Successful Divestiture of a Water Utility:

The Case of Tallinn, Estonia

By Cledan Mandri-Perrott
Senior Consultant, IP3

About the Author...

Cledan Mandri-Perrott is a Senior Consultant with IP3 in Washington, DC. He is an expert in the development of PSP structures and regulatory frameworks in the water sector and has worked in a number of countries throughout Eastern Europe, Africa, the Caribbean, and South America. Prior to joining IP3, Mr. Mandri-Perrott was an independent consultant and served as a Director of a local joint venture company for an international water operator for a three-year management contract in Trinidad and Tobago. Recently Mr. Mandri-Perrott served as the Project Manager for the privatization of Tallinn Water Company in Tallinn, Estonia, valued at over US$75 million, where he was responsible for the design of the privatization structure and implementing the transaction. In addition to his work in Tallinn, Mr. Mandri-Perrott has been involved as transaction adviser for water PSP arrangements in Nepal, Nicaragua, Bulgaria, Uzbekistan, Argentina and Chile amongst others.

Abstract

The introduction of private sector participation (PSP) in the water and wastewater sector is frequently the subject of controversy. Due to the inherently social nature of water services, full privatization is very rare. This article profiles the case of the city of Tallinn in Estonia, where the city government successfully completed a unique privatization through a partial divestiture of the city-owned water and wastewater utility. In addition, this article argues that partnering with the private sector was a successful strategy to help the country achieve water and wastewater standards needed to be part of the European Union.

I. Background

The Republic of Estonia is a country in Eastern Europe, bordering the Baltic Sea and Gulf of Finland. It has a population of 1.4 million and gross domestic product (GDP) per capita of US$10,000. The GDP is growing at 6 per cent -the highest rate of growth in Central/Eastern Europe. In 1940 Estonia was annexed by the Soviet Union, and was later established as a separate and autonomous country after the break-up of the Soviet Union in 1991.

The Estonian economy experienced a severe recession in 1991 and 1992 due to inefficiencies in the old economic system and growing difficulties in exporting to Russia. As a result, GDP decreased by 12.6 per cent in 1991 and 14.2 per cent in 1992. The decline in GDP slowed from 1993 and from 1995 to 1999, the economy experienced a period of growth. The economic decline of 1999 can be attributed to the consequences of the currency devaluation in Russia in August of 1998 and the collapse of Eastern export markets.

To stimulate development while conserving scarce public resources, the Government of Estonia (GOE) implemented a number of measures to ease and support private sector participation (PSP) in the Estonian economy. This included the currency reform of 1992 that replaced the Russian Ruble with the Estonian Kroon (EEK), which was pegged to the German Mark (DEM) at a rate of 8 EEK for 1 DEM. In addition, the GOE implemented a progressive tax policy by not taxing company profits until they are distributed as well as allowing dividends paid to Estonian residents not to be subject to further taxation. Successive governments have continued to focus on reconstruction, deregulation and private sector participation in a range of sectors. As a result of the government's proactive approach to reform, Estonia has established a successful track record of private sector involvement in such sectors as manufacturing, district heating and banking.

Estonia acceded to the European Union in 2004. One of the criteria that Estonia was required to meet for EU accession was the EU's Water and Framework Directive. The Government's decision to partner with the private sector was instrumental in achieving compliance with this Directive, and thus enabling Estonia to become a part of the EU.

II. Introduction to PSP in the water and wastewater sector

The company known as AS Tallinna Vesi (ASTV) is the largest provider of water distribution, wastewater treatment and storm water collection services in Tallinn, the capital of the Republic of Estonia. ASTV serves the City of Tallinn and its suburb of Saue and provides drinking water to approximately 405,000 people, or 99 per cent of the population.¹

Similarly, the Company's wastewater and sewage collection systems cover approximately 385,000 consumers, which is approximately 95 per cent of Tallinn's population.^²&³

Although ASTV was generally considered to be a well-run company, the City of Tallinn was under pressure to finance new social developments and to release itself from the administrative and financial burden of providing water and wastewater services. As ASTV was 100% owned by the City of Tallinn and not central government, and because the company was financially healthy, there was no constraint in the decision to bring in a Private Operator / Strategic Investor (PO/SI).

In introducing PSP, the principal objective of the City of Tallinn was to attract a Strategic Investor for the management and financing of the Company in order to achieve the quality and service standards set by National and European Union regulations.

III. The form of PSP chosen and implications with EU Competition Law

The type of PSP structure selected was a partial divestiture through the sale of a majority stake in ASTV. This was accomplished through a divestiture or partial sale, in which the City of Tallinn (CoT) granted the Strategic Investor management and operational control, whilst the CoT retained a veto on a certain number of matters considered of strategic or national interest.⁴ Under this scenario, ownership of the provider of water services was shared between the public and private sectors.

Due to this combined ownership structure, it was important to determine the extent of public involvement as provided for in Article 222 of the EU Competition Law. It follows that a preliminary test needed to be performed to gauge the level of control, exclusive right (Article 85(1)) and economic interest (Article 85(2)) that was to be exercised by the company under the proposed new regime. The diagram represents generically the 'tests' that were carried out to ensure compliance with EU Competition Law.

IV. Implementing the Transaction and the Resulting Contractual Structure

The bidding process for the ASTV divestiture was arranged as a one-stage tender with pre-qualification. As a result of the bidding process, the strategic investor was to hold 58,000,000 A-shares of ASTV, representing 50.4 per cent of the outstanding share capital of the company (after the issue of 30,000,000 new A-shares). This gave the PO/ SI management control of ASTV via a majority in the Supervisory Board and the right to appoint members of the company's Board of Management. The City of Tallinn, as the owner of the preferred B-share and party to the Shareholders' Agreement, retained control over key matters relating to the management of ASTV. It must be noted that this transaction did NOT have a limited time frame. In most PSP arrangements, such as management, lease, or concession contracts, there is a time limit or duration of contract, typically anywhere from 5 to 30 years. By contrast, under a divestiture such as that implemented in Tallinn, the new arrangement has no pre-specified duration.

The post-transaction Shareholder Structure is shown below:

The PSP structure consisted of a Shareholders Agreement (SHA) between the City of Tallinn and the PO/SI and a Service Agreement defining the manner in which the PO/SI would conduct himself. The sale process was to be defined under a Share Sale and Subscription Agreement.

The Shareholders Agreement (SHA) between the City of Tallinn and the PO/SI defined the roles and responsibilities of the parties, voting rights, board membership, dividend policy, the link between the SHA and the Services Agreement, termination, and approvals of the City to any changes in the Company's shareholder structure, including investor's share transfers. Notably, the investor's management control over the company is subject to the City of Tallinn right of veto on a certain number of issues considered of fundamental interests to the citizens of the City.

The Services Agreement on the other hand defined the mechanisms for (a) ensuring the functioning and maintenance of the public water supply and sewerage system of Tallinn, (b) extraction of fire fighting water from fire hydrants in the public water supply system and extraction of water from public water extraction points and (c) channelling of rain water, drainage water and other soil and surface water from public roads, streets and squares to the public sewerage system and the treatment thereof.

The Share Sale and Subscription Agreement defined the manner in which the transfer of shares would be done after the confirmation of the successful bidder.

V. Obligations of the Private Sector and Investments

The obligations of the PO/SI are enshrined within the SHA and Service Agreement. These obligations can be broadly defined as the following: having responsibility for the infrastructure and all assets of ASTV; operating, maintaining and developing the Tallinn water supply and sewerage system; and designing, financing, constructing and commissioning all works required for rehabilitation and construction of the water and wastewater system in accordance with National and EU standards and in particular, with the WFD.

There was a notable exception relating to storm water drainage systems, which would be financed directly by the City of Tallinn with no recourse to the existing tariff. In this case, although the City of Tallinn would fund storm water drainage, it would be the responsibility of ASTV to use good business practices to implement the funding in a manner that would enhance its ability to deliver services to the public and meet its operational obligations under the Service Agreement.

Also there was a clear obligation to meet prescribed Levels of Service and other associated specified outputs and deadlines, including established performance indicators in water supply, wastewater collection and treatment, surface water drainage and other areas of ASTV's operations, to be achieved in the first 5-year term from 2001 to 2005.

In order to meet the specifically defined levels of service and outputs, the PO/SI was also required to finance investments estimated to be up to US$ 100 million. It is important to note that in relation to the required investments, the intention of the CoT was to provide bidders with an indication of the amount of investment needed to meet the levels of service and performance indicators. However, the Service Agreement is not prescriptive about this amount; it is simply concerned with the outputs of the PO/SI. The way in which the PO/SI achieves these objectives is left to his discretion. Therefore, this PSP project is considered to be output and not input driven.

VI. Conclusions

The key outcomes of this process can be summarised as a 'fast-track' bidding procedure that was completed in a total of nine-months from initial notice to bid. Notably, the bidding process did not result in a tariff increase in the first year and pre-defined tariff increases thereafter until year five. In addition the transaction achieved a commitment to meet the EU's Water Framework Directive (WFD) standards and a prescribed timetable in which to do so; retraining of local staff and outsourcing; as well as an emphasis on improved customer service. Moreover, the form of PSP chosen and its contractual structure allowed for investment continuity through a pragmatic approach to asset renewal through the first five-year investment plan. This plan focussed mainly on above ground assets and network extension (water and sewerage) to provide 100% coverage of services. Finally, the flexibility of the shareholding structure, which allowed for the shares to be owned by the City, the Private Operator/Strategic Investor and the employees of the company, allowed for a future public offering in the stock exchange.

For more information, please contact Cledan Mandri-Perrott at cmandriperrott@ip3.org

¹ The Company operates water distribution, sewerage and storm water networks. The lengths of these networks are, respectively, 820.5 kilometres, 739.4 kilometres and 151.0 kilometres. In the older parts of Tallinn, the sewerage network of the Company is combined with the surface water drainage network. It is this section of the Company that expects considerable expansion within the next six years, as it is the City of Tallinn's priority to fully develop the sewage collection system by 2006.

² Tallinn Water and Wastewater Company have net sales of US$ 27.5M (1997), 27.8 M (1998) and 24.6 M (1999) respectively.

³Telephone interview with Mr Chris Shugart, Senior Banker, European Bank for Reconstruction and Development (15 October 2001). Mr Shugart explained the role that the EBRD played with ASTV and the bank's commitment to private sector participation in the water sector. He mentioned that ASTV was considered one of EBRD's success stories being a recipient of US$ 20.5 M for capital investment projects from 1994 to 1999 prior to the introduction of the private sector. Mr Shugart mentioned that a good level of investment had already been made in underground assets, as well as water treatment technology through ozonation. He then provided a summary of what he felt were the key problems facing ASTV prior to the introduction of the private sector. These included inefficient operation due to an 'over dimensioned' water network resulting in poor quality stale water, underinvestment in wastewater network and an increasing risk of non-compliance with discharge standards into the Baltic Sea, billing inefficiencies and low collection rates, a need for improved technological, business management processes and procedures and a need to improve service levels to customers.

⁴The City of Tallinn's right of veto related mainly to the change in the PO/SI ownership structure and the selling of Private Operator/Strategic Investor's shares.

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