Historically, the CIF has advocated that municipalities split material sales revenue between themselves and their contractor, provided the municipality has sufficient tonnage to warrant the extra administrative work. This approach was intended to mitigate the impact of shifting commodity prices on contractors and incentivize them to maximize the value of marketed materials. But what are the implications for a municipality transitioning under the, yet to be written, new Blue Box regulation?
Risk Management and Incentives
Over the years, municipalities have endeavoured to encourage their processing contractors to maximize material capture and sales revenue by offering the contractor a portion of the revenues. If, however, you’ve followed commodity pricing in the CIF Price Sheet over the years, you’re all too aware that prices can shift over 200% between bull and bear markets. While leaving all the revenue to the contractor seems simple, it actually puts them at considerable risk and typically means that they need to increase their processing bid price in a multi-year contract to protect their margins. Sharing revenue is a way of rewarding a contractor while mitigating risk so they can focus on operating costs legitimately under their control.
Municipal Administrative Costs
All revenue sharing agreements require an appropriate level of due diligence. That means, checking the contractor’s reported revenue against appropriate indices/end markets, as well as monitoring quality control and tonnage reports. In periods of weak revenue, significant time can be lost to resolving issues and negotiating fair compensation. So, for smaller programs it simply may not be worth the effort. But what is the cut off point? For the purposes of this analysis, four primary variables were modeled to determine the minimum tonnage required to offset managing a revenue sharing agreement and to identify the preferred revenue split:
A composite price of $90/tonne (based on the CIF Price Sheet) was used to represent the predicted revenue. A fully burdened labour rate of $41.07/hour (Statistics Canada) and an estimated average of 62 hours/year of net labour was used to represent administrative costs needed to manage a small tonnage revenue sharing agreement. Finally, processing costs were adjusted on a sliding scale to model risk for revenue sharing deals ranging from the municipality keeping 100% of the revenue (and risk) to the contractor keeping 100%.
The ‘break-even point’ (i.e., the point at which the added contract management costs can be justified) for the most common scenario of an 80% municipal and 20% contractor revenue share deal, was a minimum of 125 tonnes marketed per year. This scenario assumes approximately $5,500 in monitoring and administrative costs and would leave the municipality with a net profit of $3,000. While that may seem worthwhile, one rejected load of fibre returning from an overseas market can quickly erase a municipality’s revenue depending on the terms of the contract. In fact, because administrative costs go up as tonnage increases, the model predicted that volumes closer to 200 tonnes per year are likely required to cover typical load rejection write-offs, price fluctuations and other unexpected costs, in order to still turn a net profit.
The model also suggested that under the above variables, there was no clear benefit between different revenue sharing ratios since the impact is linear. In reality, adjusting the revenue sharing ratio simply shifts the risk and reward to either party. Ultimately, the decision to go with an 80/20 or 50/50 formula, or anything in between, depends on the risk tolerance of the parties and the contractor’s ability to produce premium quality materials which tend to be preferentially purchased by buyers, irrespective of market conditions.
How processing agreements evolve as municipal programs transition under the yet to be developed regulation is unknown. Municipalities are encouraged to consider the possibility that their contracts may need to be broken and processing could be reassigned to a new contractor. In considering three options ranging from: 1) the municipality keeping 100% of the revenue; 2) a 50/50 split; and 3) the contractor keeping 100%, the easiest early termination to negotiate would be a scenario where the municipality kept all the revenue since the current contractor incurs no impact. Clearly, any other arrangement is likely to require that the municipality and contractor agree on the impact of the projected revenue loss over the remaining years of the contract. Municipalities procuring new contracts are encouraged to establish a benchmark for compensation such as the CIF Price Sheet or other suitable indices. Alternately, including robust change management provisions in their RFP and asking prospective proponents to include pricing for early termination in their submissions can aid in avoiding unexpected adverse results.
It’s up to you, but anyone marketing less than 250 tonnes per year should look at the risk/reward of maintaining a revenue share system for their municipality going forward. In any event, in the face of transition to IPR, every contract should have strong change management provisions in place. Watch for future CIF blogs on that topic.
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