A Guide to Performance Contracting of Water Service Provision

A Guide to Performance Contracting of Water Service Provision For Regulatory Agencies, Local Government Units, Water Districts, and Private Water Service Providers

for Regulatory Agencies, Local Government Units, Water Districts, and Private Water Service Providers This guide was published with assistance from the USAID Philippine Water Revolving Fund (PWRF) Support Program. The views expressed here do not necessarily refl ect those of USAID or the United States Government. The PWRF Support Program is a collaborative undertaking of GOP partners, USAID, Japan International Cooperation Agency (JICA), LGU Guarantee Corporation (LGUGC), and private financing institutions (PFIs) through the Bankers Association of the Philippines. The Program s GOP partners are led by the Department of Finance and include the Development Bank of the Philippines and the Municipal Development Fund Offi ce. The PWRF Support Program aims to establish a co-fi nancing facility that combines ODA/JICA resources with PFI funds for creditworthy water service providers, using a financial structure that allows affordable loan terms without sacrifi cing the viability of PFIs. PFIs have access to credit risk guarantees provided by LGUGC and USAID s Development Credit Authority. The PWRF Support Program operates around three main objectives, which are to: Establish the co-fi nancing facility and develop a long-term fi nancing strategy and mechanism with broader private sector participation; Strengthen water project fi nancing and enable other conditions necessary for optimizing the PWRF Support Program s positive impact on the sector, including corollary regulatory reforms; and Assist water districts and local government units in developing a pipeline of bankable water projects. The PWRF Support Program is implemented by Development Alternatives, Inc. in association with The Community Group International LLC, Resource Mobilization Advisors, and CEST, Inc. Month and year of publication: October 2011. iv

TABLE OF CONTENTS 1 INTRODUCTION... 1 2 OVERVIEW OF PERFORMANCE CONTRACTS... 3 2.1 What is a performance contract?...3 2.2 Why use a performance contract?...3 2.3 Types of Performance Contracts...4 2.4 The Contracting Parties: Water Utilities and Staff...6 2.5 Case Studies and Lessons Learned...8 3 PREREQUISITES OF PERFORMANCE CONTRACTING... 17 3.1 Ring-fencing of Utility Accounts...18 3.2 Development of Performance Improvement Plan/Business Plan...18 3.3 Key Requirements...21 4 STEPS IN PERFORMANCE CONTRACTING... 23 Step 1 - Identifi cation of Contracting Parties and Contracting Instrument...24 Step 2 - Setting the Strategic Goals, Objectives, Scope and Timeframe...24 Step 3 - Determining Activities to be Contracted...25 Step 4 - Defi ning the Roles and Responsibilities of the Contracting Parties...25 Step 5 - Setting Performance Indicators and Targets...25 Step 6 - Determining Performance Incentives/Linking Incentives to Performance...27 Step 7 - Setting Penalties, Dispute Resolutionand Modifi cation Provisions...27 Step 8 - Termination of Performance Contracts...27 REFERENCES AND LINKS... 29 ANNEX 1 Institutional Set-Up of Water Service Providers... 32 ANNEX 2 Sample Performance Contracts... 35 2-1 Improving Production, Revenue Generation and Quality of Service of the Jagna Waterworks System...35 2-2 Improvement of the Mahayag Local Waterworks System (MALOWAS) for Better Service Provision and Revenue Generation...47 2-3 Performance Contracting to Reduce Subsidies for Water Service Operations in Alburquerque...55 2-4 Area and Branch Performance Contracts in Uganda, East Africa...61 2-5 Contracting with the Utility Management in Lesotho, South Africa...65 2-6 Copies of Sangguniang Bayan Resolutions Endorsing Performance Contracts...69 ANNEX 3 System of Incentives for Performance Contracting... 74 APPENDIX A Legal Bases and Types of Outsourced Performance Contracts... 76 APPENDIX B Some Examples of Outsourced Contractual Arrangements in the Philippines... 78 v

LIST OF TABLES AND FIGURES Table 1 Benefi ts to Contracting Parties and Clients... 4 Table 2 Types of Outsourced Contractual Arrangements... 6 Table 3 - NWSC Performance Improvement... 15 Table 4 - Example of a Performance Improvement Plan... 19 Table 5 - Example of a Performance Improvement Plan... 20 Table 6 - Setting Strategic Goals... 25 Figure 1 Possible Contracting Arrangement within the LGU... 7 Figure 2 Possible Contracting Arrangements for Water Districts... 8 Figure 3 Utility Reform Glide Path... 18 Figure 4 - Steps in Performance Contracting... 24 vi

LIST OF ACRONYMS BEM BOD BOT BWSI COA DBL DILG GOCC JV KPI LGU LWUA MALOWAS MPDO MWSS-RO NRW NWRB NWSC O&M PIP PPP PRAISE PWRF-SP SB SMART USAID WASA WD WSP WSS business effi ciency measures Board of Directors build-operate-transfer Balibago Water Systems, Inc. Commission on Audit design-build-lease Department of Interior and Local Government government-owned and controlled corporation joint venture key performance indicators local government unit Local Water Utilities Administration Mahayag Local Waterworks System Municipal Planning and Development Coordinator Metropolitan Waterworks and Sewerage System Regulatory Office non-revenue water National Water Regulatory Board National Water and Sewerage Corporation (Uganda) operation and maintenance Performance Improvement Plan public-private partnership Program on Awards and Incentives for Service Excellence Philippine Water Revolving Fund Support Program Sangguniang Bayan specifi c, measureable, accurate, realistic, and time-bound United States Agency for International Development Water and Sewerage Authority (Lesotho) water district water service provider waterworks and sewerage system vii

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1. INTRODUCTION More than 80% of water service providers (WSPs) in the Philippines are public utilities, owned and managed by government personnel and subject to government laws and procedures. These include water districts (WDs) and the utilities run by local government units (LGUs). Having been vested with the power to establish and operate water utilities as part of their devolved function, the LGUs serve more than half of the total population. Water districts, meanwhile, account for about 20%of the water supply market; and the rest is accounted for by the private utilities, cooperatives, and other independent providers. Despite the sizeable share of LGU water utilities in the water supply market, their performance is characterized not only by slow expansion but also by poor quality of services, high levels of non-revenue water (NRW), and dependence on government subsidy. The LGU-run systems, based on a benchmarking study conducted by the Department of Interior and Local Government (DILG) in 2008 1, are deemed the poorest performers among the WSPs given that they have the: 1 Based on the results of the Performance Benchmarking of Small Towns Water Supply: Enhancing Performance in the Delivery of WATSAN Services, Water Supply and Sanitation Program Management Offi ce, Department of Interior and Local Government, 2008. 1

lowest average service coverage; shortest water availability per day; least amount of water delivered to consumers; lowest average tariffs charged per cubic meter; lowest revenue collection effi ciency; highest average operating ratio; highest staff/1000 connection ratio; and very low capital per expenditure connection. The dismal performance of public utilities especially LGU-run systems is attributed to lack of technical and managerial capacity, lack of access to fi nancing for WSS development, and dependence on subsidies, which are often episodic. These problems are compounded by the weak regulation in the sector characterized by institutional fragmentation and lack of performance standards and targets to gauge the effi ciency and effectiveness of water service operations; inadequate guidelines on compliance and enforcement of performance standards and targets and dissemination thereof; and insuffi cient capacity to enforce regulation and monitor compliance. There is also a need for key performance indicators to guide the provision of water services and incentives to promote good performance. In August 2008, major stakeholders in the waterworks and sewerage system (WSS) sector agreed to push for a regulatory reform agenda to address these issues. The reform agenda envisioned to promote efficiency, drive service improvements and coverage expansion and also bring to fore other concerns related to lack of information, resource sustainability, health, and sanitation. The agenda also underscored utility reform to address ownership, governance, and resource issues hindering the performance of WSPs particularly the water districts and LGU-run utilities. It also emphasized the need to tie up fi nancing with regulatory, governance, and performance reform. The reform agenda reinforced institutional, capacity building and fi nancing initiatives outlined in the Philippine Water Supply and Sanitation Roadmap. Utility reform measures such as ring-fencing, benchmarking, business planning and performance contracting have been introduced as part of capacity building and performance improvement glide path for WSPs. 2 Among these reform measures, internal performance contracting of service delivery that is, forging of performance contracts involving the internal management of the utility or outsourcing with public or privately owned utilities has been recommended as an option for LGUs or other WSPs to strengthen accountability and motivate excellence. While not an entirely innovative concept, performance contracting has yet to be widely introduced and implemented in water service provision. Hence, this guide on performance contracting is envisaged to inform and promote the implementation of this scheme, primarily targeting LGUs and water districts with the aim of improving the performance of public-sector entities. The succeeding sections provide an overview of performance contracting involving public-sector entities; present experiences and lessons from cases studies; and outline the requirements and procedures for parties willing to engage in internal performance contracting. 2 Guidebooks related to ring-fencing, benchmarking and business planning developed with assistance from the World Bank-Water and Sanitation Program and USAID Philippine Water Revolving Fund Support Program, respectively, are available to aid utilities in adopting and implementing these measures. 2

2. OVERVIEW OF PERFORMANCE CONTRACTS 2.1 What is a performance contract? A performance contract is a negotiated agreement between the owner of a public utility (for example, a local government unit or a water district) and another entity to undertake specifi c actions, meet targets to improve performance within a fixed time frame and provide incentives for achieving the targets. The utility owner s contracting party may be its management or implementing unit (WSS operator or staff) or an unrelated party (a private-sector entity or another publicsector entity). Within the utility, the senior management may also contract out service performance to its specific unit, branch, or zone managers. 2.2 Why use a performance contract? Public utilities carry out several functions and have multiple principals and objectives. Most often, their numerous functions are not matched with the required capacity and resources. Hence, they are usually unable to fully undertake these functions and meet objectives. Some public utilities are also affected by changes in the political administration, thus, have short-term plans and poor governance. 3

The use of a performance contract is one way of ensuring stability in the operations of a public utility and focusing its performance of specifi c undertakings. It helps establish a commitment regarding performance objectives, measurable targets, aligned incentives and required resources, especially if important stakeholders, such as the economic regulator, are involved during design, and if the agreement is made public. In the case of water services, performance contracts have been used in developed and developing countries to improve service levels and quality, reduce NRW, improve billing and collections, and extend services to the poor, among others. Performance contracting improves transparency and clarity in operations, fosters better partnership and commitment among involved parties, and facilitates monitoring of performance. A performance contract benefi ts all involved parties from owners and to operators, managers and clients of water utilities being a tool that improves oversight of service delivery and pushes for measurable targets and time-bound results (See Table 1). Table 1. Benefits to Contracting Parties and Clients Utility Owner/Management (Government/LGU) effective means to delegate responsibility and accountability Implementing Unit (WSS Operator/ Staff) helps provide clarity and stability to the utility s operations given that objectives are clearly defined Clients/Customers spells out transparency, responsibility and accountability in operations of the water utility provides the basis for specific time-bound results and regular and focused reporting motivates performance since incentives are tied to delivery of outputs improved water services improves oversight of service delivery aligns resources (e.g. personnel, expertise, funds, etc.) with objectives, ensuring that management has the resources needed facilitates monitoring of water utility s performance of water utility helps define and align objectives so that both parties work towards the same goals facilitates monitoring of activities facilitates monitoring of performance The processes involved in performance contracting from conduct of due diligence, negotiating the contract, defining performance objectives, setting targets, and identifying the resources required to meet the agreed objectives put pressure on the concerned parties to improve performance. The contract monitoring process, including required reporting and periodic performance measurement, further helps to sustain this pressure. 2.3 Types of Performance Contracts Contracting arrangements vary based on: a) risks borne by utility owner and contracting party, b) objectives, c) responsibilities of parties, and d) features including the terms and conditions of the agreement and have varying degrees of effectiveness. Contracts involving a greater shift of risks from the utility owner to an independent party (outsourced 4

arrangement), for instance, will have higher performance achievement. More resultsoriented contracts can also lead to better performance improvement. Contracts with monetary incentives are usually more effective than those without monetary incentives. 3 Performance contracts can be classified into internal or in-sourced and outsourced agreements based on the nature of the utility owner s contracting party. 2.3.1 Internal (In-sourced) Contracting Arrangements An internal contracting arrangement involves the owner or board of directors (BOD) of the water utility and its management, or its management and its concerned units or branches. Under most circumstances, such an arrangement is between unequal parties and not necessarily legally binding. The utility owner or BOD may enforce the agreement to improve oversight, delegate responsibilities, and monitor staff performance. Most often, such contracts form part of a management strategy to define responsibilities vis-à-vis key results, the utility s incentive or compensation package and monitoring and supervision system. Internal contracting arrangements: are focused on specified performance targets being contracted; are easy to monitor since personnel and records are within the utility; have terms and conditions that can be easily renewed with revised terms and targets; and enable the owner, being the superior party,to easily impose sanctions and terminate the contract. 2.3.2 Outsourced, Formal Contractual Arrangements 4 An outsourced contractual arrangement, on the other hand, is a legally enforceable agreement between unrelated parties where the owner of the utility transfers or delegates service provision responsibility. An unrelated party may be a private-sector entity or another public-sector entity. There are several types of formal contractual arrangements for water supply operations, usually involving public-private partnerships (PPPs). They vary depending on the nature of responsibility being contracted, agreement on ownership of capital assets, accountability for investment, assumption of risks, and duration of the contract. Thus, a formal contractual arrangement can range from short-term simple management contracts (with or without investment requirements) to long-term and very complex, sophisticated BOT form, to concession. These types of arrangements are based on legal issuances (laws and executive orders). Table 2 sums up the features of various types of outsourced contracting arrangements. 3 John Sitton. Using Performance Agreements to Improve Water Sector Performance in the Philippines. Final Report, PWRF-SP, November 2009. 4 For further reference on outsourced contractual arrangements, see laws and issuances in Appendix A; examples of outsourced contractual arrangements in the Philippines in Appendix B; and the following links: ppp.gov.ph; rru.worldbank.org/documents/toolkits/water/water_full.pdf www.adb.org/.../handbooks/public-private-partnership/default 5

Table 2. Types of Outsourced Contractual Arrangements Objective Who owns capital assets? Who pays for capital investments? How is the contractor paid? How are risks shared? Typical contract duration Management Contract Management of services Design-Build or Turnkey Construction of a facility; turn over facility after completion Lease Operation and maintenance of the facility Concession Building, operation and maintenance (O&M) of assets and financing and investment management LGU/WD LGU/WD LGU/WD LGU/WD ultimately retains ownership LGU/WD Contractor LGU/WD Contractor Fixed fee + bonusoperating expenses LGU/WD bears commercial risk Fixed fee- investment Contractor bears construction risk; LGU all others Revenues-O&M-lease fee Contractor bears commercial risk Revenues-O&Minvestment costconcession fees if any Contractor bears construction, commercial risks 5 years 2-5 years 15-30 years 25-50 years 2.4 The Contracting Parties: Water Utilities and Staff In the Philippines, there are two public entities that can engage in internal performance contracting for water service provision. These are the local government units (LGUs), which run their own water systems, and the water districts (WDs), which are classifi ed as government-owned and controlled corporations (GOCCs). 5 (See Annex 1 for a detailed description of their legal mandates and governance structure.) 2.4.1 Local Government Units The Local Government Code of 1991 vests the responsibility of ensuring water supply and sanitation service provision to the LGUs. LGUs have used various service provision models, such as those through third party providers (creation of water districts, use of community-based operators, and concessions) or through forced account or directly managed utilities. The latter are typically treated as part of the overall operation of the city or municipality. LGU-run water utilities have no uniform organizational structure. The mayor sets policy direction and directly supervises the utility manager who is often the Municipal Engineer or the Municipal Planning and Development Coordinator (MPDO). The Municipal Engineer or MPDO, together with other LGU employees such as the accountant and treasurer who share their services with the utility, usually comprise the water utility staff with contractual or job-order employees for technical support and bill collection. LGUs have legal autonomy that precludes involuntary control from most nationallevel agencies. Thus, a possible internal contracting agreement will be between the mayor and the utility staff, subject to approval or endorsement by the Sangguniang Bayan (SB), which is the legislative body of the LGU. A committee of the SB can also be set up to mediate any disputes that might arise between the contracting parties. If the LGU opts to be regulated by the National Water Regulatory 5 As GOCCs, they are covered by COA audit, Civil Service rules and regulations, the Salary Standardization Law and government procurement guidelines. 6

Board (NWRB) on consensual basis, the latter can provide the regulatory guidelines and performance standards to serve as basis of the performance contract. Figure 1 shows the possible internal contracting arrangement within an LGU involving the mayor or its water utility staff. 2.4.2 Water Districts Presidential Decree 198 or the Provincial Water Utilities Act of 1973 authorizes the creation of water districts. By virtue of the law, WDs are under the supervision of the Local Water Utilities Administration (LWUA). WDs operate as autonomous Figure 1. Possible Contracting Arrangement within the LGU Performance Contract Approval, Dispute Mediation Sangguniang Bayan (SB Council) NWRB Mayor Performance contract Water Utility Staff Regulatory Guidelines/ Performance Standards corporations that rely entirely on their revenue stream to leverage capital funding and defray operation and maintenance costs. 6 Most water districts maintain a professional staff, with core knowledge of the technical aspects of the utility s operation, accounting, and fi nancial management. The management and staff have secure tenure, meaning their composition does not change with changes in the political administration. The corporatized structure of the Water District lends itself better to internal performance contracting. There is a clear delineation of the policy setting and oversight, as well as of management. There is stability in the organization structure and there are dedicated resources. There are two possible performance agreement schemes for WDs: one is between its BOD and its general manager; the other is between the general manager and the WD staff. Dispute mediation may be done by an agreed independent adjudicator or expert panel for the first scheme or by the BOD for the latter scheme. LWUA has the authority under PD 198 and EO 279 to set regulations or require graduation plans. Hence, it requires the implementation of performance agreements. It also has the authority in its role as fi nancier to require, as part of the loan, WDs to adhere to certain targets. Figure 2 shows possible contracting arrangements for WDs. 6 Water districts have no national government equity, nor are they entitled to national government transfers from internal revenues. 7

Figure 2. Possible Contracting Arrangements for Water Districts BOD Performance Contract & Approval, Dispute Mediation LWUA General Manager Performance contract WD Staff Regulatory Guidelines/ Performance Standards 2.5 Case Studies and Lessons Learned Performance contracts involving the internal management of the utility have been recommended as an option of LGUs or WDs to promote governance and improve water utility performance. Unlike outsourced arrangements, performance contracting within the water service utility has yet to be widely introduced and implemented in the Philippines. Such arrangement has been recently tested by pilot LGUs in the country under the assistance of the USAID-Philippine Water Revolving Fund Support Program (PWRF-SP). Developing countries like Uganda and Lesotho have adopted this scheme and have seen positive results from it. 2.5.1 Case Study 1 - Improving Production, Revenue Generation, and Quality of Service of the Jagna Waterworks System Profile of the Utility. The Jagna Waterworks System (JWS) is a water utility established in 1925 and run by the LGU of Jagna in the Province of Bohol. The utility is registered with the NWRB and is licensed to provide water supply services to the municipality. At present, the utility s service coverage is about 27.7% of the municipality s total population. Water supply services are provided to 11out of 33 barangays. 8

Jagna is fortunate to have abundant supplies of water with excellent quality. Most of the spring sources are naturally located at an elevation higher than the service area, so that water can be distributed to the consumers by gravity alone, thereby saving pumping costs. Problems Faced by the Utility. Being one of the municipality s economic enterprise programs, JWS is expected to operate autonomously using its own organization and resources. An assessment of its current situation, however, has revealed a need for: organizational change; investments in physical as well as in human assets, improvements in management systems, securing water resources, improving provision of services to more citizens, and generating adequate revenues to position itself for long-term operability. Aside from the poor service coverage, the utility lacks basic facilities such as fi ltration and water treatment facilities, mother meter, leak detection devices, and a calibration machine for flow meters, among others. Its decrepit pipe network accounts for its huge non-revenue water (NRW). During the rainy season, water turbidity is also experienced due to the uncovered water channels from the spring source. Target/Objective a) to upgrade the waterworks system in order to maximize production capacity and increase service connections b) to account for water consumption in order to increase water sales and improve billing efficiency c) to improve water quality and ensure its potability and safety d) to improve the quality of customer service e) to improve the utility s revenue-generating capacity Activities Although the water utility is able to raise funds to cover its operations, it remains heavily dependent on subsidies from the LGU s annual budgetary appropriation and internal revenue allotment. Tariff is set through a municipal ordinance with its attendant public hearings and consultations. Current tariff, however, is still the lowest among other municipalities in the province. Moreover, while staffmembers are generally dedicated, the quality of personnel has suffered due to insecurity of tenure, low salaries, lack of skills training, and political interference in hiring practices. Key Terms of the Agreement. Driven by the vision and mission to provide its population with suffi cient potable water and become a self-sustaining water utility, JWS agreed to be a pilot for utility reforms with the assistance of the PWRF-SP. After ring-fencing its water utility accounts, it conducted business planning and prepared its performance improvement program (PIP) to address the utility s problems. With the PIP as basis, the utility staff and the mayor entered into a performance contract to undertake priority activities to be funded by the LGU and accomplished within one and a half years (from July 2011 to December 2012). The key activities include: rehabilitation or replacement of old pipes, rerouting of submerged pipes along canals and drainage, expansion of spring box and construction of bigger reservoir installation of water meters and stub-outs in all service connections, including public taps and institutions installation of chlorinator and disinfection of water throughout the distribution system acquisition of a service vehicle, upgrading of tools and equipment, computerization of customer ledger cards and database, and establishment of strategic collection centers implementation of better financial management measures and imposition of new water tariff 9

Annex 2-1 shows the specific targets and timeframes of the above activities. A mid-year assessment shall be conducted in August to evaluate accomplishments vis-à-vis targets. An annual assessment and business plan review should be carried out in February. The annual assessment and review shall be attended by all JWS staff, the LGU local fi nance group, the Municipal Water Board, the Sangguniang Bayan, and the Mayor. Incentives. The contract is based on performance with incentives to be provided for accomplishment of defi ned and agreed milestones. As a government agency, provision of incentives is bound by certain policies and conditions, for example, personnel services limitation and availability of funds (see Annex 3). Both parties agreed to the following incentives: a) training of the JWS staff on water utility operation and maintenance (including NRW management) (a big brother type of arrangement with another utility will be facilitated); b) awards and recognition, and c) exposure visits or out-of-town trips based on accomplishment of performance targets. Incentives will be funded from the LGU s General Fund allotment for training and travels and maintenance and other operating expenses (MOOE). Results/Benefits. Performance contracting between the JWS staff and the mayor facilitated the assessment of the state of the utility and identifi cation of specifi c areas needing reforms and improvement. It has defined and delegated responsibilities to implement planned reforms, ensured funding for reform initiatives with the endorsement of the Sangguniang Bayan (for both the business plan and the performance contract) and provided a transparent basis for monitoring activities to improve water utility performance. Performance contracting also incentivized the staff to undertake assigned responsibilities. Mayor Fortunato Abrenilla of Jagna, in his latest testimonial, said that: The reform process has already delivered benefi cial results to the JWS. Key performance indicators monitored showed that our utility has increased its revenues by 34% due to improved collection effort, which has shortened collection period from 1.5 months to 0.57 months. Return on assets has also increased from 2.6% to 7% and average cost per cubic meter has been reduced from PHP4.74 to PHP3.79. We have also substantially reduced our subsidy to the utility by 32%. Currently, the JWS is still facing challenges in its operation. But with a good performance monitoring scheme stipulated in our performance contract with the JWS staff, we will be able to further institute required reforms towards the effi cient delivery of water services to the people of Jagna. 2.5.2 Case Study 2 - Improvement of the Mahayag Local Waterworks System (MALOWAS) for Better Service Provision and Revenue Generation Profile of the Utility. The Mahayag Local Waterworks System (MALOWAS) was established in 1972 through the grant-in-aid from the government. While a number of improvements were made possible by local development funds as well as allocations from the Countrywide Development Fund since its establishment, the present condition of the waterworks system does not effi ciently serve the needs of the area s residents. Although MALOWAS has abundant water supply, only 1,524 (or 21%) of the total 7,276 households in ten lowland barangays are covered by level III systems. About 52 level II connections have been established with an average of fi ve households per communal faucet. The utility plans to expand its service area to six more barangays, bringing water services to a total of 17 barangays. The LGU secured a PHP28 million loan in 2007 to rehabilitate and improve the existing waterworks system and another PHP2 million from a rural bank for the installation of laterals and stub-outs, including the transfer of old service connections to the new system. Problems Faced by the Utility. Despite the loans, the current state of the utility is far from ideal. More facilities, such as a chlorinator and a fl ow meter, have to be installed. The water supply system (both 10

old and new facilities) has yet to be fully integrated. Worn-out pipes are major sources of leaks and make the water supply prone to coliform contamination. There are unmetered and unbilled connections like public taps in government facilities (market, schools, barangay halls, health centers, and offices) resulting in a high volume of unaccounted-for water. While the utility is manned by mostly regular staff, enhancements are needed in the areas of customer service, billing procedures, and recording systems as evidenced by consumers complaints about billing errors and slow response to minor repairs. Customers who are not yet connected to the new system continue to be billed the fl at or old tariff rate while those connected to the new system are charged new tariff rates, causing confusion and inconsistencies in tariff collection. As a consequence, there is a significant volume of accounts receivables and a long collection period equivalent to nine months. Utility operations therefore continue to be highly subsidized. Key Terms of the Agreement. The need to become a viable and self-sustaining utility prompted the LGU to improve the operations of MALOWAS in order to provide better and sustainable water supply services to its constituents and improve revenue generation to pay its debts. The LGU took the opportunity of being a pilot utility under PWRF-SP to pursue fi nancial and operational reforms. As a pilot utility, it ring-fenced its water utility accounts, which has allowed it to calculate the fi nancial losses being subsidized by the LGU and increased the latter s resolve to pursue reforms. The utility staff underwent training in business planning and developed its business plan and performance improvement plan (PIP) thereafter. The mayor and the utility staff agreed to enter into a performance contract for a period of two years (July 1, 2011 to June 30, 2013) to focus the LGU s limited resources on performing the following priority activities in the PIP: Target/Objective a) to upgrade the distribution network in order to match the increasing demand for service connections b) to account for water consumption, increase water sales, and improve billing efficiency c) to improve the efficiency of the water supply system and assure better service provision Activities pipe- laying in identified barangays installation of water meters and stub-outs in all service connections including public taps and institutions transfer of all service connections to the new distribution system d) to increase revenue generations phase out of the flat- rate and implementation of the approved new tariff rates Annex 2-2 shows the performance contract of the MALOWAS staff with their mayor. A monitoring and review team was formed consisting of the Municipal Planning and Development Offi cer, the Chairman of the SB Committee on Ways and Means, the Chairman of the SB Committee on Appropriations, the Local Finance Committee and two representatives from the Local Development Council. Review of implementation progress and accomplishment of targets by the Mayor and the monitoring and review team will be done every six months until the expiration of the contract in 2013. Incentives. Both the mayor and the MALOWAS staff agreed to have incentives for performance of defi ned tasks within specifi ed timeframes. For accomplishment of targets six months after the contract takes effect, the staff will be trained in technical/capacity building related to the operation and management of a water utility system. The LGU will arrange the training with a water district in the country with distinct competence on the subject. Exposure or study visits to highly specialized WSPs in the country will also be conducted for accomplishment of the following year s target. For achievement of targets leading to improved income generation, staff will be awarded a plaque 11

of appreciation. Funding for all the incentives will be appropriated from the LGU s General Fund allotment for training and travels and MOOE. Results/Benefits. The performance contract forged between the MALOWAS staff and the LGU management provided both parties a transparent guide to the implementation of priority reform initiatives in water service provision. The contracting process secured the full support of the mayor for the required financial and technical assistance to facilitate the performance of the activities indicated in the contract. Aside from ensuring mutual cooperation between the mayor and the water utility staff, performance contracting also provided the platform for information exchange to ensure the timely performance of activities agreed upon under the contract. The provision of incentives also encouraged the staff to strive for the successful completion of their target activities. Mayor Lorna S. Espina of Mahayag acknowledged the benefi ts of the reform initiatives undertaken by MALOWAS as a pilot utility. She noted that they now have a basis for fi nancial analysis of water utility operations and have improved their collection effi ciency by 14%. We now have a guide in pursuing strategies and allocating investment requirements to increase the coverage & and improve service delivery of our utility. Embarking on performance contracting especially helped us improve enhance the transparency in our water utility operations and monitor related civil works and fi nancial transactions. These reforms have paved the way towards our utility s fi nancial viability. 2.5.3 Case Study 3 Performance Contracting to Reduce Subsidies for Water Service Operations in Alburquerque Profile of the Utility. The Alburquerque Waterworks System (AWS) was established in the 1940s and is currently run by the Municipal Government. Through the LGU s initiative, the utility underwent major expansion and rehabilitation in 2004. The AWS is responsible for providing potable water to all 11 barangays of the municipality. At present, the utility has 1,188 active level 3 service connections. Water sources include spring sources and groundwater. Problems Faced by the Utility. The AWS has suffered major setbacks, especially during the last three years. All water samples from each of the 11 barangays failed the bacteriological test because of the absence of water chlorinators. Water availability in all barangays averaged only 16 hours per day and there were occasional service interruptions particularly in the upland barangays. The problem is attributed to old and worn-out distribution lines (some of which were installed in the 1960s), the use of substandard diameter pipes, and insufficient water sources. The volume of unaccounted-for water is high since there are no water meters installed in public facilities such as public markets, the municipal hall, the municipal health offi ce, and the police station. The utility personnel are inadequate. There is a lack of full-time staff to manage the offi ce. There is also a need to hire more job-order workers to serve as support staff for the Waterworks Supervisor or Manager who is at the same time the Municipal Engineer. The utility generates income from the water tariffs. However, the rates are low and collection effi ciency is only 88%. Income derived is only about PHP1 million annually compared to the cost of operation (covering salaries and wages of personnel, power cost, and other operating and maintenance cost) that amounts to PHP2.7 million annually. Given the fragile monetary position of the municipality, improving the fi nances of the AWS is one of the top concerns of both the water utility and the LGU. Key Terms of the Agreement. The LGU envisions having a well-developed and managed water utility under an effective, effi cient governance, sustainably providing safe potable water to its citizenry. Consistent with this vision, the LGU agreed to be a pilot utility under the 12

PWRF-SP. As with the other pilot utilities, the AWS staff completed the ring-fencing of their water utility accounts, embarked on business planning, and proceeded to performance contracting to improve the utility s operations and revenue-generating capacity. The performance contract between the mayor and the AWS staff is focused on accomplishing the following priority activities within one and half years from July 2011: Target/Objective Activities a) to intensify the collection of overdue accounts issuance of disconnection notices to customers with overdue accounts and disconnection of customers with unpaid overdue accounts 5 five days after disconnection notices were served b) to improve the tariff structure categorization of water users, conduct of tariff analysis and consultations, issuance of ordinance on the new tariff structure, and implementation of new tariff rates c) to decrease incidence of water-borne diseases to 50% by 2012 installation of chlorinator, conduct of water testing and analysis, and regular chlorination d) to rationalize the use of electric water pumps construction of elevated reservoirs e) to improve the utility s water revenue revenue-generating capacity improvement of collection efficiency improved from 88 % to 90%, shortening of collection period from 3.7 to 3 months, and improvement of operating ratio from 113 % to 100% The detailed terms and conditions of their performance contract are found in Annex 2-3. Incentives. The mayor and the AWS staff agreed to adopt an incentive system for accomplishment of performance targets indicated in the contract. The incentives include training or capacity building, awards and recognition, and exposure visits or out-of-town trips, and will be based on whether specifi c targets have actually been met. Results/Benefits. Part of the performance contracting process is getting buy-in from the mayor and the SB to adopt the activities stated in the contract. While the process was a tedious one involving several meetings and workshops, it prompted the LGU management and the SB to pursue the priority PIP activities and provided the basis for budget allocation for these activities. The performance contract also facilitated the delegation and monitoring of activities intended to improve the operations and revenue-generating capacity of the AWS. Mayor Efren Tungol of Alburquerque remarked: The utility reform process was an eye opener to us. We realized how big our subsidy to the utility is every year. It was a shock to know that we have been operating a losing enterprise for almost two decades already. Embarking on utility reform has strengthened our resolve to improve our water utility operations. Performance contracting has especially facilitated the move to increase our water tariff to support reforms. It is now on its second reading at the Sangguniang Bayan and we have conducted the fi rst public hearing on this proposed increase. 2.5.4 Case Study 4 - Area and Branch Performance Contracts in Uganda 7 Profile of the Utility. Water supply services in Uganda, Africa are provided by the National Water and Sewerage Corporation (NWSC). NWSC is fully owned by the Government of Uganda. It was established in 1972. The corporation s mandate as defi ned in the National Water and Sewerage Corporation Statute of 1995 is to operate and provide water and sewerage services in areas entrusted to it, on a sound, commercial, and viable basis. The NWSC operations were initially in three towns. Currently, it serves 22 towns encompassing the larger urban centers within Uganda. 7 John Sitton. Using Performance Agreements to Improve Water Sector Performance in the Philippines. Final Report, PWRF-SP, November 2009. 13

Problems Faced by the Utility. In 1998, the NWSC reported that its water supply operations were dismal, as evidenced by the following facts: only three cities were breaking even fi nancially, revenue collections were low and customer arrears high, and volume of unaccounted-for water was 60%. Key Terms of the Agreement. To improve performance, the NWSC began a series of service and revenue enhancement programs in 1999. In 2000, it introduced Area Performance Contracts between its headquarters and area managers. These increased the autonomy of the area managers, encouraged a commercial orientation and began focusing on results and outputs. The contracts were later revised to add incentives to motivate the staff. In 2004, the introduction of in-sourced competition, which invited all staff to compete for the management of NWSC s subsidiary utilities, showed the present management that it did not have a monopoly on running its business units. This induced better performance among the managers and eased out poor performers. The top managers also delegated responsibility to branch management in the larger cities by implementing Branch Performance Contracts, which offered rewards based on performance. Key contractual arrangements between the NWSC Headquarters and the area management team include: Scope and definition of responsibilities Performance Measures Operator s obligations: Operations and maintenance; billing and collection; preparation of a one-year rolling business plan, safeguard, maintain assets; rehabilitation, extension of the system, recordkeeping and reporting. Headquarters obligations: bulk procurement, major capital works, coordination of area business plan with company-wide budget and tariffs, provision of strategic support and guidance, monitoring and performance evaluation, non-interference in area management, inspection and audit Water balance indicator, operational indicators, service indicators and financial indicators. Indicators are weighted with cash operating margin (12), unaccounted-for water (10) and billing (10), and collections (9) having the highest weightings. The duration of the contract is two years, which may be re-negotiated and renewed. Funding is based on a one-year rolling business plan prepared by the area management team, which the Headquarters coordinates with company-wide budget and tariffs. Fees and Incentives. The area management team receives a management fee consisting of a base fee, performance fee, and incentive fee. The base fee is a pass-through of O&M costs that are outside the management s control. The performance fee covers performance-related costs: those that management can control, or those that are discretionary and tied to collection effi ciency. The incentive fee is paid if management performance exceeds agreed minimum performance standards. Penalties apply if the performance falls short of the minimum performance standards. Results/Benefits. The contracting scheme between the NWSC headquarters and its area management units had been very benefi cial. Within 10 years, there were substantial improvements in NWSC s water services. Service coverage increased from 48% in 1998 to 72% in 2008 (see Table 3). The number of connections increased by almost 300% (from 50,826 to 202,559) with new connections averaging 25,000 per year. Staff effi ciency considerably improved from 36 per 1,000 connections to seven per 1,000 connections. Collection efficiency now stands at 92% and non-revenue water at 32.5%. 14

Table 3. NWSC Performance Improvement 1998 2008 Service Coverage 48% 72% Connections 50,826 202,559 New connections per year 3,317 25,000 Staff per 1000 connections 36 7 Collection efficiency 60% 92% A more detailed description of the terms and conditions and incentive structure of the performance contract are found in Annex 2-4. 2.5.5 Case Study 5 - Contracting with the Utility Management in Lesotho 8 Profile of the Utility. Water and Sewerage Authority (WASA) is owned by the Government of Lesotho in Africa. Established in 1992, WASA currently delivers potable water to more than 300,000 people.it provides safe drinking water to approximately 47,000 postpaid connections and approximately 400 public standpipes. There are also more than 2,500 domestic prepaid connections and more than 2,200 communal prepaid card holders. The Authority also serves many industrial and commercial premises, particularly in Maseru, including Nien Hsing, C&Y, Global Garment, and Lesotho Brewing Company, which use about 36% of the water produced. In total, 40% of the water produced is used in industries and commerce. WASA has over 5,000 customers who are connected to the sewerage system. Over and above the said connections, the Authority operates a tanker service that serves more than 8,000 registered customers in all of the country s urban centres. The emptying service is provided to households and businesses in areas that have a reticulated water supply but do not have access to piped sewerage. The tankers are used to empty septic and conservancy tanks, including VIP toilets. Problems of the Utility. In 2004, the utility had fi nancial problems and had diffi culty expanding its services. The government availed itself of World Bank assistance to improve WASA s operations. Key Terms of the Agreement. WASA (represented by the Ministry of Finance and Development Planning), entered into a three-year performance agreement with its management (represented by its Chairman of the Board and the chief executive), the operator, as a loan condition under the World Bank project. The key objectives of the agreement were to: establish key fi nancial parameters, tariffs and levels of service necessary to achieve the agreed level of fi nancial sustainability by the end of the period, identify and register all WASA assets and describe their condition, improve water and wastewater service levels, including the implementation of systems and procedures for proper measurement, and establish a mechanism for period reviews of the tariff necessary for WASA s long-term sustainability. Key contractual arrangements between the government and the WASA management include: 8 Ibid. 15

Scope and definition of responsibilities Operator s obligations: to strive to achieve service levels set by GOL government policy; to improve the utility s financial health of the utility; to optimize asset performance of its assets; to improve planning and management of capital works; to improve human resource management; to maintain the appropriate level of staffing; to develop a strategy to implement the Government s policy on service in peri-urban areas. 16 Performance Measures Government s obligations: to permit full commercial freedom to WASA; to carry out a tariff study, revise regulations and carry out periodic tariff revisions to enable WASA to recover its operating and financing costs; to revise its water resource strategy to ensure sufficient water supply and to enable WASA to achieve its performance targets; to permit WASA to disconnect any Government agency for non-payment without interference from another government agency; to develop a policy for providing services to peri-urban areas and to allocate funding from World Bank loan to procure services, goods, and equipment needed to achieve the performance targets. Include targets in the following areas: customer service, water resource management, corporate strategy, operations optimization and finance. Performance was assessed by a Technical Auditor appointed by the Commissioner of Water within the Ministry of Natural Resources. (The agreement indicates that this role would have been performed by an economic regulator had one existed.) The contract s duration was three years, renewable with revised terms and targets after the third year based on WASA s performance. A business plan was prepared during the development of the agreement which was updated annually. Financing from the World Bank loan was linked to specifi c procurements intended to enable WASA to achieve its objectives. Incentives. Management was paid an incentive fee or bonus based on performance. The annual incentive fee was calculated using a formula, so that any individual performance that does not hurdle the passing rate reduced the overall award (see Annex 2-5 for details). However, no penalties were applied. Results/Benefits. Having improved WASA s financial standing and increased services to peri-urban areas, the agreement facilitated improvement in the Authority s operations. In terms of incentives, the contract produced mixed results, with management receiving 76.8%, 66%, and 80% of their incentive bonus in the fi rst, second, and third years, respectively. 2.5.6 Lessons Learned Results from the preceding experiences attest to the merits of performance contracting. Performance contracting has improved water supply services through expanded coverage and better operational and fi nancial systems. It has relieved the utility owners (either national or local government) of the burden in water service operations, enabled them to generate more revenue, and reduced political influence on decisions regarding water service provision. For the managing or implementing parties, performance contracting not only meant getting incentives but also gaining professional mileage and fulfi llment in serving customers interests. There were also challenges faced in implementing performance contracts. Foremost was the need to generate the required budget to implement the agreed activities and meet targets. Most often, the implementing unit s capacity to implement the activities for improved performance also required capacity building or staffi ng complement. Some parties were also resistant to increases in the cost of service (tariff) and a certain degree of political infl uence affected contracting arrangements. The key to successful implementation of contracts, however, was the strong political will of the government entity and the support of the utility s management and other stakeholders. Extensive advocacy on the advantages and potential benefi ts of performance contracting also helped. As regards the contracts, the following guidelines helped the utility in presenting clear activities and targets: The contract should be complete, simple, and easy to understand; All key words in the contract should be clearly defi ned; Contracting parties need to take time to think through the objectives, terms and conditions and targets; and Some fl exibility, especially for the first contract (or if initial data is unreliable), should be allowed.

3. PREREQUISITES OF PERFORMANCE CONTRACTING Utility reform involves a series of interventions (see Figure 3). The last step in these series of interventions is performance contracting. Two major activities, ring-fencing (specifi cally for LGUs) and business planning, are undertaken prior to performance contracting to ensure identifi cation of the performance improvement program. 17

Figure 3. Utility Reform Glide Path 18 3.1 Ring-fencing of Utility Accounts Ring-fencing entails the segregation or isolation of the water utility s transactions from the general account of the LGU. The rationale behind ring-fencing stems from the lack of reliable fi nancial and operating reports, which makes it difficult to set the appropriate tariffs and plan for appropriate service improvements. It is common practice for LGUs to combine the costs of their water and sewerage services with those of other municipal services. For instance, staff may work across different departments. Vehicles and other assets may be pooled and used across different services. Revenues also may flow into a general municipal fund. In these situations, determining the actual cost of providing service and monitoring fi nancial performance from one period to another can be extremely diffi cult. Thus, it is inappropriate to enter into performance contracting without ring-fencing the water utility accounts and physically/organizationally ring-fencing its operations. Ring-fencing will enable the concerned parties to have suffi cient information to evaluate the agreement during negotiations and to monitor performance so that the utility has adequate control over the resources needed to meet its commitments. Ring-fencing involves the following steps: establishing and maintaining separate books of accounts and fi nancial statements; opening a separate bank account; formulating and implementing ring-fencing fi nancial management guidelines; realigning and defi ning duties and responsibilities of the water utility staff; and transferring control and responsibility for staff and assets. For a more detailed discussion of ring-fencing, please refer to the Guide to Establishing LGU- Run Water Utilities as Economic Enterprises, PWRF-SP, 2011. 3.2 Development of Perfomance Improvement Plan/Business Plan After ring-fencing, the next step in the utility reform glide path is business planning. It helps water utilities determine the required technical operations and fi nancing needs, including tariff levels and collections, and quantify and schedule capital investments in a sustainable manner. The preparation of a business plan will help the utility management and staff in making rational decisions related to the levels and types of service provisions. It will also ensure the effective use of the utility s resources through clear fi nancial planning.

The business planning process entails a) strategic planning, which quantifi es the strategic goals identifi ed and agreed upon by stakeholders, and b) preparation of the Performance Improvement Plan (PIP), which translates these goals into a set of concrete and measurable actions. The strategic planning process defines the utility s vision, sets longrange goals and areas of primary focus to identify key performance indicators, and spells out the broad actions needed to achieve longterm performance improvement. The process establishes the utility s core priorities and sets the guidelines for future managerial decisions in the business planning process. The preparation of the PIP will set the specifi c targets for each broad action agreed upon in strategic planning. The PIP will have the following elements: Statement of Specifi c Action Strategic Goal Addressed Description of Primary Actions Schedule of Tasks and Milestones Application of Investment Capital Measurable Improvement in Performance The PIP is used as the basis for the performance contract to be forged between two concerned units: the mayor or the general manager and the operator or implementing unit or staff. (See Tables 4 and 5 for sample PIPs.) Table 4. Example of a Performance Improvement Plan 19

Table 5. Example of a Performance Improvement Plan 20

9 Ibid. In business planning, it is important to involve both the a) management team composed of the Water Supervisor and members representing the utility s key units (including operations and maintenance, customer accounts management, and general administration and fi nance), and b) the Policy Governing Body that will ultimately approve the business plan and the PIP. The Strategic Business Planning for LGU- Run Water Utilities: Guide and Model for Preparation of Business Plans, PWRF-SP, 2011 provides an instructional process of conducting strategic planning and preparing the PIP for LGUs. For water districts, refer to the Strategic Business Planning for Water Districts: Guide and Model for the Preparation of Business Plans, PWRF-SP, 2010. 3.3 Key Requirements 9 Once the water utility s fi nancial accounts have been ring-fenced and the PIP has been prepared, the concerned units are ready to enter into performance contracting. There are key requirements for the parties to enter into performance contracting to ensure that the contract will be effectively implemented. These key requirements include: Trust between parties. The utility owner or management and the utility staff do not enter into performance contracting negotiations as equal partners. The former has more control over the resources required to achieve the target activities. In order for both parties to negotiate in good faith, there must be a reasonable level of trust that will prompt each of them to perform the role agreed upon. Ability to enter into an agreement. Both parties must have the authority to bind the government suffi ciently to meet the commitments made. Willingness to enter into an agreement. Both parties should be genuinely willing to enter into a performance contract and both should see some value in the agreement in order to commit to its performance. Ability to adequately defi ne the scope of the agreement. For a performance contract to last, the parties must have a common understanding of its objectives, the roles and responsibilities of both parties, the resources required, and the timeframe for achieving the targets. Expertise to understand and evaluate the obligations accepted under the contract. Both parties must have the knowledge and experience to understand what they are agreeing to. Ability to achieve the desired outcomes of the contract. The objectives of the performance contract must be achieved solely by the parties involved and not depend on the actions of others. Suffi cient information so that each party can evaluate and monitor the contract. Both parties must have access to adequate, relevant, timely, and verifiable information so that they can agree on the current situation and objectives of a contract, evaluate their roles and responsibilities, set baselines for monitoring performance and monitor implementation performance. Capability to control the resources needed to honor their commitments. The concerned parties must have authority and control over the resources needed to implement their parts of the contract. Ability of third parties to measure performance. Dispute resolution mechanisms cannot function unless those tasked with mediating disputes can independently verify (for example, through the use of external auditors) the information presented by the parties. A legal or institutional framework. There must be an adequate legal or institutional framework that permits the parties to enforce the contract and to resolve disputes. Limiting the contract to two parties. The contract will be diffi cult to enforce if there are other individuals and entities that will interfere in its implementation. It is necessary to limit outside interference that would undermine the authority of the parties involved. 21

22

4. STEPS IN PERFORMANCE CONTRACTING Performance contracting involves a series of activities or steps (see Figure 4). 23

Figure 4. Steps in Performance Contracting Note: Boxes in broken lines signify prerequisites to performance contracting. Step 1 - Identification of Contracting Parties and Contracting Instrument The stakeholders (utility owner represented by the mayor for LGUs or the General Manager/BOD for WDs, management and staff) will first agree to embark on a performance contract. The contracting parties will then identify the specifi c staff to be involved and the signatories to the contract. As much as possible, the contract should be just between two parties to limit interference and focus roles and repsonsibilities. The contracting instrument will be in the form of a performance contract (see Annex 2 for samples) or a memorandum of agreement between the utility owner and the utility management and staff. Step 2 - Setting the Strategic Goals, Objectives, Scope and Timeframe With the Performance Improvement Plan (PIP) as basis, the contracting parties will agree on the specifi c goals and objectives of the contract. The goals and objectives should address current issues faced by the utility. They should be specifi c, measurable, achievable, realistic and time-bound (see Table 6 for a detailed description). 24

Table 6. Setting Strategic Goals Characteristic Specific Measurable Acceptable Realistic Time Bound Description A Strategic Goal must be clearly stated in specific terms, so that there is no confusion as to the meaning and purpose of the goal. A Strategic Goal must be measurable in quantitative terms so that it can be monitored and assessed objectively, which in turn, facilitates evaluating progress towards achieving the goal. Example: Non-revenue water will be reduced from 40 % to 30% by 2013. If the work force of the utility does not accept a particular Strategic Goal, achieving it will be difficult. Effective management requires that the work force take ownership for achieving the stated Strategic Goals. If they do not understand why they are being asked to achieve a particular Strategic Goal, or if they do not know the possible impact the Strategic Goal will have on them and the utility, once achieved, they will not pursue it with commitment and determination. While a Strategic Goal should be challenging, it must also be realistically possible to achieve the goal as stated. If a strategic goal is unrealistic, the staff may become unmotivated to work towards it, because they will never be able to reach it. A Strategic Goal should be stated such that it is accomplished within a specified time frame, say from one to five years. When stating a longer- term for a strategic goal, it is advisable to state interim target goals to be met. For example, if the goal is to increase the bill collection efficiency rate to 95% by the end of Year 4 of the business plan, and if the collection efficiency rate is currently at 25%, then interim goals could be stated as: The interim bill collection goal for end of Year 1 is 35%, end of Year 2 is 50%, end of Year 3 is 70%, and end of Year 4 is 95%. Source: Strategic Business Planning for LGU-Run Water Utilities: Guide and Model for Preparation of Business Plans, PWRF-SP, 2011 The scope of the contract will defi ne the area or activities to be covered by the contracting arrangement. There is no set timeframe for a performance contract but it should be realistic and suffi cient to implement the necessary activities, especially when substantial effort and resources are required to achieve the desired performance goals and objectives. Performance contracts should be typically short ranging from one to three years (for LGUs in particular, the duration should be within the term of the mayor) to minimize uncertainties and risks such as changes in management and policies. One other important factor to consider in setting the timeframe is the budgeting process affecting the water utility to ensure funding for planned activities. Thereafter, the contract may be re-negotiated and renewed as required and agreed upon by both parties. Step 3 - Determining Activities to be Contracted The activities or actions to be contracted should be linked to the objectives set by both parties. These are preferably the priority activities from the PIP. Both parties must have access to adequate, relevant, timely and verifi able information so that they can agree on the current situation and set baselines for determining the priority activities and monitoring performance. In determining the activities, the timeframe and budgetary constraints should be taken into consideration. Step 4 - Defining the Roles and Responsibilities of the Contracting Parties The roles and responsibilities should be well defined and within the offi cial mandate or function of each party. In discharging their roles and responsibilities under the contract, both parties have to exercise due diligence, effi ciency, and economy in accordance with generally accepted professional conduct and practice. They should also comply with pertinent policies governing civil service and the performance of duties of public employees. Step 5 - Setting Performance Indicators and Targets The performance indicators should be adequate to measure and gauge progress towards the desired objectives. Select indicators that clearly link to objectives, which can be clearly defi ned by both parties and readily measured using available and verifi able information. 25

The corresponding targets should be specifi c to the performance objectives of the agreement. Just like the goals, performance targets should be specifi c, measureable, accurate, realistic and timebound (SMART). The information/targets needed to monitor them should be available on a timely basis and auditable. They should be ambitious yet Examples of Key Performance Indicators and Targets A) Financial management of the water supply operations improved by (target date) - Collection effi ciency improved from % to % - Collection period shortened from months to months - Operating ratio improved from to - Cost recovery ratio increased from % to % B) Non-Revenue Water reduced from % to % /or billed water increased from % to % of total connection by (target date) - Rehabilitation of old pipes of m into PVC or PE pipes of m completed by (target date) - Upgrading of distribution system and installation of stub-outs completed by (target date) - Leak detecting devices installed in areas by (target date) - Flow meter at water source facility installed by (target date) - Metered residential, commercial, and institutional connections and public taps increased from % to % of total connections by (target date) - Defective/old water meters calibrated or replaced/changed with more effi cient ones by (target date) C) Billing and collection effi ciency of water supply services improved to at least % and %, respectively by (target date) - Metered residential, commercial and institutional connections and public taps increased from % to % of total connections by (target date) - 100 % computerization of customer ledger cards and database by (target date) - strategic collection centers established by (target date) - Operation Cut-Off for delinquents and long overdue accounts undertaken every (target date) - Discount or rebate system for timely payments in place by (target date) D) Water quality improved by (target date) - Construction of slope protection/retaining wall of water source completed by (target date) - Filtration facility(for systems with surface water sources) installed by (target date) - Chlorinator installed by(target date) - Regular chlorination conducted starting and every thereon - Water testing and analysis conducted starting and every thereon E) Improved tariff structure for water supply services implemented by (target date) - Capacity building on tariff setting conducted - Classifi cation of current water user/customers completed by (target date) - Tariff analysis conducted by (target date) - Proposal for new tariff structure completed by (target date) - Public consultation conducted by (target date) - Sangguniang Bayan ordinance passed by (target date) - 100% phase out of fl at- rate by (target date) - New water tariff rates implemented by (target date) realistic in that the improvements they measure are achievable considering the time frame and availability of resources (skills and fi nancing, among others). Targets must be time-bound to provide the necessary pressure for performance improvement (see the box below for examples). 26

Normally, there is no single best practice target but there are industry and technical standards that can be used as basis. Having too many targets can make monitoring cumbersome and costly. Also, a large number of targets tend to give equal weight to each target and often the least useful are the hardest and most costly to measure. Step 6 - Determining Performance Incentives/Linking Incentives to Performance Performance contracts commonly tie incentives to accomplishment of defi ned and agreed milestones to motivate the utility owner s contracting party. In the Philippine setting, provision of incentives is bound by certain policies and conditions, such as personnel services limitations and availability of funds (see Annex 3 for details). Some possible incentives include: Awards and recognition Exposure visits or trips Training or capacity building Merit incentives allowed under the Salary Standardization Law and Civil Service Law, such as Program on Awards and Incentives for Service Excellence (PRAISE) To facilitate monitoring of accomplishment and provision of incentives, the following can be done: setting performance targets and weights for performance targets (which amount to 100%) to stress importance; measuring performance during the period versus the target to determine the percentage of achievement (for example, 1,000 new connections achieved versus a target of 2,000 = 50%); and for monetary incentives, calculating the percentage of the maximum agreed bonus to be paid by comparing with agreed rating or scoring system with weighted values. Step 7 - Setting Penalties, Dispute Resolution and Modification Provisions Penalties, like incentives, can also drive performance. However, like incentives, penalties for public utilities are governed by civil service policies. Firing, demotions, or salary deductions are not applicable penalties in public service unless they are based on justifi able grounds. Meanwhile, the setting of dispute resolution mechanisms is highly recommended with the involvement of the economic regulator (such as the NWRB) or the legislative body (Sangguniang Bayan) for LGUs or third-party adjudicators for WDs. Performance contracts should be fl exible enough to consider unexpected and fortuitous factors (including sudden changes in policies or the occurrence of major calamities). Modification of any provision or termination of the contract will be mutually agreed upon by both parties and will be recognized only if evidenced in writing signed by each party or their authorized representatives. Step 8 - Termination of Performance Contracts Performance contracts may be terminated based on agreed terms and conditions, for example, non-compliance with or violation of the terms and conditions provided in the contract, or as determined on probable cause by the designated dispute mediator or third-party adjudicator. Finally, when designing performance contracts to improve WSS services, consider the following good practices: Ensure that both parties have expertise to negotiate agreements; Keep contracts simple and easy for both parties to understand; Ensure that both parties have suffi cient information to set baseline measurements and targets, and to monitor performance over time; Develop a fi nancial model (for example, a business plan) to understand the link between objectives and resources; Ensure that both parties have control and authority over the resources needed to meet their commitments; Link incentives to performance; Limit the number of performance measures to those needed to measure the desired improvement; Use only performance measures that can be audited by third parties; Make dispute resolution mechanisms simple and easy to use; 27

Be fl exible by allowing adjustments or amendments, especially when fi rst introducing internal agreements or when available information is unreliable; Involve key stakeholders, such as the economic regulator, in the design of the performance contracts and in their approval or endorsement by the legislative or policy making bodies to ensure full support for the implementation of the contract and achievement of targets. For LGUs, in particular, it is strongly recommended that the performance contract be adopted or endorsed by the Sangguniang Bayan to make it more transparent and binding especially in terms of budgetary appropriation for the planned activities and for monitoring purposes (see Annex 2-6 for copies of SB resolutions); Make performance contracts and periodic performance reports publicly available on a timely basis; Limit outside interference (that is, from individuals and entities not party to the agreement) that would undermine authority; and Encourage competition among several potential operators whenever possible, whether by means of in-sourcing or outsourcing. 28

REFERENCES AND LINKS Alburquerque Waterworks Strategic Business Plan, 2011-2015 Strategic Business Panning Guide for Water Districts: Guide and Model for the Preparation of Business Plans for Water Districts, PWRF-SP, 2008 Guide to Establishing LGU-Run Water Utilities as Economic Enterprises, PWRF-SP, 2011. Jagna Waterworks Business Plan, 2011-2015 John Sitton. Using Performance Agreements to Improve Water Sector Performance in the Philippines. Final Report, PWRF-SP, November 2009. Mahayag Local Waterworks System Strategic Business Plan, 2011-2015 Strategic Business Planning for LGU-Run Water Utilities: Guide and Model for Preparation of Business Plans, PWRF-SP, 2011 Asian Development Bank website. www.adb.org/.../handbooks/public-private-partnership/default National Water and Sewerage Corporation, Uganda website. www.nwsc.co.ug/about.php Public-Private Partnership Center website. www.ppp.gov.ph The World Bank website. www.rru.worldbank.org/documents/toolkits/water/water_full.pdf Water and Sewerage Authority, Lesotho website. www.wasa.co.ls 29

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ANNEXES AND APPENDICES 1 - Institutional Set-Up of Water Service Providers 2 - Sample Performance Contracts 2.1 Improving Production, Revenue Generation and Quality of Service of the Jagna Waterworks System 2.2 Improvement of the Mahayag Local Waterworks System (MALOWAS) for Better Service Provision and Revenue Generation 2.3 Performance Contracting to Reduce Subsidies for Water Service Operations in Alburquerque 2.4 Area and Branch Performance Contracts in Uganda, East Africa 2.5 Contracting with the Utility Management in Lesotho, South Africa 2.6 Copies of Sangguniang Bayan Resolutions Endorsing Performance Contracts 3 - System of Incentives for Performance Contracting APPENDIX A - Legal Bases and Types of Outsourced Performance Contracts APPENDIX B - Some Examples of Outsourced Contractual Arrangements in the Philippines 31

ANNEX 1 - Institutional Set-Up of Water Service Providers This section reviews the institutional set up for two types of water service providers: LGUs and water districts, both public entities and loosely regulated vary widely in size, from 100 to 5,000 service on service coverage and quality of performance connections. targets. The Local Government Code vests economic regulation of LGU-run water utilities on the Local Sanggunians. Since these Sanggunians are not bound by national guidelines or subject to oversight, nor are members trained in sound economic regulation, utilities are not guided or compelled to achieve performance targets. Water Districts, on the other hand, are regulated by a national agency, the Local Water Utilities Administration (LWUA). However, the LWUA is also a specialized lending agency of Water Districts. Thus, inherent in its interest as a funding agency, the economic regulation exercised focuses on tariff regulation, motivated by ensuring loan repayments. Regulation of service coverage and performance targets is not actually exercised. Unlike the contracted utilities, which have defi ned targets in their agreements and built-in incentives and disincentives for performance or non-performance, the LGUs and WDs do not have drivers or anyone compelling them to perform. Hence, internal performance contracting is offered as a self-propelling mechanism for progressiveminded Boards and management to improve the quality of water utility services. 1. Local Government Units Mandate and Jurisdiction The Local Government Code of 1991 (Republic Act 7160) gave LGUs, particularly cities and municipalities the mandate and the responsibility of ensuring water supply and sanitation services to their respective constituents. LGUs have used various service provision models. Some LGUs have relied on third-party providers, i.e., creation of water districts, use of community-based operators, and private contracts, but LGUs mostly operate the water utility directly. Water supply service is typically treated as part of the overall operation of a city or municipality. Operation of the utility is normally part of the task of the municipal engineer. Majority of LGUs do not ring-fence their utilities as independent economic enterprises, hence performance is diffi cult to assess. LGU-run systems Under the Local Government Code, LGUs are entitled to annual block grants from the national government. These grants are determined through a formula-based internal revenue allotment (IRA), which are automatic appropriations and cannot be earmarked by the national government. LGUs can use at least 20% of their IRA for development projects, prioritization of which is at the discretion of the LGUs. They are authorized to generate their own revenues through taxes, fees or charges, such as for water supply services. They can also utilize various fi nancing mechanisms, like bank loans and bonds, provided debt service obligation does not exceed 20% of the LGU s regular gross income. BOT or joint venture contracts, LGU loans for water projects or other revenue generating projects for that matter, fall under general obligation, as these are backed up by IRA pledges. Governance Structure There is no uniform organizational structure for LGU-run water utilities. The mayor sets policy direction and directly supervises the utility manager. In many cases, the Municipal Engineer is also the utility manager. Similarly, other LGU employees such as the accountant and treasurer share their services with the utility. The Mayor is elected every three years, and may be re-elected twice. In that case, a mayor can potentially be in power for nine years. However, since re-election is not a certainty, the mayor tends to have short-term plans. The LGU staff, on the other hand, has permanent appointments subject to Civil Service Rules. In theory, they are supposed to provide project continuity. However, in practice, the mayor can move or freeze the personnel and hire other staff as consultants or contractuals. It is also important to take note of resource constraints. Investments in water supply and sanitation compete with other services. Only a few LGUs leverage their internal revenues with loans or cost-based tariffs, thus constraining further available resources. Moreover, water supply and sanitation 32

projects take longer to prepare and implement. Hence, they often rank low in the priority list of local chief executives who want highly visible and quickly implementable projects that they can show off in the next elections. All these set a limitation on the scope and timeframe of performance contracts with LGUs. Realistically, performance contracting with LGUs will tend to focus on short-gestating tactical measures more than strategic reforms. 2. Water Districts Mandate and Jurisdiction Advocacy for corporatized service providers grew in the 1970s, which paved the way for the promulgation of Presidential Decree 198 or the Provincial Water Utilities Act of 1973. PD 198 authorized the creation of water districts and established the Local Water Utilities Administration (LWUA), a financing and regulatory institution for water districts. The creation of water districts is initiated by LGUs. The LGU legislative body (Local Sanggunian) enacts a resolution naming the district, defining its boundaries, transferring assets of the existing waterworks system, and naming the initial set of its Board of Directors. Subsequently, the appointment of the Board of Directors rests with the municipal mayors or provincial governors. 10 The resolution is then forwarded to the LWUA for the issuance of the Conditional Certifi cate of Conformance (CCC), essentially giving it the privilege to operate the public utility. By jurisprudence, water districts are qualifi ed as government-owned and controlled corporations. As GOCCs, they are covered by COA audit, DBM-approved plantilla positions, Civil Service rules and regulations, the Salary Standardization Law and government procurement guidelines. The ruling, however, fell short of identifying who owns them (whether they are LGU-owned or if NG-owned, who they will be accountable to). The LWUA is able to impose key performance and financial indicators for water districts with loans, but do not do so for those without loans. Water districts are autonomous corporations. Although their assets came from the LGUs, these were paid for over time. They were not provided with national government equity, nor are they entitled to national government transfers from internal revenues like the LGUs are. Hence, they rely entirely on their revenue stream to leverage capital funding and to defray operation and maintenance costs. Water districts are classifi ed into: Very large, Large, Big, Medium, Average and Small. The classifi cation is based on the size of resources, financial capability in satisfying operating requirements and scope/complexity of operation, and service connections. The table below shows the categories and geographic distribution of water districts in the country. Water Districts by Category as of December 2007 Category (service connections) Luzon Visayas Mindanao Total Very Large (19,000-135,000) 3 3 3 9 Large (15,000-58,500) 12 4 2 18 Big (3,500 to 27,000) 38 1 11 50 Medium (2,300 to 14,000) 41 14 9 64 Average (1,500 to 7,500) 22 12 12 46 Small (100 to 4,500) 153 72 61 286 Total Operational Water Districts 269 106 98 473 Non-operational Water Districts 144 Grand Total 617 Source: LWUA Corporate Planning Office and Management Services 10 In case the Water District covers several municipalities, the mayor of the municipality or city with at least 75% of service connections will be the appointing authority. Otherwise, authority is vested in the provincial governor. 33

Governance Structure Water districts as corporate entities have better governance structure. There is a Board that provides policy direction, approves major capital projects and their fi nancing, and approves tariffs endorsed to the LWUA. The Board has the authority to set performance standards, hire and fi re management within the ambit of Civil Service Rules and Regulations, and (although covered by the Salary Standardization Law) exercise some fl exibility in providing incentives to management and staff. The governor or mayor appoints the board members if the franchise area of the water district extends beyond one municipality. Hence, in some cases, political interference by the LGU Executive is exercised through the Board. However, considering the arms-length relationship, the political infl uence in policy or management decisions is not as pervasive as it is in the case of LGU-run utilities. Most water districts maintain a professional staff with core knowledge of the technical aspects of the utility s operation, accounting and fi nancial management. The management and staff have secure tenure. The Figure below shows the typical organizational structure of a water district. Typical Organizational Structure of a Water District General Manager (1) 75 Administrative Office 3 Engineering and Planning 3 Secretary (1) Section Cleaning Services (1) Senior Engineer (1) Driver (1) Junior Engineer (2) Finance Section 3 Technical Section 55 Customer Service 10 Head of Section (1) Head of Section(1) Head of Section (1) Accounting 1 Water Production and 12 Equipment/Services 9 Water/Sew age Netw ork 16 Water Reservoirs # Customer Service 9 Treatment Head of Sector (1) (5-Work Teams) Head of Sector (1) Meter Installer (1) Accountant (1) Head of Sector (1) Welder (1) Head of Sector (1) Workers Res. No.1 (4) Meter Readers (5) Lead Operator (4) Excavator Operator (1) Supervisor (5) Workers Res. No.2 (4) Billing Clerk (1) Pump Operator (4) Equipment Operator (2) Netw ork Specialist (10) Workers Res. No.3 (4) Cashier (2) Electrician (1) Electrician (1) Guard (4) Supplies 1 Mechanic (1) Driver (3) Chemist (1) Supplies Clerk (1) Source: Strategic Business Panning Guide for Water Districts: Guide and Model for the Preparation of Business Plans for Water Districts, PWRF-SP, 2008 The corporatized structure of Water District lends itself better to internal performance contracting. There is a clear delineation of policy setting and oversight, as well as management. There is stability in the organizational structure and there are dedicated resources. In addition, relative to the LGUs, Water Districts leverage their resources more through credit financing, and generally charge cost-based tariffs. 34

ANNEX 2 Sample Performance Contracts 2.1 Improving Production, Revenue Generation and Quality of Service of the Jagna Waterworks System

2.2 Improvement of the Mahayag Local Waterworks System (MALOWAS) for Better Service Provision and Revenue Generation

2.3 Performance Contracting to Reduce Subsidies for Water Service Operations in Alburquerque

2.4 Area and Branch Performance Contracts in Uganda, East Africa

2.5 Contracting with the Utility Management in Lesotho, South Africa

2.6 Copies of Sangguniang Bayan Resolutions Endorsing Performance Contracts