5.1. Payment Mechanisms
The mechanism by which the private partner receives revenue with which it covers its costs, services its debt obligations, and generates a profit must be linked to the performance of its obligations under the PPP contract. The very heart of risk transfer and, therefore, Value for Money lies in the degree to which the private partner is incentivized to deliver the required services so as to receive the maximum amount of revenue.
The payment mechanism should incentivize the private partner to deliver the right level of performance, without unnecessary and costly over-performance, and penalize it if it fails to do so (European PPP Expertise Centre [EPEC] 2014).
In its broadest terms, the payment mechanism could either incentivize the private partner by increasing the revenue it receives when the services are delivered optimally (usually up to the maximum payment defined in the contract as a ceiling, but sometimes with a certain bonus that may go above the ceiling), or by dis-incentivizing the private partner from poor performance by means of reducing the revenue by applying penalties or abatements (see below).
In considering a penalty mechanism to dis-incentivize poor performance, a distinction must be drawn between government-pays PPPs and user-pays PPPs because the source of revenue, and thus the payment mechanism, differs between the two. In government-pays PPPs, the revenue stream almost exclusively comprises regular payments from the government (there may be some minor exceptions in the form of limited rights for the private partner to generate other income through commercial activities such as retail or advertising opportunities). The government also has the contractual rights to apply deductions that reduce the amount of the unitary payment (see chapter 5.10 and specifically 5.10.3).
In user-pays PPPs, the source of revenue is predominately the users of the infrastructure, such as a port, toll road, or airport. These users do not have the contractual right to make any deduction to the toll or tariff they pay in the event that performance is below that specified in the PPP contract. The contractual right to impose a financial penalization (a penalty or a LD amount) must therefore reside with an entity that represents the user’s interests in performance of the private partner. This entity might be the government itself or an independent regulator acting in terms of a legislative mandate. The most common sectors that have independent regulators are telecommunications, ports, electricity generation, transmission and distribution, and water.
This PPP Guide focuses on the role of the government in imposing financial penalizations on a private partner in either type of PPP where the government has the explicit contractual right to impose a financial penalization for poor or non-performance by the private partner.
5.1.1. Features of Revenue Regimes and Payment Mechanisms
There are two primary types of revenue regimes. The first is one in which the government pays the fee on a regular basis for the provision of the facilities and services stipulated in the contract, with or without deductions being made for performance (government-pays PPPs), and its structure and process of calculation is referred as “payment mechanism”. The second is that used when the revenue for the private partner is primarily from user fees (user-pays PPPs).
For government-pays systems, when designing the payment mechanism (besides taking into account risk transfer, Value for Money, and affordability), three other factors need to be taken into account: performance indicators and the initial performance targets for those indicators; regular measurement during the Operational Phase and the link between those indicators; and the appropriate payment deductions.
The payment mechanism should be built on clear performance measures linked to the service performance and key performance indicators. They should be simple and objective, as well as linked to penalty deductions that are equal to the private partner’s under-performance. They should not be linked to profitability and should not unduly affect the viability of the project.
If the private partner in a user-pays PPP under-performs, it faces reduced demand and will be penalized by a corresponding loss of revenue. However, a public partner may contractually define some penalties, and such penalties may still be applied if the partner fails to comply with a contractual obligation. Examples include not providing information on time, or if the private partner under-performs on specific obligations such as road maintenance.
For a government-pays PPP, there are certain essential elements of a payment mechanism.
- There should be no payments made until service commencement, and no payment should be made in advance of a service being delivered;
- The unitary payment should not be split into categories based on how it will be used by the private partner. This means that the unitary payment is not divided into amounts that would be applied, for example, to service debt or to fund maintenance by the private partner. This is the concept of a single and indivisible payment for full availability and performance of the services by the government;
- There should be an appropriate indexation of the unitary payment on an annual or semi-annual basis. The term “appropriate” is used here to reflect the underlying cost inputs of the private partner for a particular type of PPP. The default should be the relevant consumer price index (CPI), as this reflects the overall indexation normally applied to the government’s budget. There may be valid reasons as to why this would not provide Value for Money in the context where the private partner is exposed to significant cost components that historically deviate from CPI. These could include fuel or labor costs where the private partner would price in risk of above CPI increases into its base unitary payment. As payments to lenders are generally unaffected by the CPI, the proportion of the unitary payment related to debt service should generally not be indexed;
- There should be a mechanism for penalizing partial or complete failure of the availability and performance of the service by means of payment deductions. This requires a scale of deductions that reflects the severity of the performance failure. Too harsh a penalty for relatively minor failures may lead to adverse outcomes and disputes. Too lenient a penalty may leave the government with continuing failures that the private partner is not incentivized to remedy. Sector specialists and experts should be used to determine this proportionality for each project;
- Generally there should be no limit to deductions for non-availability. Notwithstanding the fact that the private partner has fixed costs that include the servicing of its debt; the government should not be in a position to pay for services that are not available. The negative political and public perception of a project in which the government pays for services not provided in cases of fault by the private partner would be a significant challenge to overcome;
- There should be a mechanism for dealing with changes to service requirements. As stated in section 6, a variation or change mechanism must be built into the payment mechanism;
- There may be a need for a mechanism to deal with pass through costs for items, services, or consumables where the government has control over usage levels (or where usage is dependent upon demand for service and outside the control of the private partner), and where it is inappropriate to place risk for usage and cost of supply with the private party; and
- In many PPPs, there are costs that do not relate to the provision and maintenance of the assets, but rather to the services, such as cleaning or catering, where there can be variations of costs over time (so called ‘soft services’). The United Kingdom’s HM Treasury Standardization of PF2 Contracts describes two ways of implementing a value testing procedure to apply at regular intervals (for example every five years) allowing for the soft services to be re-competed or re-priced. The government will take comfort that there is some means of ensuring that the price it has agreed to pay in future years will not be in excess of future market prices for such soft services. The two methods are: (i) market testing or re-tendering by the private partner of a soft service to ascertain the market price of that service; and (ii) benchmarking by which the private partner compares either its own costs or the cost of its sub-contractors for providing certain services against the market price of such services. Any increase or decrease in the cost of such services, following market testing, will be reflected in a revision to the unitary charge. This is known as market testing or benchmarking.
For user-pays PPPs, many of the characteristics of a government-pays PPP penalization approach for poor performance may be included when the government has an obligation to make payments of, for example, a minimum revenue guarantee. Alternatively, in some user-pays projects, a mechanism can be created whereby penalties are payable to the government, refunded to users, or (with the government’s consent) reinvested in the asset to provide additional services or amenities.
One additional consideration for user-pays PPPs is a sharing of returns between the public and private parties above a benchmark or base case return on equity. The reasoning is that it is appropriate to incentivize the private partner to benefit from its efficiencies while permitting the government to benefit from financial efficiencies that arise from economic factors that are outside the control of the private partner, but have resulted in a financial benefit (for example, revenue may be higher than expected because general growth in the economy has been higher than expected). A common argument raised is that this is one-sided in that the pubic partner does not share in the down-side risk. However, such arguments ignore the strong role and implicit support provided to PPPs by governments.
5.2. Managing the Budget during the Operations Phase
When considering the budget and its management during the Operations Phase of a PPP contract, one of the most important tools needing to be taken into consideration, as well as managed and updated throughout the phase, is the financial model. The financial model is used by both parties in order to manage budgets as well as to quantify the effects of variations and external events on the parties.
The financial model forms a critical component of a PPP project throughout its life cycle. Initially, a model is developed by the government or its appointed advisor in order to predict the private partner’s costs, financing structure, and other outputs in order to assess the acceptability of the cost to the government. During the bidding (procurement) stage, the preferred bidder will have developed its own financial model and reflected the specific cash flows required to deliver its proposal. The preferred bidder’s financial model ultimately becomes the base case financial model and part of the PPP contract (the preferred bidder's model is used rather than government's model, as the preferred bidder's model reflects the actual base case for the project, whereas the government’s model was a model of a hypothetical bid for the project that does not reflect the solution being delivered by the private partner).
The financial model continues to be used throughout the actual period of construction and operation by the private partner and the government to review long-term prospects and risk exposure. It is also used to consider price variations and compensation payments in terms of the PPP contract, to calculate any potential refinancing gain (if the contract requires the private partner to share this with government), as well as the amounts payable in the event of variations.
In government-pays PPPs, the unitary payment will need to be adjusted on a regular basis to take into account inflation- and performance-related deductions and penalties. Occasionally, the payments will need to be adjusted in specific circumstances, such as delay or additional cost risks not borne by the private partner, force majeure events, and so on. In all such cases, the adjustments, the budgets, and even long-term sustainability assessments are based on the financial model. All changes to the financial model need to be recorded accurately and agreed between the parties.
5.2.1. Managing Contractual Payments
Effective financial administration involves the development of systems and procedures to make and receive financial payments and to keep records of financial transactions.
In preparing the PPP contract, the government should include procedures for making unitary payments and additional payments to the private partner, administering penalties and/or deductions, calculating inflation, dealing with late payments, and receiving reports linked to unitary payments and additional payments.
The contract should also require the private partner to prepare financial statements and enable the government to monitor key financial indicators, such as gearing, debt cover ratios and internal rate of return, as well as calculation of the compensation sums due by the government in the event of an early contract termination (for example, following a serious default or a mutual desire to terminate the partnership early).
The government should also ensure that during the Operations Phase, the management of contractual payments takes into consideration forecasting values with the actual values, resetting the assumptions used to update forecasts based on actual data, restoring key historic data (both financial- and performance-related), and performing financial control analyses.
5.3. Contingency Planning
Contingency planning is one of the most important steps within the contract management and financial allocation for PPPs. Both the government and the private partner should undertake contingency planning, albeit for different reasons.
The private party will, within its cost baseline, set aside contingency reserves as a budget allocated for identified risks which it has accepted and for which contingent or mitigating responses are developed. Contingency reserves are often viewed as the part of the budget intended to address the “known-unknowns” that can affect a project. For example, the re-work of some project deliverables could be anticipated, but the amount of this re-work may be unknown. Contingency reserves may be estimated to account for this unknown amount of re-work.
Such reserves can provide for a specific activity, for the whole project, or both. The contingency reserve may be a percentage of the estimated cost, a fixed number, or may be developed by using quantitative analysis methods. As more precise information about the project becomes available, the contingency reserve may be used, reduced, or eliminated. Contingency should be clearly identified in cost documentation and is part of the cost baseline together with the overall funding requirements for the project.
For the government, contingency planning is related to the risks it retains, for example, land acquisition or for funding of variations it requires. It is unusual for the government to maintain explicit reserves, as this is generally discouraged under public budgeting rules. Instead, budget adjustments are made on an annual or semi-annual basis for contingencies that have been realized.
A contingency plan should be developed as part of the contract management manual. This plan covers what happens if the private partner fails in its duty to deliver the services, whether as a result of an external emergency or due to issues within the private partner and its sub-contractor group. It should include emergency planning measures that should be implemented in the event of a major incident that affects the unavailability of all or a large part of a facility. The plan should not be over complicated or extensive because if it needs to be implemented, it is likely to be during a period of high pressure. As a result, it needs to be accessible and easy to implement effectively.
Box 8.4 describes a typical contingency plan that should be developed by the government contract management team during a PPP.
BOX 8.4: Contingency plan
The plan should identify the following information:
5.3.1. Force Majeure
Although it is highly unlikely, some form of contingency planning for force majeure events needs to be put in place because such events are significant in terms of their impact — and because the associated risk is shared between the private partner and the government.
Estimates for the amount of contingency reserves that a party should set aside for force majeure events must be based on the probability of the risk occurring and on the amount of likely shortfall that would arise from insurance proceeds (or the time taken before any such proceeds are received).
The focus should be on continuing the services as much as possible after such an event, with the contingency reserve covering the costs of acquiring additional resources to do so.
For the government, it is likely that any contingency reserve to meet the government’s costs associated with force majeure events would be part of a larger government-wide contingency reserve managed by the finance department/ministry. As such, the procuring authority should keep the finance ministry/department informed of any increased force majeure risks.
The private partner would more typically maintain some sort of access to additional (stand-by) equity or debt facilities, and pay some availability fee to maintain such access. It generally does not make sense to maintain a large contingency reserve in the form of cash as this is an expensive use of funds.
Although compensation payable upon termination is a significant amount in most PPPs and almost always requires disbursement by the government (see section 10 below), it is not the norm for the government to maintain any contingency reserve for termination payments. This is partly because the probability of termination is generally very low and partly because the causes of termination are often under the control of the government. Therefore, maintaining a contingency reserve would be unnecessary.
Instead, the risk of termination following a breach by the private partner should be regularly monitored and reported to the relevant ministry/department.
5.4. Managing Renewal Funds
The revenue collected by the private partner by way of a unitary charge payment, user fees, or a combination of user fees and government payments will include amounts to cover the private partner’s anticipated future expenditures on maintenance and renewal of assets over the life cycle of the PPP. The obligation to do such maintenance, overhauls, and renewals remains with the private partner. The public partner, as well as the lenders, requires that money needed for such maintenance, overhauls, and renewals not be paid out as distributions to shareholders. The financial model will have provided for the anticipated costs in accordance with a schedule prepared by the private partner and monitored by the lenders and the government. The risk of adequate life-cycle arrangements for the assets remains with the private partner.
The funding of renewals is enabled through building up a life-cycle renewal fund over some years. This should be done in anticipation of the significant capital expenditure that such renewals require in future periods. A renewal fund is drawn down at times of such renewals (and overhauls of existing plant and equipment), and then refunded (topped up) on an ongoing basis.
The need for a life-cycle renewal fund is related to the concept of depreciation. Depreciation is recognition from an accounting perspective that the value of an asset declines over time, while the life-cycle renewal fund is recognition from a practical perspective of the need to build up cash to meet the costs of periodically renewing the asset to restore its value and functionality.
In this regard, the private partner is rewarded for efficiency in managing such a fund in that at the end of the PPP contract period, the cash balance remaining usually belongs to the private partner.
The government needs to ensure that the assets are maintained and renewed. It should therefore have the ability to conduct a final survey toward the end of the contractual period. At that time, it needs to either withhold payment of the unitary charge or require that the private partner put a performance bond in place if the assets are not restored to the required standard (normally of remaining residual life at the end of the contract period). The private partner should also prepare a maintenance and renewals report which shows the costs incurred and payments made to and from the renewals fund, any deferrals of maintenance and renewals, and a revised and updated renewals plan for the remainder of the contract period.
 See Reference literature on Economic Regulation of PPPs at the end of this chapter.
 These may generally also be classified into two types: availability (or quality) payments and volume-linked payments. This chapter will assume an availability payment under a unitary approach as a default scenario. Most of the intelligence and knowledge provided here is also applicable to other payment mechanisms. See chapter 4.4 for more information on revenue regimes and payment mechanisms.
 An exception may be some structures/projects in emerging and developing economies (EMDE) countries, with immature PPP programs where there may be limits to deductions in order to ensure commercial feasibility and especially bankability (see box 11 in chapter 4).
 United Kingdom (UK), HM Treasury, Standardisation of PF2 Contracts, December 2012, https://www.gov.uk/government/uploads/system/uploads/attachment_data/fil...