6.2. PPP Contract Structure (upstream) and Introduction to Payment Mechanism

The PPP contract structure (upstream) is defined by the public authority.

As chapter 5 explains in detail, the structuring of the contract has a number of aspects: scope and responsibilities, financial structure, and risk structure. It defines the commercial terms of the contract, fundamentally those related to financial terms or the “financial structure of the PPP contract” (how the private partner will be paid) and risk allocation terms or “risk structure of the PPP contract” (how risks are allocated to each party to the contract). In government-pays projects, the payment mechanism is at the heart of the financial and risk structure, and it is introduced in this section.

The financial structure compensates the private partner for its investment and ongoing costs. In government-pays PPPs, the majority of the revenues should be linked to performance, and the means to compensate the private partner is generally called a payment mechanism.

The payment mechanism is the major source of revenue for the private partner for the works and services that it performs (design, construction and other development works, life-cycle management (major maintenance), operations and ordinary maintenance). Other potential revenue may be in the form of direct payments or grants for the construction works, operating grants or subsidies, the right to collect fees from users, or revenue from the operation of collateral business (for example, hotels, gas stations, and so on).

The right to charge users in user-pays PPPs is also sometimes referred to as a form of payment mechanism[68]. However, this PPP Guide considers it more accurate to use the term payment mechanism only in the context of government-pays PPPs or user-pays PPPs where there is a clear component of public payments.

In a government-pays PPP, the design of the payment mechanism is essential for a number of reasons; these are related to the need for alignment of interests between the two parties and the effective transfer of risk.

· A PPP transfers construction risks, including time for construction. Payments should only be made once the asset is operational, that is, in service, as it is only from that moment that the infrastructure asset (as a public investment) is generating value for the user (the user being the general public or the government as public service provider, for example, in social infrastructure).

· PPPs, especially government-pays projects, are about service. Payments should be made only to the extent that the asset is operational, or, for example, when the service rendered by the private partner to users is available (when a public service is included in the scope of the contract). The infrastructure should not simply be constructed, but maintained in a constant technical state to deliver the requisite level of service. The service rendered therefore has to meet the “performance requirements”.

Also, payments should compensate in an integrated way not only for O&M costs and renewals, but also for the original capital investment. This means that the investment (and therefore the construction) is at risk of performance variance or quality of the service.

· In PPPs, payments are for results and not for means. This relates to the level of innovation needed to provide an optimal service in the most cost-effective way. Therefore, payments are not granted as the private partner incurs costs, but depending on whether it meets the “output specifications” (which is another term used for performance requirements in the PPP context).

There are two main types of payment mechanisms (with a number of variations and combinations):

• Availability payments: Payment is granted as long as the asset is available, and depending on the availability, deductions or abatements will take place. Available may have two meanings: availability to use or deemed availability. The former refers to the actual ability of a user to use the asset (e.g. the road may be used under reasonable safety conditions), and the latter refers to the accomplishment of the level of service established in the contract (e.g. the road has no more than one carriageway or one lane out of 3 lanes closed in one section).

Payments may also be linked to the achievement of quality requirements. In some projects, the quality concerns can be covered under the availability concept. In others, the quality requirements are separate from the availability requirements. It is good practice in all availability-payment PPPs for the government to carefully consider whether there are quality elements that should be incorporated into the payment mechanism. This can be done either by deeming failures to meet quality standards as ”unavailability”, or by using a separate basis by which deductions can be made from payments.

• Volume payments: Payment is linked to number of users (for example, a shadow toll payment in a toll-free highway) or to other outputs measured by volume (for example, cubic meters of water treated in a wastewater treatment plant).

As the payment mechanism should protect and even maximize the alignment of interests, the type of payment mechanism has to be carefully considered. For example, in a hospital PPP the government should not be interested in higher demand by the public for the clinical services rendered within the hospital, but in the hospital facility guaranteeing an adequate standard of availability or functionality under comfort, space, safety, cleanliness and other quality parameters.

Volume linked payments are sensible when there is a government objective to maximize the utilization of the asset (for example, public transportation). In some projects, quality concerns and risk allocation considerations may make it advisable to apply availability or quality based payment mechanisms together with more limited payments linked to volume.

For user-pays PPPs, the fact that the private party receives revenue from public use of the infrastructure provides a strong incentive to ensure the infrastructure is available. However, there is less of an incentive for the private party to ensure quality outcomes when these do not materially affect demand for use of the infrastructure. For example, in a toll road PPP the private party may not have an incentive to keep the road reasonably free of litter, or to prevent drainage from the road flooding surrounding properties. To address such issues, some user-pays PPPs include minimum service or quality requirements, with the private party required to pay penalties or liquidated damages to the public party or to users (for example, in the form of discounts to user fees) if the requirements are not met.

Further explanations of potential misalignments and other more specialized features to consider when designing a payment mechanism are provided in chapter 5.