Performance Contracting: A New Paradigm for Infrastructure Improvement

By William Atkinson

For water utilities that are cash-strapped and fatigued from spending a significant amount for various projects, the concept of performance contracting may be of interest. But what exactly is performance contracting?

According to John De Yonge, director of EY Global Cleantech Center for Ernst & Young (Secaucus, N.J.), performance contracting provides an opportunity for the supplier to essentially own or operate its systems or equipment rather than directly manufacture or sell them to a water utility.

"The financing for the equipment or systems will come either from the supplier or a third-party," said De Yonge, "and the supplier guarantees that the equipment or systems will provide cost savings, whether through efficiencies or enhanced performance, that will pay for the improvements. That is, certain metrics are established, and the supplier guarantees those levels of performance and is paid through the savings generated for the utility."

As such, the risk is transferred from the municipality to the supplier, since the supplier guarantees the performance and will also typically finance the acquisition. "There are no up-front costs to the water utility," said De Yonge. "It becomes an operating expense situation rather than a capital expense situation."

Derek H. Clayton, market manager of municipal utility solutions for Johnson Controls (Milwaukee, Wis.), added, "Performance contracting is a mechanism for entities to find a means to make capital improvements based upon guaranteed outcomes."

According to Clayton, there is a significant need for infrastructure improvement across the water industry. The traditional way to make these improvements is to establish specifications, place them up for bid and select the lowest bidder.

"With performance contracting, the idea is to equate capital needs with efficiency needs," said Clayton. "For example, if you have 30- to 50-year-old production pumps that are very inefficient, this inefficiency represents a dollar value."

Accordingly, that dollar value can help fund the performance contracting project as well as the efficiency or improvement outcome guaranteed by the contractor. If those results are not realized, the contractor is accountable, meaning he or she must offset the mismatch between what the contract requires and what is actually occurring.

According to Jordan Lerner, regional director of sales and engineering for Schneider Electric's Seattle region, performance contracting is a turnkey method of project delivery. "Every state, with the possible exception of Iowa, notes performance contracting as a specific procurement and delivery method for projects - different from traditional public works contracting," he said.

As a turnkey contractor, Schneider Electric designs and builds a project and verifies performance over time. "As such, it is an outcome-based design," said Lerner. Schneider Electric focuses on the performance metrics that it wants to achieve. "In the long run, we guarantee performance, costs and savings," he said. The company monitors and validates performance using an international protocol widely accepted and written by the U.S. Department of Energy and ASHRAE.

"We have been practicing performance contracting for over 20 years and have completed over 500 projects," he said. "We operate as the general contractor and, if the client prefers, we will use local subcontractors to help keep money in the client's community, provided those subcontractors meet our requirements through a rigorous qualification process, such as bonding and insurance."

Benefits of Performance Contracting

One benefit of performance contracting, according to De Yonge, relates to the improved efficiency of equipment or systems. "The supplier has a strong incentive to seek the greatest efficiencies possible, since this is how they are paid," he said.

Another advantage is that the municipality may not have the financial resources or the in-house expertise to install and maintain the equipment or systems, which are ultimately responsibilities of the supplier.

"The arrangement may obviate the need to confide in the bond market or voters since the upfront costs are covered by the supplier and are operating expenses rather than capital expenses," said De Yonge.

Moreover, the largest benefit of performance contracting, according to Clayton, is the ability for a municipality to realize guaranteed benefits in a timely manner from the improvements they receive. "The risk is not on the municipality anymore," he said. "It is on the performance contracting company." In the past, utilities were required to rely on funding such as loans, float bonds and capital expenses in order to complete the project - with no guarantees; the utility simply accepted the risk of performance.

Another benefit involves the ease of day-to-day operations, management and reporting, said Clayton. "They (utilities) aren't constantly challenged to make capital improvements," he said. In the past, the uncertainty of a price tag prevented utilities from planning for the future; they were constantly in a reactive mode.

"With a performance contracting arrangement in place, managers now have the ability to take a holistic approach to addressing capital needs and determining what they want to do, how they want to do it, when they want to do it, and knowing where the dollars come from to help fund that program, meaning that they can be in a proactive mode," Clayton said.

Once performance contracting is in place, managers can begin to manage the business side of operating the water and wastewater systems, rather than having to leave their offices or respond to main breaks and lift station alerts. "They can monitor the systems through telemetry," said Clayton. "They can thus manage systems and identify symptoms of problems instead of having to chase and respond to them."

Concerns with Performance Contracting

The one concern with performance contracting, according to De Yonge, is the difficulty in assessing the value provided by the supplier, especially as it relates to comparing suppliers and their propositions. "You are looking at efficiency gains and performance gains, and you have to determine how to monetize these over a period of time," said. "The performance metrics have to be formulated, and these need to be validated."

Getting Started With Performance Contracting

According to De Yonge, most, if not all, of the large systems suppliers have entered, or are entering, the field of performance contracting. As such, if they are already working with a large water equipment company, it is likely that a unit within that organization is focused on performance contracting. As a first step, De Yonge suggested contacting that unit to receive preliminary information.

Clayton also recommended attending local trade shows and conferences because performance contracting is being discussed more frequently at these events.

Performance Contracting in Action

According to Chuck Gray, water superintendent for the city of Mount Vernon, Ind., his utility faced a large number of tasks with very little revenue to support those improvements. "In fact, our infrastructure was failing," he said. "When I took over, we were experiencing city-wide boil orders every 90 days. We had experienced boil orders for four out of the previous five Thanksgivings, and Christmas boil orders were common."

Gray was at the Indiana Rural Water Association conference and attended a presentation on performance contracting. "Previously, we had been the victim of several engineering companies misquoting costs on improvement projects," he said. "As a result, we didn't have any more money, and we didn't have the stomach for any more risk like that. Once I saw what performance contracting could do, we decided to go with it, and we selected Johnson Controls."

With performance contracting, Gray emphasized the fact that once a certain price is established, it doesn't change. "They couldn't come back and increase the price on us," he said.

At the time, the utility considered replacing its water meters, given it was losing 50 to 65 percent of its production every year due to faulty meters. When it implemented performance contracting, the facility initially replaced every water meter in the city, including residential, commercial and industrial meters, without any rate increases. As a result, the utility's income increased because customers were only paying for what they were using. The greatest increase in revenue, as expected, came from industrial customers.

"Johnson Controls did such a good job for us on this first phase that we decided to work with them on the second phase, which was replacing our filters," said Gray. "The impact was dramatic. Our chemical usage decreased 64 percent. Our power bill declined so much that the power company came out and changed our meter a number of times because they thought our meter was defective."

Not only did Johnson Controls help the utility with its filters, it also installed two new booster stations as part of the second phase to distribute water to the plant's outlying areas. "At the time, there were a lot of people wanting to receive city water, but we just hadn't been able to issue it to them because we didn't have the money for the additional infrastructure," said Gray.

For the third phase, the utility selected Johnson Controls once again to help replace its river intakes, which were about 100 years old. "We built an entire new intake structure on the river bank, with new lines stretched into the river and drawn up into the plant; we oversized them in order to take future growth needs into account," he said.

About the Author: William Atkinson is a correspondent for WaterWorld Magazine. He has been a full-time freelance business magazine writer since 1976, specializing in infrastructure, sustainability, supply chain, risk management, and safety/health. Circle No. 253 on Reader Service Card