visits, a formal Q&A process and a contracts comments process. Once shortlisted, parties were required to execute a Process and Probity Deed which governed these interactions and ensured that all tenderers were afforded equal opportunity and equal information. For example, answers to questions submitted through the Q&A process were provided to all tenderers in summarised form; The procurement process was rigorously documented including throughout the contract negotations; and The process conformed to the Victorian Government s probity requirements to ensure a fair and transparent business decision process. In line with this approach, independent probity advisors and probity auditors were appointed and all processes captured in a Procurement Conduct Plan. The following arrangements were also established: o All Coliban Water and advisor employees directly involved signed confidentiality agreements at various stages of the process; o The key elements of probity were discussed and explained to project team staff to ensure that the same information was being provided to all tenderers; o A Project Manager was appointed to control the flow of key information; o A secure office was established for the storage of information and secure IT processes and electronic storage was established with access only available to the project team; o A probity auditor was appointed to review key decisions and independently report to the Board; and o A probity advisor was retained throughout the procurement process to assist with the ongoing management of probity and provide advice on probity matters identified by the project team. The interactive tender process extended to a contract comments process. The intent of this process was two-fold. To test the market's appetite for the risk allocation profile proposed by the O&M contract. Allow each tenderer to identify and demonstrate that alternative risk positions that would deliver greater value for money to Coliban Water. To enable this process, during the tender period: 1. Tenderers were requested to submit proposed contract comments marking each comment with its relative importance. Tenderers were asked to submit comments with no identifying markers so that Coliban Water and its advisors could consider the comments on a "blind' basis. The contract comments were not taken into account in the formal evaluation process of the RFT; 2. Coliban Water and its advisors then assessed these risk/contract positions to identify common themes and consider whether Coliban Water should reconsider its position. The market response was, on the whole, that the contract risk allocation was acceptable with little alteration. The result was that the contract was re-issued with minor amendments; then 3. Tenderers were requested to resubmit the final contract departures with their tenders, taking into consider Coliban Water s revised position. These formal contract departures were assessed in the final evaluation of tender responses. Tender evaluation was undertaken by separate and independent teams; Team 1: validate tender conformance on receipt and manage the tender clarification process; Team 2: financial assessment; and Team: 3: non-financial assessment. The benefit of this approach to Coliban Water was that it was only in the final stages of evaluation where moderation and compromises between financial and non-financial criteria would be drawn. The Industry Comparator was again used as part of the financial assessment. ENTERPRISE IMPACTS Given that the O&M of assets is a key function of any water authority, a change in the manner that this function is executed will lead to enterprise-wide impacts. These impacts were not just restricted to Coliban Water, but alsoextedned to the previous O&M service provider and the new service provider. These risks included:

The previous and new O&M contracts have different commercial structures promoting different management and operational styles. This presented a risk that Coliban Water staff would continue to interact with and manage the new O&M service provider as per the previous model. This would have resulted in Coliban Water not realising the benefits of the new contract, such as transfer of knowledge; There was a risk that fundamental understanding and/or knowledge of Coliban Water s systems and assets would be lost through the transition period leading to below standard customer outcomes during the initial transition period following contractor changeover; and There was a risk that staff in both Coliban Water and the previous O&M service provider would have uncertainty through the procurement process regarding their roles. Coliban Water proactively managed risks for which they were responsible through a number of actions including regular all staff updates, employing a dedicated transition period manager to assist with the close-out of the previous O&M contract, assigning a Coliban Water representative to act as the transition coordinator for the new O&M contract and implementing numerous transition requirements with both the outgoing and incoming O&M services contractors. APPLICATION TO OTHER WATER AUTHORITIES Both the overall process and individual aspects are directly applicable to other water authorities considering outsourcing business functions. The ultimate result of the methodology employed by Coliban Water and its advisors was the development and award of a contract that aligned to the Guiding Principles. The Board's development of the Guiding Principles early in the process meant that Coliban Water's strategic goals as reflected in the Guiding Principles could be used throughout the process as a benchmark for evaluation in quite disparate aspects of the RFT process. For example, the previous O&M contract was evaluated against the Guiding Principles to determine whether a business model review was required or not. Additionally, the business functions that changed in the outsourcing model during the business model review were evaluated to determine whether the change was warranted at a strategic, and not just organisational, level. Finally, the new O&M contract was evaluated just prior to award to confirm that it would achieve the Guiding Principles. In addition, the development of an Industry Comparator enabled a baseline cost for the contract model to be developed. This was important as the contract model differed significantly from the previous model. The baseline cost was used to evaluate tenders, inform the Essential Services Commission of the expected future service cost to Coliban Water and it will be used over the contract term to evaluate revisions in scope and price for services as a result of capital works undertaken by Coliban Water. The procurement process utilised a two-stage contract departures process so that Coliban Water could test the tenderers appetites for the risk allocation profile proposed in the O&M contract and also gave each tenderer the opportunity to demonstrate that alternative risk positions would deliver greater value for money to Coliban Water. Finally, the commercial framework financially incentivised the tenderers to adopt Coliban Water s specific O&M objectives of: retaining knowledge of the treatment and reticulation assets within the business; nominating maintenance standards that are representative of the fact that asset lifespans are far in excess of the contract lifespan; and building in flexibility into the O&M contract that allows Coliban Water to remain agile to changing external conditions and business objectives. CONCLUSION Coliban Water achieved the successful outcome of a contract for the frontline service provision of O&M activities of its network and treatment assets. The contract was awarded on time and within budget. This outcome was achieved, in part, through the novel combination of contract development processes: Defining key strategic objectives through the Guiding Principles that were used throughout the procurement process; A holistic approach through the business model review, including the contract model continuum, which identified the appropriate scope and packaging options; An Industry Comparator that provided both a baseline cost as well as maintenance strategy to be used during the contract term; and A contract comments process that both clearly conveyed Coliban Water s intended position during the tender period as well as reduced the overall procurement timeframe. ACKNOWLEDGEMENT There were many people that contributed to the success of the process. The authors would like to acknowledge the significant contribution of Coliban Water s Rick Jackel as project manager.