November 11, 2003

SUBJECT: Request by Bay Counties Waste Services to Extend the Length of Its Contract to 27 Years

EXECUTIVE SUMMARY

Fiscal Impact

Public Contact

Recommendation

BACKGROUND

Current Contract Term

The City Council approved the assignment of the contract to BCWS in a series of actions in late 1992 and 1993.  Included in the approvals were changes to the franchise agreement that extended its term by an additional three years (to 2004) and that significantly redesigned the methods for determining the annual payment to the contractor (as discussed in more detail in “Contractor Compensation and the ‘Return on Efficiency’ Clause,” below).

In 1996, BCWS approached the City with another request for an extension of the term of the contract.  On June 11, 1996 the City Council approved the Sixth Amendment to the contract (RTC #96-224).  This amendment added seven years to the contract, extending it to its current end date in 2011.  In exchange, BCWS agreed to an immediate reduction in its profit, from 11.1% to 9.3%.  Following the Sixth Amendment, the contract term totaled 20 years (1991-2011).

Contractor Compensation and the “Return on Efficiency” Clause

Stated simply, the BCWS contractor payment is determined by a “cost plus” method in which the contractor’s “necessary and reasonable” costs are carried forward, adjusted for inflation, then added to an agreed percentage of profit, currently 9.3%.  This basic approach to contractor compensation is common in municipal refuse collection contracts and accommodates the unpredictable year-to-year variation in numbers of customers, quantities of waste and recyclables collected, cost of labor, fuel, insurance, etc.  However, by its nature, this method of setting payments is an incentive for contractor inefficiency, since the higher the contractor’s costs, the larger the future payment (and profit) will be.

To provide a countervailing incentive for efficiency, the contract also includes what is known as the Return on Efficiency clause.  The provision says that the contractor gets to keep 50% of any cost savings that results from a proposal that has been approved by the City, with the City keeping the other 50%.  This essentially provides the contractor with a 50% return on efficiency, as compared to a 9.3% profit on inefficiency.  BCWS has used this process to propose and benefit from five successful efficiency measures:

·         Worker’s Compensation Insurance (1994)

·         Residential Refuse Route Reduction (1994)

·         Residential Recycling Route Reduction (2000)

·         Residential Yard Waste Route Reduction (2001)

·         Interest Cost Reduction through Use of California Pollution Control Financing Authority funding (2001)

To illustrate how the contractor payment is set; the components of the annual payment for the current fiscal year are shown in the table below.

EXISTING POLICY

Solid Waste Sub-Element

Goal 3.2A. Ensure that all municipal solid waste generated within the City is collected and transported in a manner that protects public health and safety.

Policy 3.2A.1 Provide convenient, competitively priced solid waste collection services.

Action Statements

·                     3.2A.1a. Establish, enforce, and periodically update collection service standards.

·                     3.2A.1c. Evaluate methods of achieving increased efficiencies in solid waste collection.

·                     3.2A.1d Compile and analyze information regarding collection operations to ensure that existing operations are operated in a safe, sanitary, and efficient manner and that collection costs are necessary and reasonable.

Goal 3.2G. Contribute to an economic development environment that is supportive of a wide variety of businesses.

Policy 3.2G.1. Provide solid waste services desired by businesses at competitive rates

DISCUSSION

The contract presently has a term of 20 years and will expire on June 30, 2011.  Staff anticipates that work on a competitive process for a post-2011 contract would begin approximately two years in advance of the expiration of the current contract.  A typical procurement process would include:

·         Legal review and update of the contract language to address customer service issues, changes in law, changes in industry technology, and any other updates desirable to the City

·         Development of a Request for Proposals (RFP) document

·         Issuance of the RFP

·         Financial and technical evaluation of the proposals received

·         City Council selection of a service provider

·         Transition period (for new or existing hauler to procure new equipment)

The City’s use of a competitive RFP process to select its post-2011 contractor provides two main benefits as compared to a contract extension:

1.      Requires proposers (including the incumbent contractor) to “sharpen their pencils” and provide competitive pricing

2.      Allows the City an unfettered opportunity to make beneficial changes to the franchise agreement

In 1989, the last time this contract was procured competitively, the RFP resulted in a 16% price reduction and improved services.  This was accomplished partly through more efficient collection technology that the City required through the RFP and partly by the contractors searching for efficiency improvements.

By allowing the City to prepare a new contract, the 1989 RFP process also gave the City (and its customers) higher standards of service and enhanced protection on legal and financial matters.  However, the passage of time has brought new technical and legal issues that are not addressed by the 1989 RFP and resulting 1991 contract.  An RFP process prior to expiration of the existing contract in 2011 would leave the City free to update the contract to current legal standards.  Staff expects there to be considerable industry response to an RFP for the Sunnyvale collection contract, as Sunnyvale is the fifth-largest city in the Bay Area and the contract has significant value.

First Proposal

In the past four years, BCWS has twice proposed that the term of the contract be further extended, this time to 27 years (2018).

The first proposal was received on November 28, 2000.  BCWS proposed that the company be given an Annually Renewable Franchise Agreement (ARFA) also known as an “Evergreen” contract that would be automatically extended each year to maintain a perpetual ten-year remaining term.  In exchange for this, the company offered to reduce the contractor payment by approximately $285,000 per year.  However, if the City exercised its right to give a ten-year notice to terminate, the $285,000 savings would go away for the remaining ten years of the contract.

Following a staff analysis of the offer, this first proposal was turned down by way of a letter from the City Manager.  This letter and the results of the staff analysis were shared with the City Council on March 30, 2001 (see Attachment A).  The most significant drawback of the ARFA proposal was that it would strip the City of real control over who the contractor was and how long the contract would run.

Second Proposal

BCWS presented a second proposal on March 18, 2002.  This proposal had three key elements:

1.      Extend depreciation of trucks and equipment to 10 years from 7 years and 5 years, respectively

2.      Savings from the extended depreciation to be split 50/50 between BCWS and City, treating this as a Return on Efficiency proposal

3.      Extend the contract term to 27 years (moving the end date from 2011 to 2018)

BCWS has the option to, at any time, propose the depreciation extension as a Return on Efficiency proposal and thus increase its profits (and reduce City costs and refuse collection rates) through June 30, 2011.  City staff has suggested that BCWS separate its proposal into two pieces, i.e. (1) a Return on Efficiency proposal based on extending depreciation and (2) extension of contract term to 27 years.  However BCWS has opted to not do so and continues to attempt to link these two issues.

The second proposal was turned down on July 10, 2003 after careful review and analysis of the technical, financial and legal aspects of the proposal by the Departments of Finance and Public Works.  The analysis found that the proposed change was not likely to be advantageous to the City over the long term for the reasons described in more detail below.

·         The savings described by BCWS would be accomplished by using the company’s trucks and equipment for 10 years instead of the current seven years.  This lengthening of depreciation is not without cost to the community, as trucks, bins and other equipment will, on average, be older, somewhat less reliable, and somewhat less attractive.  Introduction of improvements in truck technology (most notably in the fast-changing area of engine emissions) would not be incorporated into the truck fleet as quickly.  Thus the City’s savings could not be achieved without risking reduced reliability of collection, reduced air quality, and reduced quality of appearance of these highly visible features of the community.  All of these issues are of concern to the City, its customers, and the community at large and must be weighed against any financial benefits of extending depreciation.

In one current example, the California Air Resources Board (ARB) has proposed new regulations that essentially require all waste collection vehicles statewide to be converted to alternative fuels by December 31, 2010.  BCWS has a diesel truck (debris box truck #224) that is currently scheduled to be replaced with an ARB-compliant truck in FY 2008/09, in time to meet the 2010 deadline.  If depreciation were immediately extended to 10 years, BCWS would not be able to comply with the proposed ARB regulations unless it retired and replaced that truck before getting 10 years of use from it.  Doing so would reduce the cost savings below what is currently assumed.

·         The net present value of the cost savings from the BCWS proposal over the next 14 years is minimal in the context of this large expense item.  The best estimate is that accepting the proposal would generate total savings (compared to the current contract’s terms) that have a net present value of $6,637,000 over 15 years.  After a 50/50 split with the contractor, the City’s share of the savings would have a net present value to the City of $3,318,000 over 15 years.[1]  Put another way, the total dollar savings to the City over the 15 years would be just 1.8% of the projected franchised hauler payments for that time period and just 1.0% of the projected rate revenue.  This is not a trivial amount, but in accepting the proposal the City would be forgoing the opportunity to gain a much larger savings by

1.      Making the extended depreciation a requirement of any post-2011 contract and

2.      Taking advantage of market forces by conducting a competitive procurement to select the next contractor

·         Assuming that the community is willing to live with the effects of extending depreciation, the City will be able to gain financial benefits from doing so and still retain the option of a competitive procurement for post-2011 collection service.  In soliciting competitive proposals for the franchise after 2011, the City can capture 100% (as opposed to 50% under the BCWS proposal) of the 2012-2018 savings by simply incorporating longer depreciation periods into the new contract.  The net present value of the savings thus gained by the City between 2012-2018 is estimated to be $2,512,000.  In the 2004-2011 time period, the City can realize either 50% (if BCWS proposes a Return on Efficiency proposal) or 100% (if the City directs the contractor to extend depreciation) of another $4,124,000 net present value savings.  See Attachment D for details of the depreciation and net present value calculations.

A review of the franchise agreement itself by an outside legal expert did not reveal any critical flaws or important opportunities for improvement that would, by themselves, add enough value to justify reopening the contract to incorporate the proposal.  The review did note marginal opportunities for improvement to the contract in areas that include:

·         Definition and enforcement of customer service standards

·         The City’s ability to approve/disapprove assignment of the contract when the company is sold or when other events alter the controlling interests

·         Size and nature of the performance guarantee (currently a $3 million performance bond)

·         Indemnification provisions

·         City’s right to perform services

As noted above, none of these issues warranted opening the contract for legal reasons.

The City’s response to the BCWS proposal was shared with the City Council on July 10, 2003 (see Attachment B).

On August 19, 2003 a BCWS representative spoke during Citizens to Be Heard and asked that the company’s recently declined proposal be heard directly by the Council.  The Council agreed to do so, and set the agenda date as November 11, 2003.

Fiscal Impact

If the Council declines the BCWS proposal, BCWS implements 10 year depreciation as a Return on Efficiency measure and the City requires 10-year depreciation in the next refuse collection contract, the City will save a total of $4,574,000 (net present value) during the period 2004-2018.  If the City directs BCWS to extend depreciation and keeps 100% of the savings, the total net present value of the savings to the City increases to $6,637,000.  Significant additional savings are likely to result from a competitive process to select the post-2011 contractor.

A Council decision to accept the BCWS proposal and extend depreciation to 10 years will result in cost savings with a net present value of $3,318,000.  There would be no competitive selection process and thus no opportunity for further cost savings beginning in 2011.

Conclusion

The BCWS proposal attempts to link two unrelated issues

1.      Extending the depreciation of trucks and equipment

2.      Adding seven years to the length of the franchise agreement, bringing it to a total of 27 years.

These questions are, in fact, separate issues.  The first question the City Council addresses in responding to the BCWS proposal is whether or not it approves of extending to 10 years the depreciation schedules for trucks (currently 7 years) and equipment (currently 5 years).

BCWS has demonstrated its ability to specify, purchase, maintain and repair trucks and equipment in such a way as to extend their useful lives beyond the depreciation periods specified by the contract.  Staff feels that the amount of money that can be saved by doing so justifies accepting longer lives on these assets.

However, extending asset lives is not without impacts on the community, since it will result in trucks and equipment that are older, on average, and thus somewhat less reliable and attractive.  For trucks in particular, less frequent replacement will delay opportunities to implement new collection and engine technologies (e.g. alternative fuels and engine emissions controls).

Assuming that the City Council finds that extending the lives of the BCWS trucks and equipment is an acceptable way of reducing the contractor payment, the next question is how to accomplish that so as to maximize the savings to the City and its refuse collection ratepayers.  As noted in the Fiscal Impact section above, the City achieves a larger savings by declining the Specialty proposal and implementing 10 year depreciation between now and 2011 by other means than it will save by accepting the BCWS proposal to extend the term of the contract to 27 years.  By declining the proposal the City will:

1)     Retain the option of using a competitive process to select its refuse collection contractor for the period after 2011, which should result in significant cost savings due to market forces; and

2)     Realize a net present value savings of $4,124,526 between 2004-2011 by directing the contractor to implement 10 year depreciation (or half that savings by accepting a Return on Efficiency proposal); and

3)     Realize additional savings with a net present value of $2,512,000 during 2012-2018 by incorporating 10 year depreciation in the RFP for the post-2011 contract.

The second question is whether BCWS should be given a no-bid seven-year extension to its contract, bringing the total contract length to 27 years.  At nearly $15 million per year, the refuse collection contract is the largest single operating expense in the City’s budget.  Given the impact of its cost on Sunnyvale residential and business refuse collection rate payers and the potential for significant City cost savings when the contract is rebid (as currently scheduled), staff cannot advise the Council to pass up the opportunity to expose this contract to competition when it expires in 2011.

Staff does not recommend that the contract be given a no-bid extension.  However, should a majority of the Council be inclined to do so, an extension should be preceded by a thorough management audit of BCWS operations.  It is inevitable for inefficiencies to creep into any business in the absence of competition.  In this case, competition has been absent for 13 years that will be 27 years if the contract is extended.  An inferior alternative to competition would be to engage a third party consultant to thoroughly examine the company’s practices and make recommendations for improvements in efficiencies and elimination of any excessive expenditures.  Staff recommends that any proposed extension on the contract be preceded by such an examination and analysis (at BCWS expense) and implementation of the consultant’s recommendations.  This process would in no way substitute for the benefits gained by a competitive procurement, but would be preferable to simply extending the term of the contract.

An important consideration for the Council when it considers extending the contract end date to 15 years in the future is the possibility that BCWS can be sold and the contract assumed by new owners at any time.  This occurred when BCWS purchased Specialty Solid Waste and Recycling in 1992.  Other examples of this process have been seen more recently, wherein small, long-time locally owned garbage companies in Palo Alto and the West Valley cities have in recent years been sold to the largest garbage company in the nation.  The same circumstance was seen with the first SMaRT Station operating contract.  In that case, a series of corporate acquisitions led to three different companies operating SMaRT in during the seven year term of the original contract.  In short, the contract continues to the end of its term in such a case, even if the original contractor does not endure.

BCWS remains free to propose the depreciation change as a Return on Efficiency measure.  This approach would increase BCWS profits and save money for City ratepayers.  Assuming the Council approves of this concept, staff will continue to encourage BCWS to make this proposal.  Should such a proposal not be forthcoming in a reasonable amount of time, staff proposes to direct the contractor to make the change, in which case 100% of the savings will be retained by the City.

Staff recommends that the City Council decline the Bay Counties Waste Services proposal and maintain the term of the refuse collection contract at 20 years.

PUBLIC CONTACT

Public contact was made through posting of the Council agenda on the City’s official notice bulletin board, posting of the agenda and report on the City’s web page, and the availability of the report in the Library and the City Clerk’s Office.

ALTERNATIVES

Issue #A—Depreciation of Trucks and Equipment

1)     Approve in concept extending depreciation for contractor trucks and equipment to 10 years from 7 and 5 years, respectively

2)     Leave the present depreciation principles in place, unchanged

3)     Direct staff to take another action as desired by the Council

Issue #B—Extend Term of Refuse Collection Contract to 27 Years

1)     Decline the Bay Counties Waste Services proposal and maintain the term of the refuse collection contract at 20 years.

2)     Direct the City Manager to negotiate and return to Council a contract amendment with Bay Counties Waste Services that

·         Accepts the BCWS proposal to extend the term of the contract to 27 years and lengthen the depreciation of trucks and equipment to 10 years, with the City to realize 50% of the resulting savings.

·         Requires BCWS to submit its operations to a detailed performance review (by a consultant to be selected by the City) of the contractor’s operations to identify opportunities for route reductions and other efficiency improvements.

·         Requires BCWS to pay 50% of the cost of the performance review and to make changes to its operations that are identified by the review and approved by the City

·         Incorporates City-desired changes to the contract in the areas of service standards, assignment, and remedies.

3)     Direct staff to take another action as desired by the Council

RECOMMENDATION

Staff recommends Alternatives A1 and B1.

Prepared by:

Mark Bowers
Solid Waste Program Manager

Reviewed by:

Marvin Rose
Director, Public Works

Approved by:

Robert S. LaSala
City Manager 

Attachments:

A.     March 30, 2001 memorandum from City Manager to Mayor and City Council regarding BCWS proposal for Annually Renewable Franchise Agreement

B.      July 10, 2003 letter from City Manager to BCWS

C.     Net present value analysis of BCWS proposal to extend contract term to 27 years

D.     Net present value analysis of City savings from extended depreciation of trucks and equipment