Benefits and Potential Concerns Related to Davis Exercising Its Right of First Refusal for DWR

By Richard McCann and Jacques Franco

Davis Waste Removal’s owners would like to sell their business and retire, and have interest from Recology, a company with which City staff have had positive interactions. Recology serves many communities across Northern California, including San Francisco. DWR has had a long standing contract with the City and in 2015 the City wrote into its contract the ability to exercise the Right of First Refusal (ROFR) upon DWR’s notification of sale. Our City Council is weighing the opportunities here, which could include many options including: 1) owning the land only, 2) owning the facility, and facility machinery and equipment, 3) owning the collection trucks, carts and containers, or 4) taking on the full operation. At the City Council meeting October 3, the Council appeared to be interested in only a combination of the first two options. On October 12, the Utility Rates Advisory Commission (URAC) voted unanimously to recommend that the City exercise the ROFR and begin negotiations for the first two options.

We put together a list of benefits and potential concerns for the City Council to consider and to aid in the public understanding their unanimous recommendation to exercise the ROFR by the current October 17 deadline. An earlier version was presented to the URAC as part of its record for considering its recommendation. This would open a 90-day period similar to escrow on the purchase of a house with inspections of the facility and negotiating on price.

Benefits

  • The City Gains Substantial Option Value and Leverage in Negotiating with Providers

Exercising the Right of First Refusal (ROFR) provides significant option value to the City of Davis, both the short term in potential negotiations with the candidate future provider, Recology, and in the long term in exploring waste management policies and alternative uses of the Second Street property. Owning the property will open up more choices for repurposing the property to other types of development and/or relocating the transfer station without having to engage in further negotiations.

  • Owning the Property Delivers Direct Financial Benefits to the City

The City can gain access to a revenue stream that that can enhance the return on City investments while gaining control of a significant seven-acre parcel. The City of Davis’ ratepayers have
already paid for DWR’s property and facilities at least once through their historical rates, and will have to pay for it again. The only question is whether they will own the property and facility this time or again pay for a facility that they will not own. Further, the City may be able to use unencumbered reserves that are currently earning very low returns to finance the purchase of the property, which will deliver effectively higher returns.

  • Controlling the Property Gives More Control over Cash Flow from Rates

As result of owning the property and facilities, the City will be able to directly determine the return on investment to be incorporated in customers’ rates. Typical cost of capital for an investor-owned regulated utility such at PG&E is currently 7% to 10%, while municipal cost of capital is 1% to 5%. In addition, the City can extend the term of financing to lower apparent costs. For example, comparing an investor-owned facility with an 8% return and 30-year term to a municipally-owned one with a 4% interest rate over a 50-year term, the annual cost falls 48%. That is a saving that can be used to manage future solid waste rates.

  • Ultimate Control of the City’s Solid Waste Future

Owning the property and facilities at 2727 Second Street is the single most significant action the City can take to control its solid waste management future. Owning that facility:

  1. Gives the City ultimate control over who it wants to run the City’s solid waste management system now and forever; and
  2. Places the City in position of strength with respect to all future negotiations with Recology, or any other service provider.

If the City does not take ownership of the property and facility just the opposite is true.

We investigated and interviewed local agency managers for their opinions.

Doug Kobold, Waste Management Program Manager for Sacramento County Department of Waste Management & Recycling wrote to the City Council: “…This public ownership, contract operated, model exists in many communities around the Sacramento Region. The Counties of Yolo (Yolo County Central Landfill), San Joaquin (Foothill Landfill and the Lovelace Transfer Station), and Placer (Western Placer Waste Management Authority facilities), to name a few have this type of relationship in place and have been very happy with the results. Owning the land and structures on 2nd Street in Davis ensures that the City of Davis can control how the facility is operated and by whom.” He added, “I believe the Council should not miss out on an opportunity that will not likely present itself again… “ Kobold is a resident of Davis.

RethinkWaste is a joint powers authority of twelve public agencies (Atherton, Belmont, Burlingame, East Palo Alto, Foster City, Hillsborough, Menlo Park, Redwood City, San Carlos, San Mateo, the County of San Mateo and the West Bay Sanitary District) in San Mateo County, California and is a leader in the delivery of innovative waste reduction and recycling programs. Recology San Mateo County provides recycle, compost and garbage collection services for the 93,000 RethinkWaste residences and 10,000 businesses.

Hilary Gans, Sr. Operations & Contracts Manager spoke out in support of public ownership of solid waste management facilities.  “As I look at the decisions that our Agency has made over past 10+ years to improve service and manage costs, the purchase of this waste handling infrastructure has been the single most important event.” 

In Napa, the City of Napa along with the County of Napa and the Cities of Vallejo and American Canyon manage a joint power authority called the Napa-Vallejo Waste Management Authority (NVWMA).  The NVWMA owns both the Devlin Road Transfer Station (used by all the member jurisdictions) as well as the old American Canyon Landfill.  Both the City and the NVWMA have a model of public ownership of the property with private contractors running the facilities day-to-day.

Potential Concerns and Responses

  • Recology will walk away from the deal if it cannot take ownership of DWR’s property and facilities
    • If Recology is not willing to negotiate an agreement with DWR that does not include facility ownership that tells about how much vendors value facility control, and why it is critical for the City to own the facility and not allow Recology to obtain ownership and the power/control over the City’s solid waste management system that ownership brings.
    • The deal may less attractive to Recology without facility ownership as it would not have control over the City’s solid waste management system, as noted above. That being the case, if DWR’s owners want to retire and make this deal happen than it is contingent upon DWR to give up some of the value it is receiving from Recology for the remaining 10 years in the contract term, and not the City to give up its Right of First Refusal. The room to negotiate is illustrated in this graphic showing how the value of different elements interact.
    • Worst-case scenario Recology walks away from the deal. In that case the City still has 10 years remaining in the agreement with DWR and has retained its Right of First Refusal.
  • If the Recology deal falls apart, we may end up with a less qualified Service Provider

This cannot occur. Section 16.b. of the Agreement (Assignment and Transferability; Subcontracting) states that City shall be operated in good faith to evaluate the proposed Assignee and/or Transferee to determine if the Assignee and/or Transferee has prior experience in cities of similar complexity and size and has similar services and demonstrated the financial capability and capacity to perform, the reputation, responsibility, reliability, and integrity equal to or better than the current Franchisee.

  • City staff may have concerns about their ability to effectively manage facility ownership

The City could engage a qualified solid waste facility engineer to help it and staff:

  • Conduct the type of due diligence required in any transaction in escrow related to the purchase value DWR’s 2727 Second Street facilities;
  • Draft and negotiate a facility operating agreement with Recology, with the assignment contingent upon Recology entering into a facility operating agreement with a term that expires at the same time as the franchise agreement; and
  • Monitor Recology’s performance going forward to ensure that it is complying with the terms and conditions of the facility operating agreement, and appropriately operating and maintaining the property and facilities.

Owning the facility will improve City staff’s ability to manage the collection franchise, as the City will be in a position of strength with respect to all future negotiations with Recology or any other future service provider, and will have more transparency in understanding the underlying costs of operation.

There are any number of qualified solid waste facility engineers who could assist the City and URAC members have offered specific suggestions and contact information for staff to investigate.

The City Council will address this issue in the October 17 Council meeting.

Richard McCann and Jacques Franco are members of the City’s Utility Rates Advisory Commission, but this article reflects only their individual opinions and are not endorsed by the URAC.



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22 thoughts on “Benefits and Potential Concerns Related to Davis Exercising Its Right of First Refusal for DWR”

  1. Howard P

    Ideally, there would be a RFQ/RFP approach, with several vendors/potential owners, where service, revenues, costs could be compared in some sort of matrix.

    Note that the above analysis is broad-brush and theoretic, and does not speak to loss of property tax, for both real property, and equipment, if the City were to own one or both.

    Possible revenue from a ‘franchise fee’ is also not addressed.

    This should be evaluated carefully, and fully, before a decision is made.

  2. Tia Will

    Article is much appreciated. Howard, do you have the ability to “flesh out” the points you mentioned for those such as me who have zero knowledge of this area. You know, explain like I am a five year old.

    1. Mark_Murray

      Matt: Can you point me in the right direction regarding a source for your comment below regarding State Rate setting guidelines authorizing profits of up to 14% of revenues. Thanks. murray_at_cawrecycles_dot_org

      “Fourth, the State guidelines for rate setting are the Profit can be up to 14% of Revenues.  Since Recology’s Revenues are identical in both scenarios, their annual Profit will be identical in both scenarios. That works out to approximately $1.6 million per year.”

      1. Matt Williams

        Mark and Howard, the following is the language from the existing DWR contract with the City.

         

        Agreement for Collection and Handling of Solid Waste Between the City of Davis and Adopted February 24, 2015 Davis Waste Removal Co., Inc.

        Exhibit H
        Detailed Rate Review Methodology

        1.c. Forecasted Profit.

        Contractor shall be entitled to Profit on the Forecasted Total Annual Cost of Operations. Profit for the coming Rate Period will be calculated by dividing the Total Annual Cost of Operations for the coming Rate Period (the value calculated in Section 1.b.vi above) by an operating ratio of eighty eight percent (0.88) and subtracting from the result the Total Annual Cost of Operations for the coming year.

        Profit = (Forecasted Total Annual Cost of Operations for Coming Rate Period/Operating Ratio) − Total Annual Cost of Operations for Coming Rate Period 

        If you divide 100% of the costs by the 0.88 you get a rate of 113.63636% as the Revenue.  Revenue minus Costs yields Profit.  113.63636 – 100.0 = 13.63636% allowed Profit Margin.

  3. Matt Williams

    From the Article . . . “Potential Concerns and Responses

    Recology will walk away from the deal if it cannot take ownership of DWR’s property and facilities”

    There is a very simple fiscal reality that makes it foolish for Recology walk away from the deal if it cannot own the 2727 Second Street property.

    First, let’s look at what Recology’s investment costs will be in the Transfer Station purchase vs. the Transfer Station non-purchase scenarios.  Although final prices are not known, the purchase price in the the Transfer Station purchase scenario is approximately $20 million and he purchase price in the the Transfer Station non-purchase scenario is approximately $10 million.

    Second, let’s look at what Recology’s annual revenues will be in the two scenarios.  Those revenues will be identical.  The City will pay Recology the exact same Franchise Fee regardless of the ownership status of the Transfer Station.

    Third, let’s look at what Recology’s annual costs will be in the two scenarios.  Those costs will also be virtually identical.  In the Transfer Station purchase scenario Recology will have to pay the annual debt service on a loan/mortgage for a $20 million purchase, plus pay the annual Property Taxes.  In the Transfer Station non-purchase scenario Recology will have to pay the annual debt service on a loan/mortgage for only a $10 million purchase, plus the City an annual rental for use of the Transfer Station.  The City will almost surely set the annual rental fee to be equal to the annual debt service on a loan/mortgage for a $10 million amount, plus the amount of the annual Property Taxes.

    Fourth, the State guidelines for rate setting are the Profit can be up to 14% of Revenues.  Since Recology’s Revenues are identical in both scenarios, their annual Profit will be identical in both scenarios. That works out to approximately $1.6 million per year.

    Bottom-line, $1.6 million per year profit on a $10 million investment is a 16.5% Return on Investment (ROI) and a 6 year payback period.  $1.6 million per year profit on a $20 million investment is an 8.3% Return on Investment (ROI) and a 12 year payback period.  In the Transfer Station non-purchase scenario Recology has double the ROI and half the payback period.  That is too good a deal to walk away from.

    1. Howard P

      Maybe… but it’s the vendor’s calculus and evaluation that matters… no one else’s… that’s why I suggest an RFQ/RFP process…

      As I recall, you are not a SME as to solid waste issues…

      1. Matt Williams

        Howard, ROI is an accounting subject, not a solid waste subject.  So being a SME on solid waste issues is irrelevant when calculating accounting ratios.

        With that said, the team of people who collaborated on the fiscal model included a solid waste issue SME, as well as several people whose knowledge about solid waste is extensive.  100% of the thoughts on solid waste issues came from those experts on solid waste.  Just think of me as their handy-dandy model builder.  As they say, the whole is greater than the sum of its parts.

        With that said, given the currently-in-place agreement with DWR, which has either 10 years or 13 years left to run, how exactly would you conduct a RFQ/RFP process?  How could you involve multiple vendors/potential owners?  And at the end of that process, what exactly would the City be in the position to award?

        1. Howard P

          The information you have now provided makes some sense… previous info did not.

          More information is needed… if the contract still runs 10-13 years, and if DWR ceases to exist as an entity upon sale/transfer of land and improvements, does the contract extinguish?  Are there provisions for ‘assumption’?  This is not clear as to the reporting to date.

          I’d be fine with (depending on the contract assumption details), passing on the first right of refusal thing (property taxes still in place, and the new owners adhering to the service and rate provisions already in place).  Least risk to customers.  If indeed the contract is in place, would not open it up based on a new owner’s financials.  They should understand all that going in… due diligence.

          Then when the existing contract is waning, would look to the RFQ/RFP thing.

          As you have explained it, with some info missing, I’d opine that the City stay out of it, if the new owners are prepared to fully execute the remaining 10-13 year contract.  I suppose in waiving its first right of refusal, the City could insist on moving that forward as to the new owners, in the event they sell.  Beyond my ken, but think that should be a discussion item…

           

        2. Richard McCann

          Howard P,

          To answer your questions:

          – The ROFR must be exercised by October 18 or so (it may be extended for a short while by agreement of the parties.) There is no time for an RFQ/RFP. This is a choice in alternative to the DWR-Recology transaction. There is no legal basis (for another 10 years) for an RFQ/RFP. In fact, the very point of buying the land and facilities is that it allows for competitive bidding for the franchise operations after 2027. If the incumbent owns the land and facilities, this becomes a barrier to any outside bidders. If the City waives the ROFR now, that will almost certainly guarantee no competition and no price discipline for the foreseeable future. (Private ownership of monopoly infrastructure is generally not a good idea for this reason.)

          – DWR is legally committed to deliver service through 2027, and the contract requires assignment to whoever purchases DWR’s operation. The new owners must abide by the existing contract for the duration.

          – Property taxes (of which the majority go to the state, not the City) can be replaced by an in-lieu fee. This is a very common step for all sorts of public utilities.

          There’s more detail in this Enterprise article which we chose not to repeat here: http://www.davisenterprise.com/local-news/council-to-discuss-future-fate-of-local-trash-haulers/

  4. Matt Williams

    To address other issues raised in the article, I share here an e-mail I sent to all five Council members individually. The one bolded sentence here is for clarity on the Vanguard.

    Council member, Jan Troost passed on to me Brett Lee’s request that we share any fiscal information we have developed as a group regarding the DWR acquisition by Recology, especially as it relates to the City exercising, or waiving, its Right of First Refusal regarding DWR’s 2727 Second Street Transfer Station.  The attached spreadsheet contains that information.

    Bottom-line, the modeled information indicates that the difference between waiving the Right of First Refusal and exercising the Right of First Refusal is approximately $25 million over the 10-year life of the existing Franchise Agreement.  That $25 million amount appears in cell S50 of the spreadsheet.  That strongly supports the argument that the City should not waive the Right of First Refusal, and should conduct a thorough due diligence of the City’s fiscal and policy alternatives during the 90 days following the October 17th Council meeting.

    The assumptions in the Excel spreadsheet can be adjusted and the model will produce new results based on the revised assumptions.

    The assumptions currently in the Excel spreadsheet are as follows:

    — The estimated overall purchase price for Recology, including acquisition of the Transfer Station, is $20 million (entered in cell S4)

    — The estimated Transfer Station portion of the overall purchase price is $10 million (entered in cell U4), with the understanding that $10 million is the high end of a $5 million to $10 million range.

    — The respective annual Debt Service costs are based on a 10-year period (currently entered in cell M11) in order to match the remaining term of the Franchise Agreement.  The State of California does allow longer terms than 10 years, but we felt matching the remaining term of the current Franchise Agreement was an appropriate assumption in this case.  The model supports up to 30 years in cell M11.

    — The annual interest rate (entered in cell M10) is set to 3.5%, the low end of a current range of 3.5% to 3.75% available in the lending marketplace

    — The calculated annual Debt Service costs are broken into two parts, (A) the Transfer Station acquisition portion reported in cell S20, and (B) the non-Transfer Station acquisition portion reported in cell S19.

    — The Property Tax amounts in cell S21 do not include any amounts for capital equipment since that equipment will be included as part of any land sale

    — The annual Recology profit calculation reported in cell S17 uses the 14% value recommended in the State of California rate setting guidelines.

    — The Annual Operations costs reported in cell S18 is a calculated amount subtracting the other four cost/profit amounts from the total annual revenue

    The members of the URAC, NRC, FBC, as well as the members of the public who have contributed to the dialogue about this subject recognize that a little bit of knowledge is a dangerous thing.  As such we all support the City exercising its Right of First Refusal to begin a thorough 90-day Due Diligence process with the help of industry and fiscal experts who can generate the well-vetted information the Council needs to make the best possible decision on what the ownership of the 2727 Second Street Transfer Station should be post-DWR.

    Thank you for your consideration of this important opportunity.

    Sincerely,

    Matt Williams
    Member of the Finance and Budget Commission, but speaking as an individual citizen

  5. Ron

    In the long run, it’s usually better to own (and control) a facility (at least the underlying land).  Glad to see the city’s interest in doing so.

    Can’t help but remember the time that Governor “weightlifter” tried to sell state-owned buildings, and then rent them back (for the agencies that were already housed there).  Not sure what ultimately became of that. (What a stupid idea.)

  6. Ron

    Howard:  “Note that the above analysis is broad-brush and theoretic, and does not speak to loss of property tax, for both real property, and equipment, if the City were to own one or both.”

    If privately-owned, wouldn’t the owners pass those costs onto customers (us), regardless?

    1. Howard P

      There is a big difference between enterprise funds and general fund.

      There is also the factor of the reassessments due to transfer of ownership related to property tax assessments.

      To your question, “yes”.  But it is not as simple as you seem to make it.

      There still is the question of whether there is/will be a “franchise fee”.

      There is still a question of proportionality of user fees and property taxes.

      1. Richard McCann

        The loss of property tax (most of which goes to the state) will be less than $100,000 a year. The rental income will be several times that. The City can pay an in-lieu fee to replace the property tax.

        There will be a franchise fee paid through 2027 per the existing contract.

      2. Matt Williams

        Howard, as I explained in my posts above, if the City owns the Transfer Station (2727 Second Street) then Recology will have no practical alternative other than to pay rent to the City for the use of the Transfer Station.  The existing DWR contract gives the City substantial protections vis-a-vis the responsibilities of any “successor” to DWR during the term of the Franchise Agreement.

        If the annual rent is set at a level that includes the City’s purchase price annual debt service PLUS an amount equal to the property taxes Recology would be paying if they purchased the site, then the City will have been “made whole” for the loss of property tax revenues lost due to the conversion from private ownership to public ownership.

        The “i”s are dotted and the “t”s are crossed in the scenario proposed.  We learned our lesson about “make whole provisions” during the FBC deliberations on the Nishi Development Agreement.

        However, it is IMPORTANT to reiterate that the recommendation by the many individual members of URAC and NRC and FBC and the public are for the City to exercise its ROFR to do the due diligence with the help of appropriate independent experts. The 90-day window specified in the existing DWR contract is designated for that purpose. The results of the independent due diligence will show whether the purchase should actually be made, and on what terms.

      3. Howard P

        Richard and Matt.. more info than was available in the article… I appreciate that… will consider…

        But Matt, “making whole” usually means ‘break even’.. no loss, no gain… zero sum…

        If there is ANY risk, the city should at least get some sort of “premium”… but it sure sounds like “there is no profit in this” (StarTrek).

        1. Matt Williams

          To keep the model simple we settled on a debt service level (at 3.5%) that is consistent with what Recology is likely to pay for a $10 million mortgage and a Property Tax level that is equal to what Recology would pay after the Prop 13 reassessment to the purchase price.  We weren’t advocating for gain or loss, but rather to simply show that at “break even” Recology ends up with a ROI percentage that is double and an investment pay back period that is half as long … while the City’s rate payers get to own the facility outright after 10 years of paying their Solid Waste bills rather than having Recology own the facility.  Further, the cash flow from the rental fee will pay for the annual debt service, so the rate payers (the City) will not have to pay for the purchase out of pocket.  it is effectively a leveraged buyout, where the asset generates sufficient revenues to fund the purchase.

           

           

        2. Matt Williams

          Howard, by my calculations in the assumed scenario of $10 million purchase price of the 2727 Second Street parcel and an additional $10 million purchase price for the remaining assets and good will of DWR ($20 million total).  The “Star Trek” difference for the Davis ratepayers is $25,139,574 over the remaining 10 years of the DWR Franchise contract, which includes $12,024,137 of equity lost plus $13,115,436 of leveraged buyout revenue lost.

          Those calculations would be adjusted up or down based on the actual interest rate for the parcel purchase loan.  3.5% is the assumption in the above calculations.  The Property Tax component of the the leveraged buyout revenue is the $10 million purchase price times a 1.0913% tax rate (sourced from https://www.besmartee.com/blog/california-property-tax-complete-list-by-county-2014-2015 )

           

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