As in the Construction Phase, during the Operations Phase, the immediate mechanism to deal with non-compliance and contract breaches is typically a mechanism that has financial consequences for the private partner. However, the system and instruments for managing under-performance (by providing incentives for performance as required by the contract) have a higher complexity in this phase than during construction, as a wide and complex set of service requirements must now be monitored.
A contract breach is a failure to observe a provision of the contract. For the purpose of this chapter, a distinction may be made between breaches of the service performance requirements (that is, not meeting the service targets or standards) and the breach of other contractual provisions.
The distinction is useful, as the financial consequence imposed by the contract for a service performance failure or under-performance situation may take the form of payment deductions (or abatements) in government-pays contracts. However, in user-pays contracts, the financial consequence due to the lack of performance (as well as other non-compliances or contract breaches) will most often result in a direct penalty or a Liquidated Damage (LD) amount through the penalty system.
The regime for financial penalizations is a simple principle of imposing a financial consequence in specific areas of non-performance and non-compliance (that is, contract breaches).
Simply put, the worse the performance the larger the financial penalization, and the longer the non-performance persists the larger the penalization. An additional variation is to identify core performance areas and to have larger penalties for non-performance in these areas. An example of the principle, as applied in a government-pays PPP contract for a hospital, would be that non-performance leading to the non-availability of an operating theatre would attract a much larger financial consequence than the failure to meet the food quality standards required for wards.
The concept is relatively simple for government-pays PPP contracts, but it can also be applied to user-pays PPP contracts: the government may also apply the financial penalization by means of deductions from a payment that is due to the private partner (an example would be of a minimum revenue guarantee or operating subsidy payment). Where there is no payment stream to the private partner from the government, more artificial structures of performance reserve accounts — funded by the private partner but controlled by the government — may be used.
In addition to the financial penalizations, another mechanism has to be in place to control and monitor non-performance and non-compliance: it is necessary to track the breaches, which is usually done under a “performance points regime”. This mechanism will serve to trigger other remedy actions against non-performance as it becomes more serious.
The non-performance may be recurrent and result in a specific financial consequence (by means of increasing audits at the cost of the private partner, or by increasing the penalties or deductions through a ratchet mechanism), or may become so persistent that it is not sustainable to continue with the PPP contract. To effectively control this issue of the occurrence of severe and persistent breach, the contract may allow the government to levy performance points on the private partner for any single breach. When a certain threshold of such points is reached, the government partner is typically entitled to impose further or incremental financial penalizations as discussed above, exercise its right to step in, or even terminate the PPP contract.
Since termination is the last resort, the specific thresholds for the right to terminate are set high enough that termination will not happen without a chance for the private partner to remedy its deficiencies and start to perform in accordance with the specification again. In fact, it is common for a remedy period to precede termination even when the threshold has been reached.
4.1. Performance Monitoring Methodology
The performance monitoring methodology in a PPP contract typically contains a performance management model, comprised of three key elements.
- The level of performance required to achieve the output specifications: The levels should be set such that the standards are reasonable and objectively measurable;
- The means that the institution will use to monitor private party performance: The monitoring methodology included in the PPP contract should occur at three levels, such as a systematic self-monitoring by the private partner through a Quality Management System (QMS), a review of the private party’s QMS by the procuring authority or an independent third party, and end-user feedback on the quality and effectiveness of service delivery. The PPP contract must also specify the way in which performance is reported for monitoring purposes; and
- The consequences for the private partner of a failure to meet the required level: The consequences of poor performance on the part of the private partner must be handled in accordance with the PPP contract, which should contain provisions for a number of responses to performance failure, ranging from formal warnings, penalties, and/or payment deductions to eventual termination for private partner default.
As described in chapter 7 in the context of relief and compensation events, to the extent that the private partner is prevented from achieving the required performance levels by specific events outside of its control (as described and defined in the contract), or even by the public partner itself, the penalty regime and payment mechanism (in government-pays) should provide adequate and appropriate relief to the private partner.
Performance monitoring systems should be established to enable the PPP contract management team to do the following tasks.
- Check that all performance conditions and clauses in the PPP contract are acted upon;
- Develop effective mechanisms for obtaining feedback from end users and other key stakeholders;
- Review third party monitoring reports;
- Inspect deliverables to ensure inferior goods or services are not accepted; and
- Maintain comprehensive documentation on performance monitoring.
The PPP contract must specify the date by which the performance levels are to be achieved. In some projects, such as information technology (IT) projects, it is recognized that problems are inevitable in the settling-in period, and thus the private partner may be afforded a degree of flexibility in achieving the agreed performance levels. In other projects such as roads and prisons (where the safety element is crucial), it is essential that the private partner ensures that there are no settling-in problems and that the full performance level that the parties agreed upon are delivered from the outset, even if the road or prison is opened in phases. In the case of such phased service commencement, the amount of any government payments must be ramped up proportionately to reflect the phased service commencement.
Effective monitoring should provide the basis for reviewing actual private partner performance against the output specifications and other obligations contained in the PPP contract. As in the case of monitoring, reviews can be carried out by the government and/or independent third parties.
The action taken by the government to correct private partner performance must be in line with the provisions in the PPP contract and commensurate with the severity of the transgression. The application of formal warnings, penalties, and payment deductions or abatements, step-in and other responses should be undertaken in a manner that is likely to achieve the best result from the institutional point of view. An overly rigid approach may jeopardize continued service delivery to end users, while too much lenience could encourage the private partner to commit further breaches.
4.2. Quality Control and Quality Assurance Procedures
In order to encourage innovation and optimize risk transfer, the PPP contract should specify the required performance level through output specifications and not required inputs, that is, the manner of the services delivery. Suitable performance levels need to be worked out carefully by both the government and bidders during the competitive stages of procurement. The negotiated performance levels will form a key element of the risk transfer mechanism.
The monitoring requirements should be set out in a Request for Proposal (RFP) and a full methodology must be included in the bid. The methodology will normally include a substantial element of self-monitoring by the private partner, subject to periodic review by the government. Additional monitoring by the government may also take place depending on the nature of the project, for example, clinical staff in a hospital identifying and reporting performance failures.
The periodic reports to be provided by the private partner are key to the management of the PPP contract and to the payment mechanisms, and they should be specifically tailored to meet these monitoring requirements. A distinction must be made between the monitoring mechanism formulated and implemented by the private partner and any actual monitoring undertaken by the government, as and when it deems it necessary in accordance with the PPP contract. The private partner should have the primary responsibility for the former, and the PPP contract should clearly provide how it will conduct this self-monitoring which will constitute the basis for the calculation of performance penalties or deductions.
Objective performance criteria should always be used as far as is possible, but other methods of measuring performance may be appropriate in certain projects. For example, there may be qualitative aspects of performance to which it may be difficult to apply penalties or deductions objectively, but which are nevertheless important to the users of the services such as the helpfulness of staff or the quality of catering. Three possible approaches for measuring these aspects of performance are the use of end-user satisfaction surveys, the use of “mystery shoppers”, and sampling, as discussed in table 8.2.
TABLE 8.2: Benchmarking of Services during the Operations Phase
End-user satisfaction surveys
It is difficult to base financial compensation on end-user satisfaction surveys because they are based on individuals’ perceptions rather than on objective, measurable facts. The results of such surveys may therefore vary. However, over time they are a useful way of monitoring performance.
The questions should be carefully drafted in order to achieve a meaningful response. The private partner could be obliged under the PPP contract to improve end-user satisfaction and, where a survey reveals that a particular aspect of the services falls below the agreed level, a rectification plan should be required and agreed with the procuring authority. The advantage of such a system is that if end-users clearly understand the quality of services contracted for, the feedback obtained can be very useful.
A similar approach could be adopted with “mystery shopper” surveys, which is the use of qualified individuals to test aspects of the services. This removes the perception aspect of testing since the relevant individuals will apply the same objective standards to all aspects of the services tested.
Where monitoring is to be done on a sampled basis, the methodology for sampling, including sample size and frequency, should be agreed prior to the signature date.
Certain projects do not lend themselves particularly to any of these approaches. Regardless of which method is used, the quality of services must be considered in detail by both parties and included in the PPP contract.
4.3. Penalizations and Incentive Schemes Provided for Monitoring Purposes
The PPP agreement must clearly stipulate the consequences of any failure by the private partner to perform to the minimum standards of the required output specifications. The principle should be that penalizations (either penalties or deductions) are applied in a manner that is appropriate and proportional to the non-performance of the private partner. The ultimate threat of termination is reserved for very severe cases of non-performance by the private partner.
The value of the penalizations should be set based on commercial considerations, rather than the cost of providing the services. The PPP contract would in this case include a schedule detailing the level of penalties imposed for each failure to meet a required output specification. Alternatively, the payment mechanism must be clear as to how to calculate the deductions or abatements.
There should be a clear link between the seriousness of the failure, the value of penalties or deductions accrued, and the potential financial impact on the private party. For example, a failure to clean the exterior of the windows in a hospital should not accrue as high a penalization as a failure to maintain the operating theatre in the specified condition. Similarly, different failures in respect of the same part of the services may also incur different financial penalizations depending upon the context in which they arise. For example, a failure to deliver food in a suitable condition is a more serious failure than a failure to serve food wearing a waiter’s uniform.
In government-pays contracts, where the penalization is applied in the form of deductions or abatements, depending on the specific payment mechanism used, a failure may or may not have an immediate financial impact on the payments payable by the procuring authority. It is possible for payment deductions to only start once performance deteriorates below a particular level or alternatively for them to accrue on the first failure.
In some projects, it will be appropriate to have a ratchet mechanism to deal with a recurrent failure to render a particular aspect of the services. A simple ratchet mechanism could involve increasing the level of penalties or deductions awarded for a particular failure in the services that recurs too often within a specified period. For example, if deductions equal to x are made for a failure to achieve a particular output specification, then deductions equal to (x+3) may be made for each failure over and above a specified maximum number of failure repetition within a pre-defined period.
The ratchet mechanism can be useful where the financial cost of penalizations, which accrue in respect of each such failure, is insufficient to provide an appropriate incentive for the private partner to rectify the failures. A key advantage of the ratchet mechanism is that poor performance which continues for a significant period will be more difficult for other project participants (for example, sub-contractors and the funders) to ignore, thereby encouraging early action by the private partner.
It must be noted that seeking improvements is not about extracting more from the private partner against its will, but about working together to improve quality, performance, Value for Money, or other aspects in a way that benefits both parties.
Given the length of time over which a typical PPP project will run and the difficulties of predicting technological and other productivity improvements that may occur, it is important to ensure that adequate attention is devoted to the issue of performance improvement. Ideally, the requirement for improvement should be embodied in the terms of the PPP agreement or in the role of a sector regulator.
The payment mechanism contained in the PPP agreement provides some incentive for the private partner to seek improvements in performance. If prices are fixed, they can increase their profit by improving efficiency. If profits are shared, they are motivated to improve economy. The procuring authority can also provide incentives to the private partner for early commencement of services if this is affordable and provides Value for Money.
It is important that the government does not take all of the benefit of performance improvements for itself, as this will deter the private partner from identifying such improvements. The PPP contract (or sector regulatory regime) should provide incentives for performance improvement, which could be both financial and non-financial. In this context, they should also be affordable for the procuring authority.
The improvements should be introduced through the variation procedures. The incentives should also be linked to circumstances in which the private partner can provide added value. Added value means bringing something to the partnership that is genuinely worthwhile to the procuring authority and beyond what was originally envisaged in the PPP agreement. Some examples of adding value are listed below.
- Eliminating aspects of the service that are no longer required;
- The use of new technologies that would provide a cheaper and more effective service;
- Changes in procedures or working practices that provide more efficient ways of delivering the service; and
- Opportunities for innovation, where the private partner is given the chance to implement or devise new solutions that will improve the performance of the service.