As the Construction Phase progresses, the private partner (and the government in cases where the government makes a capital contribution) must make payments that match the progress made by the construction contractor in completing the construction works. These payments are typically made against milestones that are pre-agreed and part of the PPP contract. Thus, at each milestone, it is necessary for evidence to be provided that the work has advanced to the required stage and is of adequate quality to meet the output specification.
The independent certifier often plays this role if the government is making milestone payments, otherwise the lender’s technical agent will certify that the milestone has been achieved and permit the drawdown of more debt by the private partner. The monitoring of costs at each milestone is also a factor in the provision of security by the construction contractors as well as in the calculation of termination payments in cases of early termination of the PPP contract.
7.2.1. Importance of Cost Oversight during the Construction Phase
If the government is making a capital contribution to the project during or at the end of the Construction Phase, then it will have a strong interest in the costs incurred at each milestone achieved. The risk it must manage is that its grant portion is applied correctly and in the sequence determined in the PPP contract (or grant agreement). Government capital contributions during the Construction Phase are normally made after equity has been drawn down and at the same rate with debt draw downs. The interests of the government are thus closely aligned with those of the lenders.
7.2.2. Where Cost Oversight is Needed
As noted, the interest of the government and the lenders is not so much linked to the correct recording of the costs, but is more about ensuring that the sequence of financing sources is correctly followed. The risk of cost overruns is typically passed on to the construction contractor and to the private partner in cases where the overruns arise from factors outside of the construction contractor’s control. Cost overruns must be funded by the private party or the construction contractor. The government should avoid being drawn into any disputes that may arise between these two parties about such overruns. Cost monitoring should therefore be only for informational purposes for the government.
7.2.3. Explanation on Different Cost Structure Mechanisms when Constructing an Asset
The most common cost structure that arises from project finance principles being applied is that the private party is responsible for, and bears the risk of, raising all the financing required for the project. It then applies the financing during the Construction Phase by making payments to its sub-contractors.
In this structure, the financing sources are applied in the sequence of equity followed by quasi-equity or mezzanine debt and finally by senior debt. Senior debt is subject to restrictions on its drawdown, including the requirement that the specified milestones have been met. This is to ensure that the risk that the asset is not correctly constructed is assigned primarily to the equity and quasi-equity providers.
The government grants can be applied, in the form of assets constructed by the government, as a single payment at the end of the Commissioning Phase or at milestones during the Construction Phase. For each, the risk profile differs and care should be taken not to disturb the risk allocation or incentives that apply in the straight-forward project finance structure.