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Department of the Environment and Local Government Output Specification

Output Specification

Public Private Partnership Guidance Note 10

14 April 2000

Guidance Note 10 14 April 2000


Contents

Section Page

I. INTRODUCTION....................................................................................................................................... 1

PURPOSE AND SCOPE OF GUIDANCE NOTE ......................................................................................................... 1 STRUCTURE OF GUIDANCE NOTE........................................................................................................................ 1 PUBLIC PRIVATE PARTNERSHIP ROUTE MAP ...................................................................................................... 2

II. NATURE AND SCOPE.............................................................................................................................. 4

NATURE OF AN OUTPUT SPECIFICATION ............................................................................................................. 4 ORIGIN OF AN OUTPUT SPECIFICATION............................................................................................................... 5 CONTEXT IN TENDER DOCUMENTS..................................................................................................................... 6

III. GENERAL REQUIREMENTS ................................................................................................................. 7

OVERVIEW.......................................................................................................................................................... 7 SCOPE AND CONTENT ......................................................................................................................................... 8

IV. PRODUCTION OF AN OUTPUT SPECIFICATION .......................................................................... 11

INTRODUCTION ................................................................................................................................................. 11 PRELIMINARY REQUIREMENTS ......................................................................................................................... 11 REQUIREMENTS FOR TENDERING...................................................................................................................... 11 TENDER EVALUATION CRITERIA ...................................................................................................................... 13

V. ROADS PROJECTS................................................................................................................................. 14

LINK WITH PPP CONTRACTUAL FORMS ........................................................................................................... 14 SPECIFIC ISSUES................................................................................................................................................ 15

VI. WATER SERVICES PROJECTS........................................................................................................... 18


VII. WASTE MANAGEMENT PROJECTS............................................................................................. 23


VIII. CONCLUSIONS AND RECOMMENDATIONS ............................................................................. 28

APPENDICES..................................................................................................................................................... 29

A. PUBLIC PRIVATE PARTNERSHIP GUIDANCE NOTES ................................................................................. 29



I. Introduction

Purpose and Scope of Guidance Note

1.1 This Guidance Note provides guidance for Central and Contracting Authorities on the preparation of an Output Specification in the context of a Public Private Partnership Project. The purpose of the Guidance Note is:

• to explain the role of the Output Specification within the context of the Public Private Partnership Route Map;

• to introduce the key elements of the Output Specification and to provide guidance on the steps involved in producing such a document for a PPP project; and

• to identify sector specific issues for roads, water and waste projects.

1.2 This Guidance Note is one of a series of Guidance Notes which provide contextual information on Public Private Partnerships and procedural guidance for Central and Contracting Authorities covering each stage in the development and implementation of infrastructure projects using the Public Private Partnership approach. The titles of all of the Guidance Notes are set out in Appendix A to this Guidance Note.

1.3 The Guidance Notes are designed to be informative rather than prescriptive and the aim is to reflect good practice. They are generic in that they provide guidance on the use of Public Private Partnerships across a range of projects in the roads, water and waste sectors. However, different projects will give rise to different issues and the guidance provided will have to be reviewed in the context of the particular project. For this reason it is important that Central and Contracting Authorities obtain expert advice in order to help them to make best use of the Guidance Notes and to complete a successful Public Private Partnership procurement.

Structure of Guidance Note

1.4 Section Two of this Guidance Note defines the nature and scope of the Output Specification, while Sections Three to Seven deal with each of the following aspects respectively:

General Requirements;

Production of the Output Specification;

Roads Projects;

Water Projects; and

Waste Projects.

1.5 The final Section provides a summary of the main issues and recommendations that are identified and discussed within this Guidance Note.

Guidance Note 10 14 April 2000 1


Public Private Partnership Route Map

1.6 The process of project development, procurement and implementation changes significantly when a project is taken forward as a Public Private Partnership. For this reason a Public Private Partnership Route Map has been developed.

1.7 The Public Private Partnership Route Map sets out the main stages in the development and implementation of a Public Private Partnership project that must be undertaken by the Central Authority and the Contracting Authority. The Route Map is presented in the diagram shown overleaf.

1.8 The Public Private Partnership Route Map shows how the traditional processes of project development, procurement and implementation change for a Public Private Partnership project. A more detailed description of the Public Private Partnership Route Map is provided in the separate Guidance Note entitled Introduction to Public Private Partnerships.

1.9 The Output Specification forms part of the tender documents and defines the services to be provided in output terms. However, it is important to note that a preliminary identification of output requirements will have been developed during the Project Appraisal and PPP Assessment, which form part of the Option Appraisal stage.

.



Figure 1: Public Private Partnership Route Map

Project Identification

Project Appraisal

PPP Assessment

No change toexisting process

Changes toexisting process

New stage forPPP projects

Assessment of PPP Suitability

If PPP recommended

Statutory ProcessAssessment

ProcurementProcedure Selection

Project Management

Stakeholder Consultation

Elements of Statutory ProcessRetained by Public Sector

Tendering Process

Preparation of ContractDocumentation

Statutory Process

Tendering Process


Contract and PerformanceManagement of Construction

and Operation

Elements of Statutory ProcessTransferred to Private Sector

Statutory process risk withcontracting authority

Statutory process risk withprivate sector

Key

Contract Management ofPlanning Phase


and Operation



II. Nature and Scope

Nature of an Output Specification

2.1 The implementation of infrastructure projects using a Public Private Partnership approach requires a radical change of thinking compared with the traditional arrangements.

2.2 Under traditional procurement, the Contracting Authority and its advisers prepare detailed specifications that describe the works required to deliver the necessary service. These works are then put out to tender in order to get competitive pricing and the most economically advantageous tender is accepted for the construction. The Contractor that is appointed carries out the works under close supervision of the Contracting Authority or his representatives in order to ensure that they comply with the detailed specification. Using this approach, responsibility is generally shared as follows:

• the Contracting Authority takes responsibility for the design of the solution, including the associated investigations, all planning and other statutory procedures. The Contracting Authority also takes responsibility for additional costs which may arise subsequently, resulting from omissions from the tender documents, or unexpected circumstances encountered (such as ground conditions, archaeology, uncharted utility services, etc); and

• the Contractor is responsible for the construction of the works in accordance with the tender documents. The tender documents generally comprise specifications, drawings, geo-technical and other site information, a bill of quantities or pricing schedules and the conditions of contract. The risk exposure of the Contractor is generally limited to matters that are covered by the contract documents or could reasonably have been foreseen from those documents.

2.3 The traditional approach is based on the specification of inputs, whereby the Contracting Authority decides precisely what works it wants in order to deliver a particular service. The Contracting Authority then takes full responsibility for the adequacy of these works, provided they are built correctly and in accordance with the designs.

2.4 In a PPP context, an alternative approach is used. The Contracting Authority defines the service required and leaves the design of the works necessary to deliver that service to the successful private sector tenderer. This description of the operational requirements comprises an Output Specification.

2.5 For PPP projects in the roads sector, it is expected that the National Roads Authority would define the road type as well as the level of service required. Similarly, there may be key input requirements defined for water and waste projects, where, for policy or other strategic reasons, the Contractor would not be given absolute design discretion.



2.6 This document is concerned with providing guidance on the development of an Output Specification within a PPP procurement framework, and is particularly concerned with the development of infrastructure projects in the roads, water services and solid waste sectors.

Origin of an Output Specification

2.7 The purpose of this document is to address the nature and content of an Output Specification so that the service tendered satisfies the Contracting Authority expectations while leaving the maximum flexibility to the tendering parties to provide a best value for money solution by means of:

• scope for technical innovation;

• flexibility in how the service is provided;

• integration of design, construction and operational services in order to achieve optimisation; and

• effective risk transfer from the Contracting Authority to the Contractor, where this is achievable at a reasonable cost, and through a single point of responsibility (a single entity being responsible for the design, construction and operation).

2.8 The Output Specification should be developed as part of the set of tender documents. The tender documents should define the detailed requirements of the Contracting Authority for the project or service, as this is the information on which tenderers base their tenders for the project. The Output Specification relates closely to the Instructions to Tenderers, Project Agreement, and other tender documentation. The Output Specification will generally be derived from:

• The Project Appraisal and the PPP Assessment, through which the initial Output Specification requirements will have been defined;

• Environmental Impact Statement (“EIS”) and the statutory processes (where completed), from which constraints will be derived;

• detailed surveys and investigations, which will inform tenderers of relevant conditions; and

• risk allocation and technical studies, which are used to define obligations of the parties to the contract.



Context in Tender Documents

2.9 In addition to the technical requirements, the Output Specification also relates to other elements of the tender documents such as the payment criteria and the change management criteria, which are integral parts of the tender documents in a PPP context. As such, they are referenced in this Guidance Note. However, in preparing the tender documents, some of these requirements may ultimately reside in associated documents. The Contracting Authority should also take account of other tender documents including tender drawings, site information, requirements for price breakdown, etc. Circular L3/99 of the Department of the Environment and Local Government refers in relation to water services projects.



III. General Requirements

Overview

3.1 The Output Specification must be considered in the context of the type of Public Private Partnership contract that is envisaged:

• Design and Build (DB) - where the contract will provide for design and construction elements, with the project then handed over to the Contracting Authority for operation. In this case, the principal concern will be to ensure that the solution that is received is value for money, reliable and capable of meeting the design criteria for the duration of the design life without unacceptable operational risk. The most cost-effective solution is generally established from a whole-life cost analysis, having regard to both capital and running costs. The Output Specification will describe the design objectives, constraints and, of critical importance, the acceptance testing and commissioning element;

• Design, Build and Operate (DBO) - where the Contracting Authority outsources design, construction and operation for a predetermined period so that the responsibility for operation of the facility is transferred to the Contractor. In that context, the primary considerations of the Output Specification are the standards to be achieved, contract monitoring, compliance and performance related payment conditions; and

• Design, Build, Operate and Finance (DBOF)/Concessions – where, in addition to DBO responsibility, the Contractor is required to provide part or all of the finance for the facility. In the case of Concession contracts, some or all of this finance will be recovered through charges on the users of the facility. The considerations of the Output Specification are similar to those for DBO Contracts.

3.2 A comprehensive and accurate Output Specification is an essential part of the procurement process, and will underpin the entire PPP procurement. In the Output Specification document, it is important to state clearly and accurately the core requirements of the Contracting Authority. These core requirements make up a definition of the essentials of the project, comprising elements which cannot be varied, either because they define the business needs (level of service objectives) or because of external constraints which must be satisfied. Such constraints could include environmental constraints, site constraints, planning constraints, transfer of Contracting Authority personnel, etc.

3.3 In order to ensure a robust solution, the Contracting Authority may decide to include additional quality based specification requirements for the equipment being offered, such as track record, minimum standards and criteria, in order to ensure that the facility will be fit for purpose.



3.4 In theory the Contracting Authority need not be concerned with such matters on the basis that payment will only be made for satisfactory performance. In practice, however, it may be more prudent to ensure that certain minimum design and construction criteria are complied with, rather than rely on payment or penalty mechanisms alone for performance guarantee. The Contracting Authority should also be concerned with the quality and condition of the asset that will be returned at the end of the term of the contract.

3.5 The Output Specification sets out the criteria and constraints that must be satisfied by all compliant bids for the project, thereby setting a minimum level of quality. This quality objective, however, must be balanced by the desire to give as much flexibility as possible to the tendering parties to develop innovative solutions that make best use of their capabilities and expertise.

Scope and Content

3.6 The structure of a typical Output Specification is set out in Table 1, showing the key headings and content. At the heart of the Output Specification are the performance standards, which must define the services to be delivered in quantifiable terms. A tabular statement identifying individual criteria, measurement units and quantity level or range would be included to convey core service requirements to tenderers.

Table 1 Outline Specification Structure

Structure Content

Project description Policy outline and Contracting Authority requirements statement.

Contracting Authority organisation outline

Structure of organisation and project interfaces.

Stakeholder requirements Schedule of stakeholder requirements, for example, transfer of employees.

Scheme objectives Strategy outlined in preliminary report/Outline Business Case and purpose of project – What it is to achieve?

Performance standards and monitoring

Required operating performance in output terms, with details of monitoring requirements.

Quality standards Minimum asset quality criteria, codes and standards.

Constraints Constraints essential to an acceptable solution, including environmental, stakeholder or other minimum requirements.

Risk transfer Identification & allocation of risks to the Contractor.

Payment criteria Basis on which payments may be made (availability, use, flexibility, and performance).

Change mechanisms Provision for change in load conditions, etc.

Alternatives Criteria for submission/evaluation of alternatives.



3.7 The following is a brief description of key elements of a satisfactory Output Specification to be included for all projects:

• Project description - a clear, concise, logical and unambiguous outline of the Contracting Authorities requirements which will ensure that the tendering parties know the Contracting Authority needs in respect of the facility that is being tendered;

• Organisation outline of the Contracting Authority - aspects of the Contracting Authority organisation and management system may have important implications for the services to be offered, particularly where interfaces will arise;

• Stakeholder requirements - specific stakeholder requirements may have to be catered for, for example, transfer of existing Contracting Authority staff could arise, the detailed requirements of which would be confirmed in the Output Specification;

• Scheme objectives - the Contracting Authority needs to be satisfied by the proposed scheme based on the adopted strategy for the project. Of particular importance will be issues such as flexibility for future change, robustness of process for a range of load conditions, etc;

• Performance standards - the extent and nature of the service to be provided over the operational term of the contract, the minimum level of service standards to be achieved, the load criteria (volume, characteristics, variation), details of monitoring and compliance criteria, all of which must be measurable, achievable and realistic;

• Quality standards - including minimum quality criteria to apply to the asset, the codes and standards which must be satisfied by the facility and the requirements for design checking and approval. These would include requirements or constraints in relation to construction, the requirements to ensure good practice including quality control and quality assurance procedures, testing and commissioning criteria;

• Constraints - defining the constraints which may have to be taken into account in the design, construction or operational phases of the project in order to meet EIS or planning objectives, the requirements of stakeholders, or other limits on the project. Contracting Authorities should have engaged in negotiation with stakeholders which may result in the inclusion of contract requirements such as Contracting Authority staff transfers (specify numbers, skills, employment conditions), or commitments to categories of users or to the general public;

• Risk transfer - involving the identification, assessment and allocation of risk between the parties in order to ensure optimum allocation of risk as determined following the risk assessment;



• Payment criteria - setting out the basis for payments, in terms of available capacity, load, performance or a combination of these criteria. The basis for payments must be specific, measurable, achievable and realistic;

• Change mechanisms - whereby changes in certain operating conditions (such as loads, performance standards or the effects of a regulatory change) can be provided for within the contract. The Output Specification should require the Contractor to cater for a range of operating conditions, with provision for negotiation where this range is exceeded or where it results in the need for additional facilities or costs; and

• Alternatives - the Output Specification should recognise that there may be worthwhile alternatives which do not strictly comply with the tender documents, but which may be worthy of consideration. The Output Specification should provide the basis against which alternative solutions can be judged.

Brent Street Lighting PFI Contract – UK

A contract was completed in December 1998 between the London Borough of Brent and PFI Lighting Services Ltd to deliver the first street lighting project secured in the UK under the PFI. A key objective of the project was to replace and upgrade a number of street columns and street furniture. This was addressed in the scheme by the provision of a core investment period to address backlog problems.

The payment mechanism is based on the number of lights meeting defined levels and standards. A payment deduction is made in the event of failure until such time as lights are replaced. The full unitary charge is not payable until the completion of the core investment program. Performance based payments cover repair of “knockdowns”, structural and electrical integrity and maintenance standards. This project involves the upgrading of assets through investment, combined with operation to defined performance standards, with an availability based payment mechanism.



IV. Production of an Output Specification

Introduction

4.1 The Output Specification must be produced in conjunction with other tender documentation and will include technical, legal and financial elements. While the Contracting Authority may engage advisers to develop the specification, it will necessarily be involved in defining the service requirements. This process is generally facilitated through workshops in which performance indicators and standards are agreed, risk studies are carried out and the proposed allocations of risk are determined.

Preliminary Requirements

4.2 Having regard to the procedures for the development of a project in each of the sectors, the preliminary identification of Output Specification requirements should flow from the Option Appraisal stage and from the subsequent Statutory Process stage. The term Output Specification in this document is taken to be the detailed description of the output requirements forming part of the tender documents, many of which will have been identified during the statutory process.

Requirements for Tendering

4.3 Where the restricted procedure is being used for procurement, the Output Specification provides the basis on which tenders will be made and against which they must be evaluated. In these circumstances, the Output Specification should be fully developed from the outset of the procurement process and incorporate of all of the requirements of the Contracting Authority. This includes all technical, environmental and other constraints and the minimum performance standards required. The Instructions to Tenderers should specify that all Contractors must comply with the minimum requirements of the Output Specification by submitting a fully compliant bid, and state whether alternatives will also be evaluated.

4.4 Where the negotiated procedure is being used for procurement, the Output Specification is unlikely to be finalised at the outset of the procurement process. It may be developed and refined as the negotiations proceed, being finalised only at the end of the contract negotiation period. When using this procurement procedure, the Output Specification should contain the indicative requirements of the Contracting Authority. These will form guidelines on which bids are proffered and which are subsequently refined as a result of the later negotiation. In the interest of keeping the negotiation process manageable, there are limitations on the extent to which the Output Specification can change:

• certain core requirements must be fixed so that tenderers can concentrate on providing a solution which will satisfy the Contracting Authority needs;

• these core requirements should be consistent with the identified business need and therefore should not be capable of too much change;



• radical alteration in specified requirements may render particular tenderers incapable of meeting the requirements by virtue of the changed conditions at a late stage in the procurement process;

• the quality requirements may be less restrictive in order to maximise tenderer freedom, subject to the feedback of the Contracting Authority during formal review;

• the payment mechanism structure may also be open to variation in negotiation, to reflect cost structure most appropriate to the proposals submitted by each tenderer;

• where statutory processes are incomplete, physical and environmental constraints will evolve in parallel with the EIS/statutory process;

• risk allocation will be indicated in the Output Specification, with scope to modify during negotiation. For example, volume risk could be reduced by negotiating a minimum or threshold volume level; and

• ideas, which are the intellectual property of a tenderer, cannot be picked up and incorporated into the Output Specification and thereby made public to competing tenderers.

4.5 It is important that all constraints that would determine the course of action of the tenderers are identified to enable them to offer a true price for the provision of facilities and services. Such constraints could include statutory and legal requirements to be satisfied, or particular Contracting Authority. Factors that could reduce competition and thereby reduce value for money need to be carefully considered. For example, unnecessary constraints on the delivery of the service could have adverse impacts on value for money.

4.6 The Output Specification should contain sufficient high quality background information on the organisation and current operations of the Contracting Authority. This is necessary so that tenderers will be aware of the interactions that will be required with existing organisations and structures in delivering the specified services. The significance of this information can be illustrated by the following examples:

• Roads - the operating conditions for a roads project will be influenced by the nature and management of the connecting road network and by policies of the roads authority in relation to issues such as traffic management and other road development plans. All of these issues would impact on load conditions;

• Water - the operator of a treatment plant will be affected by activities in the network generally, whether it is a drainage collection system or a water supply distribution system. Contracting Authority management practices in these areas will influence loads in terms of volume, characteristics and trends. Operational management practices (valve operations, customer supply or discharge conditions) may have significant implications for the operation of a facility in a manner that meets the level of service standards prescribed; and



• Waste - waste treatment facilities cannot be considered in isolation from the collection system, the regulation of waste practices (recycling, recovery, and management of waste stream) and the activities of the Contracting Authority as service provider or regulator. These will have a major impact on operational conditions such as usage, disposal of residues, etc.

4.7 Over time, it would be useful to develop pro-forma Output Specifications in each sector, as experience of the process is accumulated. These standard documents would provide some standardisation of content and format, but would require significant development based on individual scheme characteristics. In early pilot projects, documents would be developed from first principles and drawing on previous experience, with the objective that experience and feedback would lead to guideline documents in the future.

UK Highways Agency

In the UK, the Highways Agency has developed a model contract document, which includes a pro-forma type Output Specification. This draws on the repetitive nature of design requirements and materials specifications. In Irish PPP contracts in the roads sector, such a document could be a useful starting point in the same way that UK Highways Agency specifications have been adapted in traditional contracts to suit Irish conditions and requirements.

Tender Evaluation Criteria

4.8 Given the lack of definition of the input requirements in terms of facilities, it follows that considerable care is required in the evaluation of tenders for a PPP project. This element of the project is invariably more complex, requiring specialist expertise and a longer timeframe than the conventional procedure. Tender evaluation is discussed in the Guidance Note entitled Procurement Management.



V. Roads Projects

Link with PPP Contractual Forms

5.1 Where road projects are tendered after the completion of the statutory process, indicative design detail will be available, as will land availability and the environmental constraints documentation (EIS). Should the procurement precede the statutory process, it may be necessary to incorporate contractual amendments to take account of additional constraints and requirements.

5.2 Roads projects can be procured by a number of Public Private Partnership contractual forms and the following comments are pertinent:

• Design and Build (DB) - design and build roads contracts are currently being satisfactorily implemented in Ireland and elsewhere. Where there is no operational element, the key requirement is to ensure that the design and construction quality is adequate. This means a relatively detailed definition of workmanship requirements, and continuous monitoring and compliance assessment during the period covered by the contract. This is necessary to ensure that the objectives and constraints that have been identified in the contract drawings and other documents arising from preliminary design definition, EIS and statutory process are complied with;

• Design, Build, Operate (DBO) – this contractual form transfers operational responsibility for a defined period (usually 20-30 years) to the private sector provider. The Output Specification defines the level of service or performance criteria to be satisfied during this operational period, together with minimum requirements for the condition of the facility at the end of the period (generally required to be fit for purpose). Since design or construction defects are likely to result in higher operating costs to the service provider, the Contracting Authority may be less at risk in relation to such matters. Nevertheless, a prudent Contracting Authority will want to ensure that any facilities constructed for the delivery of public services are robust and generally fit for purpose in order to reduce the likelihood of contractual dispute or breach of statutory duty during the operational phase; and

• Design, Build, Operate and Finance (DBOF) and Concessions – these contractual forms offer similar benefits to DBO and have the potential for even greater risk transfer where sufficient flexibility and scope for efficiencies can be identified to offset the higher cost of private finance. The role of funders, in ensuring that the facility provided delivers the services required, offers further assurance to the Contracting Authority that operational risk is minimised. In this context, the Contracting Authority may consider that a relatively low level of design and construction supervision is required.



A74(M)/M74 Motorway

This project was undertaken as a DBOF based on shadow tolls to provide 28km of new 3-lane dual motorway, together with operation of a further 92km to 2027. The road type was specified with performance criteria and flexibility in relation to pavement structure and materials, some horizontal and vertical re-alignment and innovation in details of bridges and other structures. A report by the Comptroller and Auditor General had the following general observations:

Extra cost of Private Finance compared to Public Funding was estimated to add 16% to overall cost. Nevertheless, construction of a Public Sector Comparator, independently verified, estimated whole-life savings of £17m in a total cost estimate of £210m;

The Contractor was able to provide significant innovation by varying the pavement structure across the carriageway depending on the relative loading. He also succeeded in negotiating out farm underpasses by way of agreements with landowners, which included the payment of compensation;

The use related charging mechanism involving shadow tolls may involve significant cost given that the Private Sector is not in a position to manage traffic flows and forecasts better than the Public Sector. The option of availability payments is suggested as a more satisfactory approach; and

Maintenance of competitiveness in the procurement process, requiring unconditional bids in a second round of bidding involved significant costs for the two remaining tenderers which costs be considered for reimbursement in future similar cases.

Specific Issues

5.3 In addition to the generic requirements already outlined, the following specific issues should be addressed in an Output Specification for roads projects in relation to each of the designing, building, operating and financing phases:

• Design requirements - a range of design requirements and constraints will apply to a PPP project in the roads sector in terms of:

design philosophy including road type and carriageway standards, reflecting the policy framework or context for the project;

design boundaries and constraints are likely to include a geometric envelope (horizontal and vertical), associated land-take limits, and physical or other restrictions which limit the scope for variation by the tenderer;

minimum workmanship specification, codes and standards to be complied with;

environmental limits and other constraints arising from the EIS and statutory processes;



third party accommodation works including requirements of utility companies, roads, rail, river, canal and other crossings and landowner accommodations;

any licences and permits to be obtained by the Contractor;

the standards of finish and completion including delineation, lighting, signage, side road upgrading/improvements, hard and soft landscaping standards;

design check and approval mechanisms;

• Building stage requirements - the Output Specification should inform the Contractor in relation to the following matters:

quality control and quality assurance procedures;

monitoring and compliance assessment including actions arising from non-compliance;

certification and payment procedures where appropriate;

compliance with environmental limits including environmental monitoring and reporting;

public relations, liaison and reporting responsibilities;

commissioning tests and completion certification; minimum requirements for the construction;

• Operating phase - the Output Specification should define the role of the works in the overall road network, in a traffic management context, based on estimated loads and projections. In addition, the following criteria must be defined:

road surface quality in terms of structure and riding surface;

minimum standards for delineation, lighting, signage and other safety requirements;

maintenance of the facility including landscaping, discharges, etc.;

compliance with environmental limits and constraints;

maintenance of the asset condition to a prescribed standard both during the operational contract and for the return of the asset;

monitoring and reporting relationships with the Contracting Authority, third parties, road users and the public; and



• Financing element - the Output Specification should define the financial framework for the project including the requirements for private sector finance for the provision of the facility and a framework for payments during the life of the contract (except for financially free-standing projects financed entirely from user charges). These arrangements would include:

payment mechanisms in terms of capacity and usage charges;

provisions for variations in usage including departures from expected loadings and variations over time;

performance related payments and penalties associated with non-availability or non-compliance with specification requirements, etc.;

mechanisms for dealing with changes in operational conditions, cost regime (tax, traffic control measures, etc) or changes in level of service performance; and

provisions in the event of default or failure to comply with specification.

5.4 Apart from clearly defined requirements for the project, the Output Specification for a roads project must have regard to risk allocation and provision for contingencies which could arise at any of the stages of the contract. Given the spatial extent of road construction sites, the construction risks associated with archaeology, geotechnical and geological systems, uncharted services and third-party interactions are potentially significant. This requires identification, evaluation and assignment of responsibility for risks. In general, construction risk is assigned to the Contractor apart from archaeology risk, which is either retained or capped. These provisions are also relevant for other elements of the contract, for example, requirement for securities, bonds, insurances and indemnities.

5.5 Notwithstanding the provisions of the Output Specification in terms of the project, it may be appropriate to afford tenderers the opportunity to offer alternative solutions for consideration. The conditions under which such alternatives might be considered should be stated so that tenderers can be clear as to whether innovative alternative tenders are welcome or not.



VI. Water Services Projects


6.1 For water services projects, similar PPP options apply, with the same general requirements for an Output Specification. If the restricted procedure is being used for procurement, it is likely that the statutory process will have been completed (in most cases) before the procurement stage. As a result, the scheme to be tendered is likely to be defined in terms of sites, abstraction arrangements, discharge arrangements, EIS and planning elements. Where this is not the case, it is likely that a planning and environmental appraisal will have been carried out whereby the significant constraints can be identified in the Output Specification. The further statutory processes to be undertaken by the Contractor will also need to be clearly defined.

6.2 In relation to the various contractual forms of PPP, the following considerations apply to water services projects:-

• Design and Build (DB) - the potential for innovative and proprietary technologies requires very careful examination of specification requirements in relation to quality, testing, commissioning and take-over certification of new facilities, since a significant level of performance risk is inevitably being retained by the Contracting Authority under this contract form. To manage this risk, minimum criteria should be specified in relation to the track record of plant and equipment offered, availability of maintenance and backup services, and requirements in terms of load flexibility to be demonstrated at take-over testing stage;

• Design, Build, Operate (DBO) – this contractual form provides for significant transfer of operational risk from Contracting Authority to Contractor. The capital cost is normally paid over in full after the plant has been successfully commissioned and put into service. The Output Specification should detail the testing regime to be implemented and the criteria to be satisfied before the plant is certified as successfully commissioned. Under these arrangements, operational responsibility will remain with the Contractor for an extended period. The payment mechanism should be related to performance in order to ensure that the Contractor prudently selects the process systems and equipment, and meets the performance standards for the range of duties specified over the Contract period. The Output Specification should define these duties, in particular the likely variations in volume and characteristics of load, the standards required and any changes anticipated in those standards during operation. The Output Specification should also set minimum requirements for robustness of the plant and equipment offered as the Contracting Authority will still be required to discharge its statutory duty. This could help to minimise the risk of dispute and potential breach of statutory duty during the operational period; and



• Design, Build, Operate and Finance (DBOF) – with this contractual form, the focus of the Contracting Authority in the Output Specification is on the performance standards to be met, the essential constraints and details of the payment mechanism. This approach provides for maximum risk transfer consistent with value for money requirements, with the Contractor taking all risk for plant selection, design, construction and operation, subject to a minimum level of Contracting Authority supervision (audit of quality assurance and testing) to ensure robustness of the plant. Similar comments apply to concession arrangements, but in the absence of charges to the non-domestic sector, such arrangements are unlikely to apply in the water services sector.

Specific Issues

6.3 Apart from the generic requirements of the Output Specification already outlined, the following general guidance is offered in relation to preparation of the Output Specification for water services projects:

• Design requirements - the range of design requirements and constraints for water services projects in a PPP context will include:

the design philosophy that reflects the policy framework or context for the project. This is likely to be derived from a general needs study and will have identified the strategic plan for the water services in an area, taking account of the planning context, river catchment management objectives, network management objectives, customer service and charging policy;

a statement of loads to be designed for, likely variations currently and over time, with extent of volume risk transfer being defined in terms of minimum volume/load guaranteed for payment by the Contracting Authority. In order to define these parameters, the Contracting Authority will have undertaken detailed studies of existing loads, variations and peaks, seasonal factors and abnormal conditions, as well as a detailed assessment of likely future trends from planning details, policies and consumer projections;

design boundaries and constraints are likely to include the site limits and physical or planning restrictions that would limit the scope for variation by the tenderer. Other constraints might include a need to maintain existing facilities in operation during the construction phase, or to facilitate the Contracting Authority organisation in operating such facilities, etc;

minimum workmanship specifications, codes of practice to be complied with, the Contractors track record in relation to quality criteria, the reliability of process and the flexibility for load variations;



the environmental limits and other constraints arising from EIS and statutory process. These will generally include landscape and visual intrusion impacts, limits for emissions to atmosphere, water or soil;

the interface with utilities, landowners or the public;

the standards of finish and completion including hard and soft landscaping, boundary treatment, etc.;

any criteria, licences or permits relating to the disposal of sludge residues;


• Building stage requirements – similarly to roads projects, the Output Specification should inform the Contractor of the minimum requirements for the construction stage including:


monitoring and compliance assessment including actions arising from non compliance;




commissioning tests and completion certification;

• Operating phase - similarly to roads projects, the Output Specification for the operational phase should set out the performance requirements in relation to:

load parameters including volume and characteristics, expressed as a range, with projected future trends;

the performance criteria to be achieved, including nature and frequency of monitoring, and procedures for Contracting Authority overview and reporting;

compliance with environmental limits, including monitoring and reporting;



requirements of stakeholders as determined from prior stakeholder consultation. This should include the numbers and skills of existing Contracting Authority staff to be transferred, any special employment or benefit conditions to be honoured, the needs of other stakeholders such as industry/business to whom service commitments have been made and the general needs vis-à-vis the public, which might include educational, environmental or other promotional activity related to the project;

maintenance of the asset condition to a prescribed quality standard both during the operational contract and for the return of the asset;

change management arrangements to cater for variations in load conditions, prescribed effluent standards or other changes arising from Contracting Authority policy, regulation or legislation;

facilities to be afforded to the Contracting Authority personnel for the purpose of managing the contract;

liaison and reporting arrangements with the Contracting Authority including necessary interface regarding the Contracting Authority’s management of the networks, or any other factors which are likely to impact on the operation of the facility;

the necessary assistance and support to the Contracting Authority in the discharge of its statutory duty, including reporting to elected members and reporting of environmental data to the national authorities; and

• Financing element – similarly to roads projects, the Output Specification will define the financial framework for the project including the requirements for private sector finance for the provision of the facility and a framework for payments during the life of the contract. These arrangements would include:

the payment mechanisms in terms of capacity and usage charges;

provisions for variations in usage including departures from expected loadings and variations over time;

performance related payments and penalties associated with non-compliance and failure; and

provisions in the event of default or failure to comply with specification.



6.4 Where the PPP project relates to the provision of water or wastewater treatment facilities, the bulk of the construction and operational activity is carried out within a defined site that is generally provided by the Contracting Authority following statutory process. As such, the key risk areas relate to the estimation of volume and characteristics of the load and potential interactions between the operation of the facility and the management of the network by others.

6.5 In relation to the ultimate handing back of the facility to the Contracting Authority, there is an inherent risk of obsolescence in relation to process equipment and plant, which may result in a significant liability for new investment at the conclusion of the contract. Appropriate maintenance, asset management and equipment renewals should be required by the Output Specification to ensure that the plant is “fit for purpose” when handed back.

6.6 Both water and wastewater treatment processes result in a sludge by-product that must be re-used or disposed of in accordance with prevailing regulations. As far as possible, the responsibility for this aspect should be devolved to the Contractor within the framework of the County Sludge Management Plan. The Output Specification for water or wastewater treatment facilities should ensure delivery of all relevant requirements of the Plan, such as sustainable sludge management and disposal strategies, appropriate end-user arrangements (landowner agreements, nutrient management plans, etc.), monitoring (organics, nutrients, metals, etc.) and reporting to the Contracting Authority.

Ringsend Wastewater Treatment Plant – Dublin Bay Project

The Dublin Bay Project – Contract No.2 is a DBO Contract to upgrade the Ringsend Wastewater Treatment Plant serving Dublin to meet the requirements of the Urban Wastewater Treatment Directive. The project was procured as a Design, Build, Operate Contract (DBO), with a 20-year operational period. The plant will cater for a 1.6 million Population Equivalent (PE). The Output Specification included the following features:

Constraints included the physical constraints of the existing site, landscape and emission limits of the E.I.S. (including height constraints on buildings) and the requirement to maintain existing treatment during construction;

Effluent standards to be achieved for a range of load conditions specified; and Options to deal with potential change conditions.



VII. Waste Management Projects


7.1 The application of PPP projects to waste management services will be influenced by the requirement for an integrated approach to waste management on a national and regional basis and by the particular statutory processes which are relevant. In particular, the following considerations will apply:

• waste management plans have been developed on a regional basis throughout the country requiring the achievement of national policy objectives in terms of waste minimisation, recycling/recovery and diversion from landfill;

• new facilities will be required in connection with recycling infrastructure, organic digestion, thermal treatment and residual disposal of waste fractions. These facilities may be procured independently or as elements of an integrated contract; and

• current statutory procedures require a licence from the Environmental Protection Agency (“EPA”) for waste treatment or disposal facilities. Currently, such a licence requires definition of the process and equipment being proposed with the result that the statutory process cannot be completed in advance of procurement.

7.2 In relation to PPP options, the following considerations apply to waste projects:-

• Design and Build (DB) – as with water projects, the potential for innovative and proprietary technologies requires very careful examination of specification requirements in relation to quality, testing, commissioning and take-over certification of new facilities, since a significant level of performance risk is inevitably being retained by the Contracting Authority under this contract form. To manage this risk, minimum criteria should be specified in relation to the track record of the plant and equipment offered, the availability of maintenance and backup services, and the requirements in terms of throughput flexibility to be demonstrated at take-over testing stage;

• Design, Build, Operate (DBO) – this contractual form provides for significant transfer of operational risk from the Contracting Authority to the Contractor. The capital cost will be paid after the plant has been successfully commissioned and put into service. The Output Specification must detail the testing regime to be implemented and the criteria to be satisfied before the plant is certified as successfully commissioned. Under these arrangements, operational responsibility remains with the Contractor for an extended period. The payment mechanism should be related to performance in order to ensure that the Contractor prudently selects the process systems and equipment, and meets the performance standards for the range of duties specified over term of the Contract. The Output Specification should define these duties, in particular the likely variations in volume and characteristics of throughput, the emissions standards required and any changes anticipated in those standards



during operation. The Output Specification should also set minimum requirements for robustness of the plant and equipment offered as the Contracting Authority will still be required to discharge its statutory duty. This could help to minimise the risk of dispute and potential breach of statutory duty during the operational period; and

• Design, Build, Operate and Finance (DBOF) and Concessions – under a DBOF or Concession, the focus of the Contracting Authority in relation to the Output Specification is on the performance standards to be met, essential constraints and details of the payment mechanism. This approach provides for maximum risk transfer consistent with value for money requirements, with the Contractor taking all risk for plant selection, design, construction and operation, subject to a minimum level of Contracting Authority supervision (audit of quality assurance and testing) to ensure robustness of the plant.

7.3 As can be seen from the above, the same considerations apply to Design and Build contracts as for water services projects. The operational risk associated with unproven or novel technologies would be considerable, where the Contracting Authority undertakes the operational phase directly. Given the limitations on technical resources of local authorities, it is likely that procurement policy will be to include operation as part of the service to be tendered for all waste projects. In general, Government policy is likely to be geared towards user charges in accordance with the “polluter pays” principle, with Concession arrangements affording maximum transparency of costs. Responsibility for revenue collection in respect of municipal waste could be transferred, with users making direct payments for waste delivered to the facility.

7.4 Where an EPA licence is required, it is likely that a general environmental framework for the project EIS, together with site selection and acquisition will have been carried out in advance of procurement by the Contracting Authority. These documents will be integrated to the Output Specification in order to define a planning framework for tenderers. Completion of the statutory process will involve the following additional elements:

• a requirement for the preferred bidder (following tender evaluation) to prepare and submit a licence application for the facility to the EPA within a specified period, including completion of EIS related to the specific process offered and its submission with the licence application;

• an extended validity period for tenders in order to retain the option of revisiting the evaluation process in the event of failure to achieve a licence for the preferred solution;

• mechanisms in the contract to deal with issues and constraints arising from the licensing stage, for example, the degree to which risk of variations at this stage would be carried by the tenderer; and



• consideration of whether or not compensation would be payable to the private sector party in the event of an unsuccessful licence application following selection as preferred bidder.

Specific Issues

7.5 Apart from these considerations, the following criteria will apply to the Output Specification:

• Design requirements – similarly to roads and water projects, a range of design requirements and constraints will apply to a PPP project for a waste management facility in terms of:

the design philosophy reflecting the policy framework or context for the project, in this case the waste plan, which sets out an integrated strategy for the management of waste to be implemented by the local authorities in the region;

site locations and characteristics, where these are determined by the Contracting Authority, for the location of works to be procured;

minimum workmanship specifications, codes of standards to be complied with;

load conditions (volume and characteristics), capacity requirements and likely usage levels to be catered for in the design;

environmental limits and constraints arising from environmental appraisal (or statutory process where it has been completed);

minimum quality standards, standards of finish and completion for buildings and site works, boundary treatment, access arrangements, reception facilities for waste, facilities for monitoring of waste loads arriving at the facility, etc.;


minimum quality criteria for the process including details of track record, proven performance and reliability;

• Building stage requirements - similarly to roads and water projects, the Output Specification should inform the Contractor of the minimum requirements for the construction stage in terms of:


monitoring and compliance assessment including actions arising from non-compliance;






commissioning tests and completion certification;

• Operational Phase - similarly to roads and water projects, the Output Specification should define the performance criteria and minimum objectives for the operational phase of the project in terms of:

capacity and availability levels;

minimum performance standards in terms of emissions and general environmental criteria, disposal of residues, etc.;

management of the waste stream, conforming to the requirements for integrated regional management objectives, compliance with regulation by the local authority, monitoring and reporting;

maintenance of the asset condition to a prescribed standard both during the operational contract and for the return of the asset;

monitoring and reporting relationship with the Contracting Authority, third parties and the public including the provision of facilities for the Contracting Authority organisation in terms of liaison, monitoring, regulation and management;

making provision for potential liability at the end of the project in respect of upgrading or environmental management/closure; and

• Financial Element - similarly to roads and water projects, the Output Specification should define the financial framework for the project including the requirements for private sector finance for the provision of the facility and a framework for payments during the life of the contract. These payments likely to be a combination of payments by the local authority and private sector user charges. The financial arrangements will include:

payment mechanisms in terms of capacity, usage and achievement of environmental objectives;

user charges as the primary payment mechanism, reflecting the cost per tonne for the service provided;

provisions for variations in Contracting Authority usage including departures from expected loadings, waste characteristics and variations over time;



provisions in the event of default or failure to comply with specification; and

provisions to ensure the application of the “polluter pays” principle on an equitable basis in respect of all waste producing sectors.

Kirklees Metropolitan Council – Integrated Waste Management Services Contract

In April 1998, Kirklees Metropolitan Council and United Waste Services Ltd. entered into a 25-year joint venture Private Finance Initiative contract to deliver an integrated solution to its waste management needs (excluding waste collection). The contract involved new capital investment of some UK£41m based around reducing dependency on landfill in favour of increased recovery and recycling.

The output specification required the successful tenderer to provide:

all end disposals; all transport requirements; all transfer requirements; all recycling requirements; and all requirements relating to the management and operation of civic amenity

sites.

The Output Specification also set out performance criteria reflecting the expected loads to be catered for, the capacity requirements of key facilities and the service standards to be attained.

7.6 Key risk areas in connection with waste management are the potential variations in

load volume and characteristics, the difficulties in controlling the waste stream and potential liabilities arising from stricter emission or general performance standards arising from public pressure, or from EU or national regulations. The Output Specification should contain mechanisms whereby these issues can be addressed during the contract period.

7.7 Unlike roads or water services projects, there could be significant potential liabilities in relation to the closure or upgrading of facilities at the end of contract term. This is particularly true of landfill sites that require long term monitoring and environmental management. These liabilities require to be catered for in terms of financing and implementation. The risk associated with the licensing of the scheme, post tender, is a major risk consideration in the process.



VIII. Conclusions and Recommendations 8.1 The principal conclusions and recommendations arising from this Guidance Note are

as follows:

• the Output Specification should provide maximum flexibility to tenderers within the Contracting Authority policy framework, in order to facilitate innovation and maximise the value for money benefits of PPP;

• performance standards must be clearly defined in achievable and measurable terms to provide a basis for determining contract performance and payment;

• monitoring requirements must be defined so that compliance with performance standards can be determined;

• early pilot project experience should be used to develop pro-forma Output Specification documents appropriate to the individual sectors. These can then be tailored to meet the needs of individual contracts;

• Contracting Authority interfaces and stakeholder requirements must be fully detailed; and

• where the statutory processes are not completed prior to the appointment of the Contractor, the Output Specification should contain available detail on planning context, environmental baseline conditions and known constraints identified in technical studies to enable the Contractor to expedite planning effectively.



Appendices

A. Public Private Partnership Guidance Notes


Department of the Environment and Local Government Output Specification – Final Draft

Public Private Partnerships Guidance Notes

The Public Private Partnerships Policy Framework comprises a series of fifteen separate Guidance Notes, the titles of which are as follows:

• Introduction to Public Private Partnerships

• Financial Context

• Legal Context

• Public Private Partnership Assessment

• Statutory Process Assessment

• Procurement Procedure Selection

• Project Management

• Stakeholder Consultation

• Procurement Management

• Output Specifications

• Risk Assessment

• Payment Mechanisms

• Key Contractual Issues

• Accounting Treatment

• Contract and Performance Management


Department of the Environment and Local Government Risk Assessment

Risk Assessment


14 April 2000



Contents

Section Page

I. INTRODUCTION....................................................................................................................................... 1


II. RISK ASSESSMENT ................................................................................................................................. 4

INTRODUCTION ................................................................................................................................................... 4 RISK AND PUBLIC PRIVATE PARTNERSHIPS ........................................................................................................ 4 PURPOSE OF RISK ASSESSMENT.......................................................................................................................... 6 CATEGORIES OF RISK.......................................................................................................................................... 6 MANAGEMENT OF RISK ASSESSMENT ................................................................................................................ 7

III. RISK ASSESSMENT AT THE OPTION APPRAISAL STAGE........................................................... 9

INTRODUCTION ................................................................................................................................................... 9 PRELIMINARY RISK IDENTIFICATION ................................................................................................................ 10 PRELIMINARY RISK ALLOCATION..................................................................................................................... 11 QUALITATIVE RISK ASSESSMENT ..................................................................................................................... 15 PRELIMINARY RISK QUANTIFICATION .............................................................................................................. 17

IV. RISK ASSESSMENT AT THE PROCUREMENT STAGE................................................................. 22

INTRODUCTION ................................................................................................................................................. 22 RESTRICTED PROCEDURE ................................................................................................................................. 23 NEGOTIATED PROCEDURE ................................................................................................................................ 26 RISK MANAGEMENT PLANS.............................................................................................................................. 28 REPORT ON TENDERING PROCESS..................................................................................................................... 28

V. INDICATIVE SECTOR SPECIFIC RISKS .......................................................................................... 29

INTRODUCTION ................................................................................................................................................. 29 ROADS SECTOR ................................................................................................................................................ 29 WATER SECTOR................................................................................................................................................ 29 WASTE SECTOR ................................................................................................................................................ 29

VI. CONCLUSIONS AND RECOMMENDATIONS .................................................................................. 31

INTRODUCTION ................................................................................................................................................. 31 REQUIREMENT FOR RISK ASSESSMENT............................................................................................................. 31 MANAGING RISK ASSESSMENTS....................................................................................................................... 32

APPENDICES..................................................................................................................................................... 33

A. PUBLIC PRIVATE PARTNERSHIP GUIDANCE NOTES ................................................................................. 33 B. INDICATIVE RISK MATRIX ...................................................................................................................... 35



I. Introduction


1.1 This Guidance Note provides advice for Central and Contracting Authorities in relation to risk assessment for Public Private Partnership infrastructure projects in the roads, water and waste sectors. The purpose of the Guidance Note is:

• to identify and set out the objectives of the risk assessment process and to emphasise its importance within the context of a Public Private Partnership procurement;

• to introduce the key principles underlying the identification, allocation and quantification of risks within a Public Private Partnership procurement;

• to identify and set out a robust approach to risk identification, allocation and quantification; and

• to identify the main outputs arising from the process of risk assessment, and to provide advice on how these outputs contribute to the successful development of a Public Private Partnership.


1.3 The Guidance Notes are designed to be informative rather than prescriptive and the aim is to reflect good practice. They are generic in that they provide guidance on the use of Public Private Partnerships across a range of projects in the roads, water and waste sectors. However, different projects will give rise to different issues and the guidance provided will have to be reviewed in the context of each individual project. For this reason it is important that Central and Contracting Authorities obtain expert advice in order to help them to make best use of the Guidance Notes and to complete a successful Public Private Partnership procurement.


1.4 The Guidance Note is structured as follows:

• Section Two - provides a brief introduction to the importance of risk assessment in the context of a Public Private Partnership project. It describes the purpose of risk assessment and introduces the requirements for risk assessment at various stages of the Public Private Partnership Route Map;



• Section Three - provides advice for Central and Contracting Authorities in relation to the preliminary assessment of risk undertaken prior to the commencement of the procurement process;

• Section Four - provides advice on the final assessment of risk undertaken during the procurement process; and

• Section Five - provides a brief description of some of the principal risks associated with infrastructure projects in the roads, water and waste sectors.

1.5 The final Section provides a summary of the main conclusions and recommendations that are identified and discussed within this Guidance Note.


1.6 The process of project development and implementation changes significantly when a project is taken forward as a Public Private Partnership. For this reason a Public Private Partnership Route Map has been developed.

1.7 The Public Private Partnership Route Map sets out the main stages in the development and implementation of a Public Private Partnership project that must be undertaken by the Central Authority or the Contracting Authority. The Route Map is presented in the diagram shown overleaf.


1.9 Risk assessment is undertaken as part of the Public Private Partnership Assessment, which taken with Project Appraisal, Statutory Process Assessment and Procurement Procedure Selection forms the Option Appraisal stage of the Route Map. Risk assessment is also undertaken during the preparation of contract documentation and during the course of the tendering process, which together form the Procurement stage. The role of risk assessment in the context of other activities in the Public Private Partnership Route Map is discussed in more detail in the next section of this Guidance Note.

1.10 It is important to note that risk assessment can not be undertaken in isolation. Accordingly, this Guidance Note must be read in conjunction with a number of other Guidance Notes including Public Private Partnership Assessment, Statutory Process Assessment, Payment Mechanisms and Accounting Treatment.





Project Appraisal

PPP Assessment





If PPP recommended



Project Management



Tendering Process


Statutory Process

Tendering Process



and Operation




Key



and Operation



II. Risk Assessment

Introduction

2.1 This section of the Guidance Note provides an introduction to risk assessment in the context of a Public Private Partnership infrastructure project. It commences by describing the purpose of risk assessment, and identifies the stages of the Public Private Partnership Route Map at which such a risk assessment is required. It then provides a summary of the purpose of risk assessment at each of these stages, and concludes by providing suggestions on how the process of risk assessment might best be managed.

Risk and Public Private Partnerships

Overview

2.2 A risk can be defined as any factor, event or influence that threatens the successful completion and operation of a project in terms of cost, time or quality. Risk management is the process of identifying the significant risks to a project, devising tactics to reduce exposure to these risks, and then monitoring the effectiveness of risk management actions undertaken.

2.3 One of the principles underlying Public Private Partnerships is that risk should be allocated to the party best able to manage it. Cost effective allocation of risk between a Contracting Authority and the Contractor will result in lower costs of construction and operation for infrastructure projects, and will provide enhanced value for money when compared to traditional procurement.

2.4 In any Public Private Partnership project, the degree of risk transfer to the private sector will be determined by the nature of the project and will by definition vary on a project by project basis. The aim is to achieve the most cost effective allocation of risk and not simply the transfer of risk for its own sake. This is fundamental to the achievement of value for money in a Public Private Partnership procurement.

2.5 Figure 2 below shows that as risk transfer is increased beyond the optimum, the incremental increase in unit cost for an incremental increase in risk transfer increases significantly. Risk transfer above the optimum therefore results in reduced value for money, due to the premium that the supplier charges for managing those risks that they are less well equipped to manage.



Figure 2: Cost Effective Risk Transfer

Risk Transfer

Unit costof service

OptimumPPP Project

2.6 Good value for money is rarely served by transferring all possible risks to private sector contractors. If a Contractor is asked to accept a risk over which it has little or no control, it is likely to charge a higher premium than the risk is worth. In addition, if the project funders are not satisfied that the allocation of risk is appropriate, then the project is unlikely to be bankable.

Objectives of Risk Transfer

2.7 Within a Public Private Partnership project, the primary objectives of transferring risk from a Contracting Authority to a private sector contractor are:

• to reduce the long term cost of a project by allocating risk to the party that is able to manage it in the most cost effective way;

• to provide an incentive to the Contractor to deliver a project on time, to the required standard and within budget;

• to improve the quality of customer service and increase revenue through better management of risk; and

• to provide a more consistent and predictable profile of Contracting Authority expenditure on a project, by converting variable capital and operating costs into more consistent and predictable unitary payments.



Purpose of Risk Assessment

2.8 Risk assessment is required to enable the objectives of risk transfer to be achieved. The assessment of risk is one of the most important activities in the development and procurement of infrastructure projects using the Public Private Partnership approach. The assessment of risk is a determining factor in many of the activities that have to be undertaken during the course of a Public Private Partnership project, and particularly activities during the Option Appraisal and Procurement stages.

2.9 The purpose of assessing risk within a Public Private Partnership project is:

• to inform the selection of the most appropriate form of Public Private Partnership for a project;

• to inform the development of contract documentation for a project;

• to facilitate negotiation between the Contracting Authority and the short listed bidders (where the procurement follows the negotiated procedure);

• to facilitate the comparison of tenders; and

• to facilitate an assessment of the value for money provided by the preferred tender when compared to traditional procurement.

2.10 Further discussion on the above issues is provided in Sections Three and Four of this Guidance Note, which set out the requirements for risk assessment during the Option Appraisal and Procurement stages respectively.

Categories of Risk

2.11 The risks associated with infrastructure projects are commonly categorised under the following headings:

• Planning risk - including the risk that planning permission for the construction of the infrastructure project may be refused, the risk that unacceptable conditions may be applied to any planning permission granted, and the risk that the planning process may take longer than anticipated and cost more than expected;

• Design risk - including the risk that the design solution adopted may not work satisfactorily and may fail to meet the requirements of the Contracting Authority, the risk that new technical standards may be introduced during the design phase, and the risk that the design process itself may take longer than anticipated and cost more than intended;

• Construction risk - including the risk that factors such as changes in labour and materials costs, inadequate cost management, adverse site and weather conditions, protester action, and the failure of contractors to perform may lead to construction time and cost overruns;



• Operating risk - including the risk that factors such as high demand volumes, shortage of skilled labour, inadequate cost management, poor maintenance scheduling, late delivery of equipment, poor public relations and labour disputes may result in operating costs being more than intended and the required standards of performance and availability not being met;

• Demand risk - including the risk that usage of the service varies from the level forecast, and the risk that revenues generated from users (e.g. road tolls) are lower than expected;

• Financial risk - including the risk that factors such as fluctuations in exchange rates, variations in financing costs and changes in indexation assumptions may lead to operating or capital losses. A key element of financial risk is residual value risk, which is the risk that the value of an asset (e.g. land and buildings) at the end of a specified period or contract term is different to that anticipated at the start of the period or contract term. The residual value of an asset is a function of the realisable value of the asset at the end of a specified period and the costs associated with the realisation of this value; and

• Legislative risk - including the risk that a regulatory or legislative change may be made that significantly effects the ability of the Contractor to continue to meet its contractual obligations.

2.12 Through the process of risk assessment, the Contracting Authority is able to explore each of the above categories of risk in detail, identify and quantify the most significant risks within each category, and allocate these risks between the Contracting Authority and the Contractor.

Management of Risk Assessment

2.13 A risk assessment for a large infrastructure project will require detailed consideration of a wide range of issues. Central and Contracting Authorities must be clear about the tasks to be undertaken at the Option Appraisal and Procurement stages, and must obtain access to all of the relevant skills, experience and expertise needed to complete the risk assessment successfully. It is vital that the right people are involved in the identification and assessment of risks, including:

• Central Authority and Contracting Authority management;

• the operational staff responsible for managing existing services;

• technical experts; and

• financial and legal advisers.



2.14 Responsibility for carrying out the preliminary and final risk assessments need to be well defined, and in the case of the pilot projects at least, it is recommended that Central and Contracting Authorities appoint technical, financial and legal advisers to assist them. Further guidance on the appointment of advisers is set out in the separate Guidance Note entitled Project Management.

2.15 The level of detail included in the risk assessment will vary according to the type and complexity of project, whether the restricted or negotiated procedure is being followed, and whether or not a Financial Comparator is required. Small, relatively straightforward projects will not require, or justify, the same level of assessment as large and complex projects, and the resources allocated to complete the risk assessment will need to be tailored accordingly.



III. Risk Assessment at the Option Appraisal Stage

Introduction

3.1 This section of the Guidance Note provides advice for Central and Contracting Authorities in relation to the preliminary risk assessment undertaken as part of the Public Private Partnership Assessment.

3.2 Within the Public Private Partnership Assessment, a preliminary assessment of risk is required to identify the potential risks in a project and to consider how they might best be allocated between the Contracting Authority and a private sector contractor. This preliminary risk assessment will inform the selection of the most appropriate form of Public Private Partnership for the project. It will also support the development of a fully costed Financial Comparator, which may be used at the end of the procurement process to determine whether the preferred tender represents value for money.

3.3 The main steps involved in undertaking the preliminary risk assessment are set out in the diagram shown below and a more detailed description of each step is provided in the paragraphs that follow.

Figure 3: Steps in a Preliminary Risk Assessment

Step Description Outcome

Identification of the principal risks associated with the design, construction and operation of an infrastructure project Formation of an initial view as to whether the Contracting Authority or the Contractor is likely to be best able to manage each risk. Risks are then either allocated to the Contracting Authority, the Contractor, or identified as risks to be shared. Qualitative assessment of the potential significance or impact of each risk. The results of the qualitative assessment are combined with the list of risks and the risk allocation to provide a preliminary risk matrix for the project. A risk management plan is prepared for those risks that are to be retained by the Contracting Authority. Preliminary assessment of the monetary value of the most significant risks identified in the preliminary risk matrix. The monetary value of the most significant risks transferred to the Contractor is included in the Financial Comparator (if required).

Preliminary list of risks

Preliminary risk allocation

Preliminary risk matrix

Risk

management plan

Risk adjusted Financial

Comparator

PreliminaryRisk

Identification

PreliminaryRisk

Allocation

QualitativeRisk

Assessment

PreliminaryRisk

Quantification

3.4 In general, the preliminary risk assessment should be informed through discussions with potential private sector contractors and experience to date both nationally and internationally.

9Guidance Note 11 14 April 2000


3.5 The precedent review and market sounding exercise undertaken as part of the PPP Assessment should provide information on the main risks associated with particular types of project, the probability of their occurrence, the scale of their impact, and the respective ability of the public and private sectors to manage these risks. More detailed guidance on precedent review and market sounding is provided in the separate Guidance Note entitled Public Private Partnership Assessment.

Preliminary Risk Identification

3.6 The identification of risk may be undertaken by means of a brainstorming exercise in a workshop or series of workshops. The purpose of the brainstorming exercise should be purely the identification of project specific risks, with a description in clear and unambiguous language. There should be no attempt to quantify risks at this point. This is because quantification of risks is a complicated process and care must be taken to ensure that experts form their own views after some thought.

3.7 When deciding who should be involved in the identification of risk, it is a good idea to select those individuals who will help to quantify risks during the Option Appraisal and Procurement stages, and those individuals that are responsible for managing risk during the construction and operational stages of projects. People who might be involved in the identification and subsequent quantification of risks are operational managers from the Contracting Authority, technical consultants such as design engineers, financial and legal advisers, and risk analysts (commonly part of the financial advisory team).

3.8 Before beginning the process of identifying risk, it is useful to explain clearly what the purpose of the exercise is and how the risks that are identified will be used. A useful tool to help structure thinking in the brainstorming session is a list of typical risks to which the infrastructure project may be exposed. The list may take the form of a generic list of risks covering all types of infrastructure project, or a more detailed list of risks developed for a similar project. The indicative risk matrix set out in Appendix B to this Guidance Note will provide a useful reference point.

3.9 Even when using an existing list of risks as a guide, there is a danger that a risk will be missed out. For this reason, at the end of the brainstorming session, it is often useful to run through the various stages of the project considering how it might turn out in practice. It is likely that most of the risks identified this way will already have been captured, but it might throw up some that are not.

3.10 A common error in risk assessment is to inadvertently duplicate risks. The risk of failure to deliver the service standard may not be independent of other risks such as process design deficiency or of inadequate resourcing or skill levels. These risks may well be inter-related and have a common result.

3.11 The primary output from the preliminary risk identification is a list of the main risks involved in the planning, design, construction and operation of the infrastructure project. The list of risks should be categorised and recorded within the structure of a preliminary risk matrix. An indicative risk matrix is presented in Appendix B to this Guidance Note.



Tips on Preliminary Risk Identification

Select the parties for the brainstorming session carefully and include those that are responsible for quantifying and managing project risks;

Use a generic list of risks to structure the brainstorming session;

Focus on risks that are specific to the project;

Focus on the most significant risks;

Provide a clear and unambiguous description of each risk identified;

Check for missed risks and duplicated risks; and

Categorise risks (for example by using the categories set out in paragraph 2.11 above).

Preliminary Risk Allocation

3.12 The guiding principle of risk allocation is that risk should be allocated to the party best able to manage it. However, there may be cases where the price charged by a Contractor for taking on a risk that it is best placed to manage exceeds the value to the Contracting Authority of transferring the risk. In such circumstances, it may not be cost effective for the Contracting Authority to allocate the risk to the Contractor.

3.13 Cost effective allocation of risk between a Contracting Authority and the Contractor will result in lower costs of construction and operation for infrastructure projects, and will provide enhanced value for money when compared to traditional procurement. However, if risks are transferred inappropriately to the appointed Contractor, value for money will decline as the premium demanded by the Contractor for managing the risk will outweigh the benefit to the Contracting Authority.

3.14 At the Option Appraisal stage, the price charged by a Contractor for taking on a risk will not be known. The preliminary risk assessment should therefore focus on determining, in principle, whether the Contracting Authority or the Contractor is best able to manage the risk, or whether the risk should be shared.

3.15 In considering the most appropriate allocation of risk, the following issues should be taken into account:

• the capacity of the Contracting Authority to manage the risk and its ability to control it;

• the capacity of private sector contractors to manage the risk and their ability to control it; and

• the preferred allocation of risk, given any public interest issues.



3.16 The preliminary allocation of risk should reflect the specific characteristics of the project and the underlying strengths and capacities of each party. The degree of risk transfer to the private sector will vary on a project by project basis and will be informed by the precedent review and market sounding exercise undertaken as part of the Public Private Partnership Assessment.

3.17 The preliminary allocation of risk will influence the selection of the preferred form of Public Private Partnership within the PPP Assessment. To illustrate this point, Tables 1 and 2 that follow provide an illustration of the typical allocation of risk under Design and Build (DB), Design, Build and Operate (DBO), Design, Build, Operate and Finance (DBOF), and Concession contracts.

Table 1: Indicative Allocation of Risk

Risk category DB DBO DBFO Concession

Planning risk 6 6 6 6

Design risk 4 4 4 4

Construction risk 4 4 4 4

Operating risk 6 4 4 4

Demand risk 6 6 4 4

Residual value risk 6 6 4 4

Financial risk 6 6 4 4

Legislative risk 6 6 6 6

4 = Typically transferred to Contractor 6 = Typically retained by Contracting Authority



Table 2: Typical Allocation of Risk

Risk Category Allocation Comment

Planning risk May be retained by Contracting Authority for pilot projects

However, there may be occasions when transfer in whole or part is appropriate or unavoidable

Further advice is provided in the separate Guidance Note entitled Statutory Process Assessment

Design and construction risk

Transferred to Contractor through payment mechanism.

Contractor bears risk of cost and time overruns.

Contracting Authority retains risk of changes to Output Specification

Operating risk Transferred to Contractor under DBO, DBOF and Concession contracts through payment mechanism.

Deductions are made from payments for failure to meet service requirements

Demand risk Often retained by Contracting Authority or shared.

May be transferred under DBOF and Concession contracts where the Contractor can control demand and forecast revenues with reasonable certainty.

An example of demand risk transfer is when the Contractor recovers its costs through user charges (e.g. road tolls).

Residual value risk Retained under DB and DBO contracts

May be transferred under DBOF and Concession contracts to ensure fitness for purpose throughout the duration of the contract

Contractor carries residual value risk if asset not automatically transferred to Contracting Authority at end of contract

Other financial risk Often transferred (or shared) under DBOF and Concession contracts

An indexation mechanism may be used

Legislative risk Often retained (or shared). Government is often best placed to control regulatory and legislative risks

Key issue is whether the regulatory or legislative change is discriminatory in respect of the specific project or sector

3.18 One of the areas in which risk transfer is most problematic is statutory process. As a general rule, the Contracting Authority is best placed to manage the statutory process by virtue of its legislative basis, experience and resources. In general, private sector parties internationally have indicated an unwillingness to accept planning risk, especially in the roads sector, identifying the following difficulties:

• a lack of familiarity with the statutory processes and procedures;



• uncertainty regarding the cost and timescale of such processes and their ability to manage this;

• the reluctance of funders to finance the costs and risks associated with the statutory process; and

• the need for price adjustment and/or negotiation to cater for changes arising during the statutory process.

3.19 Notwithstanding these reservations, there will be occasions when transfer of statutory process in whole or in part will be appropriate or unavoidable. This issue is considered in detail in the separate Guidance Note entitled Statutory Process Assessment.

Tips on Preliminary Risk Allocation

Focus on deciding which party is best able to manage each risk;

Use the results of the precedent review and market sounding;

Use either a typical risk allocation or an actual risk allocation for a similar project as a starting point;

Document the reasoning behind the preliminary risk allocation so that it can be referred to at the Procurement stage.

3.20 The primary output from the preliminary risk allocation is an indicative allocation of the main project risks between the Contracting Authority and the Contractor. The primary risk allocation is a key element of the Public Private Partnership Assessment. It will inform the decisions of the Central Authority in relation to the most appropriate form of Public Private Partnership to be used for the project (e.g. Design, Build, Operate and Finance), and also the scope of the services that could be cost effectively transferred to a private sector contractor.

3.21 The preliminary risk allocation should be recorded within the structure of a preliminary risk matrix. There are a number of handbooks that provide advice and assistance on the development of risk matrices. These handbooks generally provide proforma type tables and matrices, illustrating a general approach that can be developed on a project specific basis.



Dublin Bay Project – Ringsend Wastewater Treatment Works

This project involved provision of an upgraded wastewater and sludge treatment facility to serve a catchment comprising an equivalent population of 1.6 million persons. The project has been procured under a Design, Build and Operate contract with a 20 year operational period. The statutory process was completed by the Contracting Authority after an informal private sector consultation had identified that a number of more innovative solutions were possible at a cost comparable with the provision of conventional plant. A detailed risk assessment was undertaken as part of the procurement process, resulting in the following allocation of risk:

Demand risk was transferred to the Contractor, subject to guaranteed minimum payments by the Contracting Authority;

Design, construction and operating risks were fully transferred;

Environmental risk was retained. For example, Dublin Corporation took responsibility for satisfying the habitat needs of Brent Geese at the site; and

Sludge disposal risk was retained by the Contracting Authority subject to the Contractor meeting quality performance objectives. Sludge disposal is dealt with under a separate contract.

Qualitative Risk Assessment

3.22 Qualitative risk assessment enables the potential significance or impact of risks to be considered without the need for detailed quantification. Qualitative risk assessment is undertaken in two phases:

• Assessment of the potential impact of the risk – this is a subjective measure of how sensitive the project is to a particular risk, classified into high, medium and low impact, according to the extent to which the project is put at risk. The following table can be used as a guide.

Table 3: Assessment of the Potential Impact of Risk

Scale of Impact Description Value (% of Project Cost) *

High

Medium

Low

Critical to Continued Service

Serious Impact

Small Impact

1 > 50%

5% - 50%

< 5%

* Baseline Project Cost



• Assessment of the probability of occurrence – this is a subjective indication of how likely the risk is to occur, classified into high, medium and low probability. The following table can be used as a guide.

Table 4: Assessment of the Probability of Occurrence

Probability Description Value (% of Project Cost)

High

Medium

Low

Likely to occur

Occasionally occurs

Unlikely but possible

2 Probability > 10%

Probability 1% – 10%

Probability < 1%

3.23 The probability of occurrence and estimated impact of each risk is then combined using the following matrix to provide a measure of the significance of the risk.

Table 5: Assessment of the Significance of a Risk

Probability

H M L

H 1 1 2

M 1 2 3

Impa

ct

L 2 3 3

1 = greatest significance / impact 3 = least significance / impact 3.24 The numbers in the boxes show the level of priority that risks falling in that box have.

The closer to the top left hand corner of the matrix that a risk is placed, the more significant the risk is likely to be, and the more important it is to focus on it.

3.25 In this way the qualitative assessment provides an indication of the most important risks that should be quantified and subjected to further data collection. Relatively minor risks can be grouped into one or more generic risks where they relate to similar impacts (for example, extending the length of construction time). Where minor risks are discrete in terms of impact, they may be discarded at this stage.

3.26 A preliminary risk management plan should then be prepared for all the risks that are likely to be retained by the Contracting Authority. In preparing a risk management plan, greatest effort should be spent on planning and undertaking risk management activities for the most significant risks (as identified by the qualitative assessment) that are likely to arise first (e.g. planning risks).



3.27 Risk management proposals should be assessed in terms of their likely cost and effect (i.e. the extent to which probability and/or impact of a risk will be reduced). The cost of managing a risk should not exceed the probable cost of the risk occurring (as estimated by the preliminary risk quantification).

Tips on Qualitative Risk Assessment

Assess the potential impact of each risk using a high, medium and low scale;

Assess the probability of each risk occurring using a high, medium and low scale;

Consider the potential impact and probability of each risk to determine the overall significance of that risk; and

Prepare a risk management plan for all the significant risks that are likely to be retained by the Contracting Authority.

3.28 The primary output from the qualitative risk assessment is a prioritisation of project

risks according to their potential impact and probability of occurrence. The results of the qualitative risk assessment should be recorded within the structure of the preliminary risk matrix.

3.29 A secondary output from the qualitative risk assessment is a risk management plan for all those risks that are likely to be retained by the Contracting Authority.

Preliminary Risk Quantification

Overview

3.30 The objective of risk quantification is to express the potential impact of a risk in monetary terms. The quantification of risk in monetary terms facilitates better understanding of the potential impact of risks, and provides a strong rationale for the Contracting Authority to ensure that significant risks are managed efficiently and in a cost effective way.

3.31 Risk quantification is also required to inform the development of a Financial Comparator at the end of the Public Private Partnership Assessment. All those risks that are to be transferred to the Contractor should be quantified and included in the Financial Comparator. The net present cost of the Financial Comparator is then compared with the net present cost of the preferred tender at the end of the procurement process to determine whether the preferred tender represents value for money. A Financial Comparator will not be required for every project, and further guidance is set out in the separate Guidance Notes entitled Public Private Partnership Assessment and Procurement Management.

3.32 It is considered good practice for a preliminary risk quantification exercise to be undertaken for all Public Private Partnership projects irrespective of whether a Financial Comparator is required.



3.33 However, the time and resources expended in undertaking the preliminary risk quantification should reflect:

the size and complexity of project;

the number of significant project risks;

whether or not a Financial Comparator is required; and

whether or not the procurement is likely to follow the negotiated procedure. If the negotiated procedure is followed, then the Contracting Authority will need an estimate of the full cost (including risk) of items under negotiation.

3.34 When quantifying risk it is vital that Central and Contracting Authorities focus on significant risks and that they involve experienced personnel who are able to draw on their knowledge of similar projects. In addition, specialist technical and financial advisers should be appointed to assist in the quantification and analysis of risk.

3.35 There are a number of approaches that can be used to quantify and analyse significant risks, involving increasingly rigorous analysis. These approaches are listed below.

Table 6: Approaches to Risk Quantification

Method of risk quantification

Method of analysis Suitable projects

Range of values for selected risk factors (e.g. maximum and minimum demand)

Sensitivity analysis to look at individual risks

Scenario analysis to look at combinations of risks

Projects where there is no data to facilitate more detailed analysis.

Projects for which there is no flexibility in how risks can be managed.

Projects which will go ahead regardless of the risk analysis.

Point estimates Root-Mean-Square methods

Projects for which crude estimates of the probability and value of risk is known, and risks are independent and follow normal distributions

Consider full range of outcomes

Monte Carlo analysis Projects for which there is a reasonable understanding of the likely probability and value of risk.

Monte Carlo analysis is the most suitable method of analysis where a rational cost contingency needs to be estimated, where the likelihood of various outcomes needs to be understood, where several ways of managing risk need to be compared, or where risks combine in complex ways.

Monte Carlo analysis is the recommended approach to risk assessment on large/complex Public Private Partnership projects.



3.36 The three approaches to risk quantification and analysis are described in more detail in the paragraphs that follow.

Sensitivity and Scenario Analysis

3.37 Sensitivity analysis determines the consequences of wrongly estimating the main variables in a financial model. By undertaking sensitivity analysis on all the main variables, those that are likely to have a significant effect on the project can be identified. Sensitivity analysis will provide Central and Contracting Authorities with a range of possible outcomes and can help to identify the most important risks for risk management purposes.

3.38 Scenario analysis is a variant of sensitivity analysis and has been devised to draw attention to the major economic and technical uncertainties to which a project is exposed. This forces Central and Contracting Authorities to consider risks in clusters rather than in isolation.

3.39 Sometimes sensitivity and scenario analysis may provide all the information that is required. For example, if the worst case scenario identified by the sensitivity and scenario analysis is still reasonably attractive, and it is clear how best to manage the risks, then further analysis may not be required. This may be the case for projects with risks that are well understood and straightforward to manage, which are to be procured under the restricted procedure, or for which a Financial Comparator is not required.

Root-Mean-Square Methods

3.40 The simplest quantitative data on risk is point estimates. An example of a point estimate of a risk is, say, a 50 per cent chance of a ten per cent cost overrun. Such estimates, if well drawn, are clearly more useful than no information, but do not provide a picture of potential outcomes.

3.41 For this reason point estimates are best used in conjunction with statistical analysis such as Root-Mean-Square (RMS) methods. RMS methods use a simple concept of ‘average risk’ and ‘maximum risk’ (in a similar way to point estimates), and can therefore be used where there is limited data on the individual risks in a project. RMS methods also enable combinations of risks to be considered.

3.42 RMS methods make two important assumptions. Firstly, they assume that risks are independent and additive. Secondly, they assume that risks follow normal probability distributions. RMS methods then use a straightforward and standard technique to calculate the spread of outcomes for a project.

3.43 It is important to realise however that in many cases the assumptions of RMS methods are not appropriate and the analysis will provide spurious results. This is because many risks are heavily skewed and many are inter-linked, and therefore RMS methods of analysis can misrepresent the actual risk profile on a project.



Monte Carlo Analysis

3.44 A more reliable method of risk analysis is to consider a range of values, or probability distribution, for key assumptions on a project. This is in practice no more difficult than deriving a series of points. The availability of spreadsheet add-in software to perform more sophisticated analysis makes it easy to model these assumptions, with the added advantage that useful reports and graphs can be produced.

3.45 The most commonly used method for considering probability distributions is Monte Carlo analysis. Monte Carlo analysis is a probabilistic simulation, which analyses the factors or risks in a project that cannot be estimated with certainty.

3.46 Monte Carlo analysis requires the user to estimate a range of possible outcomes together with their probabilities of occurring. A simple software tool attaches to a standard spreadsheet to enable the user to define practical distributions on the assumptions they make. Using this information, Monte Carlo analysis is able to produce:

• realistic and sensible calculations of the likely project outturn;

• an estimate of the maximum cost, assuming the most pessimistic scenario; and

• an estimate of the lowest cost, assuming the most optimistic scenario.

3.47 Further refinement of the output is achieved by performing 1,000 randomly sampled iterations for each set of risks. The output is presented as a graphical distribution profile and a schedule of costs. The output defines the level of confidence that the outturn cost will not exceed a particular threshold value (percentage confidence), and also defines:

• Mean value - which is the average value calculated over the 1,000 iterations for the range of cost parameters input;

• Standard deviation - providing a measure of the cost deviation from the expected mean;

• Model value - defined as the most frequently occurring value over the 1,000 iterations; and

• Minimum and maximum values - corresponding to confidence levels of 0% and 100% respectively.

3.48 Monte Carlo analysis is the only approach capable of considering fully the impact of a number of risks taken together. It is therefore the generally recommended approach to risk quantification and analysis for Public Private Partnership projects, where accuracy is important and resources can be made available to gather the necessary information on risks.



Tips on Preliminary Risk Quantification

Involve experienced personnel including technical and financial advisers;

Select the method of risk quantification and analysis that best suits the characteristics of the project and the level of information that is available. Monte Carlo analysis is the recommended approach;

Obtain access to an appropriate software package and ensure that an experienced risk analyst is available to undertake the risk assessment;

Determine the base data that will form the input to the model; and

Examine the outputs from the model, but beware of spurious levels of detail.

Outputs

3.49 At the Option Appraisal stage, the primary output from the preliminary risk quantification is an assessment of the probable cost of each of the significant risks associated with the project.

3.50 The outputs of the preliminary risk quantification should be used to review and update risk allocations and risk management plans, and the total cost of all the significant risks that are allocated to the private sector should be included in the Financial Comparator (if one is required) which is prepared as part of the Public Private Partnership Assessment. Further details are provided in the separate Guidance Note entitled Public Private Partnership Assessment.



IV. Risk Assessment at the Procurement Stage

Introduction

4.1 This section of the Guidance Note provides advice for Central and Contracting Authorities in relation to the final risk assessment, which is undertaken during the Procurement stage. The primary purpose of undertaking the final risk assessment at the Procurement stage is to ensure that the Public Private Partnership procurement provides the best value for money possible. This is achieved in two ways:

• by allocating risk to the party best able to manage it in the most cost effective way; and

• by providing incentives for Contractors to deliver infrastructure projects on time, to the required standard and within budget.

4.2 Given the nature of Public Private Partnerships, the achievement of value for money will often hinge on the level and cost of risk transferred to the Contractor. It is therefore essential that risk assessments are undertaken for every Public Private Partnership project, and that they are kept up to date, are technically sound, and are informed by reliable assumptions.

4.3 The risk assessment undertaken at the Procurement stage should build on the risk assessment carried out at the Option Appraisal stage. In some circumstances the range and expected value of risk will have changed as a result of new information, and therefore at the start of the Procurement stage the Contracting Authority should consider:

• any additional risks that may have become apparent;

• any risks that may no longer be appropriate; and

• any changes to the expected value resulting from greater uncertainty or the availability of more accurate information.

4.4 Risk assessment is required during the procurement process to inform:

• Contractual terms and payment mechanism - the main way of allocating risk to a private sector contractor is through the contractual incentives and penalties incorporated within the payment mechanism. The design of the payment mechanism requires a detailed understanding of the types of risk involved in the construction and operation of an infrastructure project, and the value that the Contracting Authority attaches to such risk;



• Negotiation - if the negotiated procedure is used, then risk assessment is required to establish the full cost (including risk) of items under negotiation, and to determine whether the cost of such items is minimised by transferring responsibility to the Contractor or retaining responsibility with the Contracting Authority; and

• Financial Comparator - all those risks to be transferred to the Contractor should be quantified and included in the Financial Comparator if required. The net present cost of the Financial Comparator is then compared with the net present cost of the preferred tender. This monetary comparison is one part of the assessment to determine whether the preferred tender represents value for money.

4.5 However, the requirement to undertake further quantification of risk is highly dependent on whether a Financial Comparator is required and whether the restricted or negotiated procedure is to be followed. In this regard the following points should be used as a guide:

• where a Financial Comparator is required, it is recommended that the quantification of all significant risks should be updated, analysed and aggregated to provide a monetary value of risk for inclusion in the Financial Comparator;

• where the negotiated procedure is followed but a Financial Comparator is not required, the quantification of those significant risks that are subject to negotiation should be updated and analysed in detail; and

• where the restricted procedure is followed but a Financial Comparator is not required, then no further quantification of risk is necessary during the procurement process.

4.6 Where further quantification and analysis of risk is required during the procurement process, the Contracting Authority should employ the more sophisticated risk analysis techniques (Monte Carlo analysis is recommended) where these have not already be used at the Option Appraisal stage.

4.7 The steps involved in undertaking risk assessments for projects that are procured under the restricted and negotiated procedures are set out in detail in the paragraphs that follow.

Restricted Procedure

4.8 For projects that are procured under the restricted procedure, the assessment of risk comprises four steps that are set out in the diagram shown overleaf. The requirements of each step are described in more detail in the paragraphs that follow.



Figure 4: Risk Assessment under the Restricted Procedure


The risk matrix is updated, included in the Invitation to Tender and sent to short listed tenderers. Short listed tenderers may be asked to comment on the Risk Matrix prior to submission of tenders. If appropriate, the Risk Matrix may be adjusted and amendments to the tender documents issued. Prior to the submission of tenders, the quantification of risk is updated and included in the final Financial Comparator (if one is required). Tenderers are asked to submit details of their risk management proposals with their tenders, and these are evaluated as part of the formal tender evaluation. The Contracting Authority’s risk management plans should also be updated at this stage and included in the Report on the Tendering Process.

Updated risk

matrix

Updated risk matrix

Updated Financial

Comparator

Updated risk management

plan

Update RiskMatrix

Obtain Viewsof Tenderers

Finalise RiskMatrix andComparator

Evaluate RiskManagement

Proposals

4.9 Under the restricted procedure, the risk matrix (including risk identification, allocation and qualitative assessment) must be updated at the start of the procurement process and included within the Invitation to Tender. An example of the type of the risk matrix that should be included in the tender documentation is presented in Appendix B to this Guidance Note.

4.10 After issuing the Invitation to Tender to short listed tenderers, the Contracting Authority may decide to obtain the views of the short listed tenderers on the risk matrix, and on the proposed allocation of risk in particular, in advance of the date for submission of tenders. This should allow the Contracting Authority to effectively market test the risk matrix.

4.11 Short listed tenderers may propose an alternative allocation of risk, or they may identify additional risks inherent in the project. Where appropriate, a tender amendment could be issued involving clarification of risk allocation or some adjustment in it. Care should be taken to ensure that all tenderers can cater for any changes and that there is no infringement of intellectual property rights. Significant changes in risk allocation have the potential to give rise to difficulties if they add significantly to tender costs, lead to extension of tender period or indicate any element of bias towards a particular tenderer, process or item of equipment.

4.12 The Contracting Authority should seek advice from its appointed legal advisers in relation to the ways in which is might seek the views of short listed tenderers, and reference should be made to the separate Guidance Note entitled Procurement Management.

24Guidance Note 11 14 April 2000


4.13 The Contracting Authority’s quantification of risk should then be updated to take account of the views of the short listed tenderers on risk allocation and to include any more detailed information that may be available. The value of risk transferred to the Contractor should then be included in the Financial Comparator (if one is required), and this should be finalised prior to submission of tenders.

4.14 The Contracting Authority should require that short listed tenderers include within their tender submissions:

• a fully completed risk matrix;

• a general description of its proposed strategy for ensuring that the project is delivered within the specified time, cost and quality constraints;

• a full description of the methods and techniques that will be used to monitor and control each category of risk and the individual risks within it;

• an indication of whether each category of risk and the individual risks within it will be borne by the Contractor, a nominated supplier or an insurance company or other financial institution; and

• an indication of the potential financial impact of each category of risk and the individual risks within it.

4.15 The proposals for managing risk submitted by tenderer should then be evaluated as part of the formal tender evaluation. Under the restricted procedure there is no scope for negotiation on risk or any other issue after tenders have been submitted.

4.16 Where the evaluation of standard and variant tenders concludes that a variant tender is preferred, the risk matrix and Financial Comparator should be updated to ensure that they reflect the allocation of risk included in the preferred variant tender.

4.17 The valuation of retained risk should be included in the Contracting Authorities risk management plan, and the valuation of retained and transferred risks should be made available for accounting opinions (where appropriate). The requirements of the risk management plan are described in detail at the end of this section of the Guidance Note.



Tips on Final Risk Assessment Under Restricted Procedure

Update risk matrix for inclusion in the Invitation to Tender;

Obtain views of short listed tenderers on risk matrix prior to submission of tenders (where appropriate);

If appropriate, issue amendments to tender documents to reflect the views of tenderers;

Update risk quantification (where appropriate) and prepare the final Financial Comparator prior to submission of tenders;

Request details of risk management proposals in tender submissions; and

Evaluate risk management proposals as part of formal tender evaluation and update risk management plans for retained risks.

Negotiated Procedure

4.18 For projects that are procured under the negotiated procedure, the assessment of risk comprises five steps, which are summarised in the diagram below. The requirements of each step are described in more detail in the paragraphs that follow.

Figure 5: Risk Assessment under the Negotiated Procedure


The risk matrix is updated, included in the Invitation to Negotiate and sent to short listed bidders. Short listed bidders are asked to comment on the risk matrix prior to submission of bids. If appropriate, the risk matrix may be adjusted and amendments to the bid documents issued. The quantification of risk is updated and included in the final Financial Comparator (if one is required) prior to the submission of bids. Significant risks that have a direct impact on the overall cost of the project are the subject of negotiation. The risk matrix and Financial Comparator are continually updated to reflect the outcomes of the negotiations. Bidders are asked to submit details of risk management proposals with their bids, and these are evaluated as part of the formal bid evaluation. The Contracting Authority’s risk management plans should also be updated at this stage and included in the Report on the Tendering Process.

Updated risk

matrix

Updated risk matrix

Updated Financial

Comparator

Updated risk matrix and Financial

Comparator

Updated risk management

plan

Update RiskMatrix

Obtain Viewsof Tenderers

Finalise RiskMatrix andComparator

NegotiateSignificant

Risks

Evaluate RiskManagement

Proposals



4.19 The main difference between the restricted and negotiated procedures is that, under

the negotiated procedure, there is scope for negotiating the allocation and quantification of risk throughout the bidding process. A detailed description of the potential for negotiation is provided in the separate Guidance Note entitled Procurement Management.

4.20 However, in order to keep the scope and duration of negotiations to a minimum, it is recommended that as far as practicable, risk assessment under the negotiated procedure should follow the steps set out for the restricted procedure above. This means that the risk matrix should be developed as far as possible prior to the issue of the Invitation to Negotiate, and that the Financial Comparator should be finalised as far as possible prior to the submission of bids.

4.21 The risk matrix and Financial Comparator should be constantly updated during the course of the bidding process to reflect the outcomes of negotiations with short listed bidders. The categories of risk that are most commonly the subject of negotiation are:

• planning risk;

• demand and volume risks;

• regulatory and legislative risks; and

• residual value risk.

4.22 It is customary for design, construction, operating and other financial risks to be transferred to the Contractor under a Public Private Partnership contract.

Tips on Final Risk Assessment Under Negotiated Procedure

Update risk matrix for inclusion in the Invitation to Negotiate;

Obtain views of tenderers on risk matrix prior to submission of tenders;

If appropriate, issue amendments to tender documents to reflect views;

Update risk quantification and Financial Comparator (where appropriate) prior to submission of tenders;

Request details of risk management proposals in tender submissions;

Negotiate on the significant risks that may have a direct impact on the overall cost of the project and the value for money that is achieved;

Continually update the Risk Matrix and Financial Comparator to reflect the outcomes of the negotiations; and

Evaluate risk management proposals as part of formal tender evaluation and update risk management plans for retained risks.



Risk Management Plans

4.23 Infrastructure projects that are procured using Public Private Partnerships will commit Contracting Authorities to significant investment throughout the duration of the Project Agreement. It is therefore important that Contracting Authorities establish appropriate plans to manage the risks that they retain.

4.24 The risk management plans established by Contracting Authorities should set out how retained risks will be monitored so that their likely occurrence can be identified at an early stage. It should also set out the actions that will be taken by the Contracting Authority to manage risks if and when they occur, and identify the resources that will be required to implement the risk management plan.

4.25 For those risks that are transferred to the Contractor, the risk management plan should demonstrate how the contract facilitates the transfer of such risks, and set out the plans of the Contractor to manage those risks that have been allocated to it. The risk management plan should confirm that there are no outstanding issues affecting the allocation and management of risk between the Contracting Authority and its appointed Contractor.

Report on Tendering Process

4.26 On completion of a Public Private Partnership procurement, the Contracting Authority should prepare a Report on the Tendering Process, providing a detailed summary of each phase in the procurement process. The Report on the Tendering Process will form the basis of a submission from the Contracting Authority to the Central Authority seeking approval to enter into a Public Private Partnership contract with the preferred private sector supplier.

4.27 The requirements of the Report on the Tendering Process are described in detail in the separate guidance Note entitled Procurement Management. In order to document the approach to risk that is included in the Project Agreement, the Report on the Tendering Process should include details of the final risk matrix including;

• the methodology used to quantify risk;

• a description of each risk;

• the quantification of risk;

• the allocation of risk;

• a statement on how risks are transferred in the Project Agreement; and

• a statement on how retained risks will be managed.



V. Indicative Sector Specific Risks

Introduction

5.1 This section of the Guidance Note provides a brief description of some indicative principal risks associated with infrastructure projects in the roads, water and waste sectors. An example risk matrix for a road project is presented at Appendix B to this Guidance Note. Many of the risks included in the risk matrix are also relevant to projects in the water and waste sectors.

Roads Sector

5.2 International experience would suggest that on road projects, construction and operational risks can be successfully transferred to the private sector. In traditional contracts, the spatial extent of road schemes and the range of ground conditions encountered commonly results in a significant risk of claims for unforeseen conditions. However, these risks can be substantially transferred under a Public Private Partnership arrangement, although the Contracting Authority may retain some risk, for example, risks relating to the discovery of previously unknown archaeological artefacts.

5.3 The principal operational risk is traffic demand, the future pattern of which is often difficult to predict. If tolls are to be applied, they may need to be supported by other payments such as capital grant or revenue support to alleviate some of the risk borne by the Contractor. Many of the more successful tolling schemes have involved road improvements, where demand can be forecast with greater certainty based on historical traffic demand.

Water Sector

5.4 Water and wastewater infrastructure projects involve significant risk in relation to load conditions (volume characteristics), sludge disposal, adequacy and long term obsolescence of plant and interaction with networks managed by others. Transfer of statutory duty is not legally possible, but performance of the particular duty can be required of the contractor, enforceable through the payment mechanisms. A significant risk in water services is the effect of new regulations where higher standards of performance are introduced during the contract period.

Waste Sector

5.5 Waste management projects commonly involve significant risks in relation to public acceptance of facilities, the nature and characteristics of waste, and ring fencing of waste volumes. The requirement to satisfy national policy in relation to waste management requires particular attention, including the possibility of using integrated waste management contracts incorporating the collection, treatment and ultimate disposal of waste. Such contracts would result in significant planning risk in view of the different components that are necessary for successful project delivery. The following case study illustrates aspects of risk management in a waste project.



Kirklees Metropolitan Council – Integrated Waste Management

In April 1998, Kirklees Metropolitan Council and United Waste Services Ltd entered into a 25 year contract to jointly deliver an integrated solution to the Council’s waste management needs (excluding waste collection). The contract involved new capital investment of some £41 million to reduce dependency on landfill in favour of increased recovery and recycling. The contract involved the transport, transfer and recycling of waste and the operation of civic amenity sites.

Most of the design, construction and operational risk is transferred to the Contractor, except:

The residual value of landfill sites is shared;

The condition of existing facilities being taken over is subject to condition survey and asset transfer agreements;

The Council retains the risk associated with landfill tax and other legislative impacts;

Planning risks are shared; and

Waste composition risk is generally transferred within a wide range of calorific values.



VI. Conclusions and Recommendations

Introduction

6.1 This Section presents conclusions on the issues discussed in the Guidance Note and provides recommendations on the assessment of risk in relation to Public Private Partnership infrastructure projects in the roads, water and waste sectors.

Requirement for Risk Assessment

6.2 A preliminary assessment of risk is required as part of the Public Private Partnership Assessment to identify and quantify the most significant risks in a project and to consider how they might best be allocated between the Contracting Authority and the Contractor. The preliminary risk assessment informs the selection of the most appropriate form of Public Private Partnership for the project. It also supports the development of a fully costed Financial Comparator, which may be used during the Procurement stage to determine whether the preferred Public Private Partnership tender represents value for money. The main outputs of the preliminary risk assessment can be summarised as follows:

• Preliminary list of risks - a list of the most significant project risks;

• Preliminary risk allocation - an initial view as to whether the Contracting Authority or the Contractor is likely to be best able to manage each risk;

• Qualitative risk assessment – a qualitative assessment of the potential impact or significance of each risk;

• Preliminary risk matrix - a presentation of the outcomes of the above steps in the form of a risk matrix;

• Preliminary risk quantification - an assessment of the monetary value of the most significant risks in the risk matrix. The monetary value of risk is included in the Financial Comparator (if one is required); and

• Risk management plan - a plan setting out how the Contracting Authority will manage those risks that it is to retain.

3.29 It is recommended that preliminary risk quantification should be undertaken for all Public Private Partnership projects irrespective of whether a Financial Comparator is required. However, the time and resources expended in undertaking the preliminary risk quantification should reflect the size and complexity of project, the number of significant project risks, whether or not a Financial Comparator is required, and whether or not the procurement is likely to follow the negotiated procedure. If the negotiated procedure is followed, then the Contracting Authority will need an estimate of the full cost (including risk) of items under negotiation.



6.3 Further risk assessment is required during the Procurement stage. This should build on the risk assessment undertaken for the Public Private Partnership Assessment and its main outputs can be summarised as follows:

• Updated risk matrix - updating of the preliminary risk matrix to reflect changes to the list of risks, the qualitative assessment of risks and the allocation of risks;

• Updated risk quantification - updating of the quantification of risk where this is required (see below); and

• Risk management plans - tenderers should be asked to submit details of their risk management proposals with their tenders, and these should evaluated as part of the formal tender evaluation. The risk management plans prepared by the Contracting Authority should also be updated at this stage.

6.4 The need to update the quantification of risk during the Procurement stage is highly dependent on whether a Financial Comparator is required and whether the restricted or negotiated procedure is to be followed. In this regard the following points should be used as a guide:

• where a Financial Comparator is required, it is recommended that the quantification of all significant risks should be updated, analysed and aggregated to provide a monetary value of risk for inclusion in the Financial Comparator;

• where the negotiated procedure is followed but a Financial Comparator is not required, the quantification of those significant risks that are subject to negotiation should be updated and analysed in detail; and

• where the restricted procedure is followed but a Financial Comparator is not required, then no further quantification of risk is necessary during the procurement process.

6.5 Where further quantification and analysis of risk is required during the Procurement stage, the Contracting Authority should employ the more sophisticated risk analysis techniques (Monte Carlo analysis is recommended) where these have not already be used within the preliminary risk assessment.

Managing Risk Assessments

6.6 It is vital that the right people are involved in the identification and assessment of risks, including Central and Local Authority management, the operational staff responsible for managing existing services, technical experts and financial and legal advisers. Responsibility for carrying out the preliminary and final risk assessments need to be well defined, and in the case of the pilot projects at least, it is recommended that Central and Contracting Authorities appoint technical, financial and legal advisers to assist them.



Appendices




Public Private Partnership Guidance Notes

The Public Private Partnerships Policy Framework comprises a series of fifteen individual Guidance Notes, the titles of which are as follows:



• Legal Context








• Risk Assessment







Appendices

B. Indicative Risk Matrix



Indicative Risk Matrix

A. Planning Risk

Risk Description Probability Financial Impact

Expected Value

Indicative Allocation

A1 Planning Permission Complete loss of a project as a result of a failure to obtain planning permission.

A2 Planning Conditions Unacceptable, onerous or costly conditions applied during the planning process.

A3 Environmental Impact Unacceptable, onerous or costly conditions applied during the Environmental Impact Assessment.

A4 Public Consultation Unanticipated delays and costs arising from the legal requirements in relation to public consultation.

A5 Site Acquisition Unanticipated delays and costs arising from the process of land or site acquisition.

A7 Variations Unforeseen planning time and cost overruns arising from changes in relevant legislation or from changes in the requirements of the Contracting Authority.

A8 Legal Covenants Unforeseen legal covenants or rights of way result in a requirement for significant design change.

A9 Consents and Licenses Failure to obtain the requisite consents and licenses.

A10 Time and Cost Overruns The actual time and cost associated with the planning process exceeds that budgeted or anticipated.



B. Design Risk


Expected Value


B1 Information Quality Insufficient specification of design, material and resource requirements requiring changes subsequent to design freeze.

B2 Redesign Redesign of project required as a result of poor initial design or misunderstanding or misinterpretation of the specification.

B3 Performance Detailed design does not meet the functional requirements of the Contracting Authority.

B4 Variations Delays and additional costs resulting from changes in: ♦ Contracting Authority requirements ♦ Regulatory or statutory requirements ♦ Environmental performance standards

B5 Resources Design team does not have access to the level and quality of resources needed to successfully complete the design process.

B6 Flexibility Insufficient flexibility provided for in the detailed design in order to accommodate future changes.

B7 Design Standards Delays and additional costs arising from changes in design standards and building regulations.

B8 Inflation Construction and operating costs increase more than expected and more than allowed for in the indexation arrangements.

B9 Time and Cost Overruns The actual time and cost associated with the design process exceeds that anticipated or budgeted.



C. Construction Risk


Expected Value


C1 Ground Conditions Unforeseen delays and costs arising from poor ground conditions, archaeological discoveries, contamination or pollution.

C2 Weather Conditions Unexpected weather conditions during the construction period.

C3 Site Access Delays in construction resulting from the late transfer of an existing site provided by the Contracting Authority.

C4 Public Protest Delays in construction caused by public protests and disruption.

C5 Labour Resources Delays in construction caused by shortage of skilled and unskilled labour resources.

C6 Material Resources Delays in construction caused by shortage of key construction materials.

C7 Commissioning Facility fails to achieve necessary standards on commissioning or major incident occurs during the commissioning process.

C8 Cost Control Inadequate cost control leading to a need for additional resources.

C9 Working Practices Changes in the methods used to deliver the project requirements resulting from a need to keep to the contracted budget.

C10 Workmanship Delays and additional costs resulting from poor quality workmanship.

C11 Other Facilities Accidental physical damage caused to other facilities resulting in claims, litigation or the need for arbitration.




Expected Value


C12 Variations Delays and additional costs resulting from changes in: Contracting Authority requirements Regulatory or statutory requirements Environmental performance standards

C13 Time Extensions Cost increases due to any extensions of time granted by the Contracting Authority.

C14 Interfaces Unforeseen compatibility problems between existing systems and the new infrastructure.

C15 Works Building or sub-contractors: Insolvency or default Failure to perform Failure to achieve quality standards

C16 Site Safety Major accident occurs resulting in delay and additional cost.

C17 Utilities Delays and additional costs resulting from a loss of power or services.

C18 Industrial Action Delays and additional costs resulting from industrial action by the staff employed by the Contractor or its subcontractors.

C19 Authority Staff Delays and additional costs resulting from industrial action by the staff employed by the Contracting Authority.

C20 Interruptions Delays and additional costs arising due to: Noise complaints Disputes with local residents Access problems

C21 Inflation Construction costs increase more than expected and more than allowed for in the indexation arrangements.




Expected Value


C22 Demolition of Existing Facilities Unforeseen materials problems, unknown services, undefined interfaces and increased loads.

C23 Time and Cost Overruns The actual time and cost associated with the construction process exceeds that budgeted or anticipated.



D. Operating Risk


Expected Value


D1 Latent Defects Unforeseen costs are incurred due to a major latent defect arising after the liability period.

D2 Service Availability The availability of the service provided falls below the standard specified.

D3 Service Performance The delivery, timing or quality of the service provided falls below the required standard.

D4 Estimation Errors Additional service costs are incurred and are attributable to inaccuracies in the original cost estimates.

D5 Materials A deficiency in the performance of key construction materials results in higher than expected maintenance costs.

D6 Utilities Specified service standards not met as a result of a utility failure outside of the site.

D7 Staff Shortages Shortage of appropriately skilled staff leads to a reduction in service availability and performance.

D8 Staff Training Shortage of appropriately trained staff leads to a reduction in service availability and performance.

D9 Industrial Action Delays and additional costs resulting from industrial action by the staff employed by the Contractor or its subcontractors.

D10 Residual Equipment Incorrect assessment of life expectancy of existing facilities and equipment.

D11 Authority Staff Delays and additional costs resulting from industrial action by the staff employed by the Contracting Authority.




Expected Value


D12 Variations Delays and costs arising from changes in: ♦ Contracting Authority requirements ♦ Regulatory or statutory requirements ♦ Environmental performance standards

D13 Environmental Performance Delays and additional costs resulting from a failure to meet performance standards.

D14 Third Party Claims Additional costs arising from third party claims resulting from a failure to meet the performance standards specified.

D15 Cost Control Inadequate cost control leading to the need for additional resources.

D16 Technological Obsolescence Advances in technology resulting in the risk of early obsolescence and the requirement to upgrade the technical infrastructure earlier than anticipated.

D17 Maintenance Additional maintenance costs resulting from estimating errors, increases in usage or poor life cycle maintenance procedures.

D18 Design Deficiencies Deficiencies in infrastructure design or build quality resulting in higher than anticipated maintenance and servicing costs.

D19 Infrastructure Damage Infrastructure damage or destruction arising from an insurable event.

D20 Infrastructure Damage Infrastructure damage or destruction arising from an uninsurable event or civil unrest.

D21 Inflation Operating costs increase more than expected and more than allowed for in the indexation arrangements.

D22 Subcontractor Performance Failure to meet availability and performance standards as a result of subcontractor: ♦ Insolvency or default ♦ Failure to perform ♦ Failure to achieve quality standards



E. Demand Risk


Expected Value


E1 User Charging Failure to secure anticipated income from user charging due to either estimation errors, the availability of alternative solutions, or changes in the scope and nature of demand.

E2 External Developments Failure to secure anticipated income from user charging due to wider social, economic and political developments.

E3 Excessive Profits Income generated from user charging exceeds the level anticipated in the original tender submission.

E4 Price Changes Costs increase more than expected and more than allowed for in the indexation arrangements.



F. Financial Risk


Expected Value


F1 Affordability Lack of sufficient public finance to fund the unitary payment or subvention.

F2 Interest Rates Pre Financial Close Prior to financial close, interest rates and any other costs of finance increase by more than anticipated in the tender submission.

F3 Interest Rates Post Financial Close Post financial close, interest rates and any other costs of finance increase by more than anticipated in the tender submission.

F4 Foreign Exchange Additional costs or savings arise as a result of fluctuations in foreign exchange rates.

F5 Tax Assumptions Costs incurred by the Contractor increase or decrease due to inaccurate tax assumptions.

F5 General Tax Changes Costs incurred by the Contractor increase or decrease as a result of: ♦ Changes in stamp duty ♦ Changes in income tax ♦ Changes in corporation tax ♦ Changes in value added tax ♦ Changes in capital gains tax

F6 Value Added Tax Change in the status of the service for the purposes of value added tax.

F7 Residual Value The value of the underlying infrastructure at the end of the project is less than expected by the Contractor.

F8 Insurance Scope Key risks become uninsurable over the life of the project.

F9 Insurance Cost Insurance costs increase faster than allowed for by the Contractor.



G. Legislative Risk


Expected Value


G1 Discriminatory Change of Law A change in law that only applies to: ♦ The project being procured ♦ The Contractor providing the service ♦ Public Private Partnership projects

G2 General Change of Law General legislative or regulatory changes giving rise to increased capital or revenue costs.

G3 Authority Default Termination Financial consequences of any termination arising from Authority default.

G4 Voluntary Termination Financial consequences of any voluntary termination caused by the Contracting Authority.

G5 Contractor Default Financial consequences of any termination arising from Contractor default.

G6 Force Majeure Financial consequences of any termination arising from a force majeure event.


Department of the Environment and Local Government Payment Mechanisms

Payment Mechanisms


14 April 2000



Contents

Section Page

I. INTRODUCTION....................................................................................................................................... 1


II. PAYMENT MECHANISMS...................................................................................................................... 4

INTRODUCTION ................................................................................................................................................... 4 BASIC ELEMENTS OF A PAYMENT MECHANISM .................................................................................................. 6 UNDERLYING PRINCIPLES................................................................................................................................... 7 DEVELOPING A PAYMENT MECHANISM .............................................................................................................. 8

III. USER CHARGES ..................................................................................................................................... 16

INTRODUCTION ................................................................................................................................................. 16 SUITABILITY OF PROJECTS TO USER CHARGES ................................................................................................. 16 APPLYING USER CHARGES ............................................................................................................................... 17 BASING A PAYMENT MECHANISM ON USER CHARGES ..................................................................................... 18 SETTING USER CHARGES.................................................................................................................................. 22 SUBVENTIONS................................................................................................................................................... 24 GUARANTEES AND EXCESSIVE PROFITS ........................................................................................................... 26

IV. USAGE PAYMENTS ............................................................................................................................... 29

INTRODUCTION ................................................................................................................................................. 29 USE OF USAGE PAYMENTS ............................................................................................................................... 29 PARTIAL USAGE PAYMENTS ............................................................................................................................. 33

V. AVAILABILITY PAYMENTS................................................................................................................ 36

INTRODUCTION ................................................................................................................................................. 36 USE OF AVAILABILITY PAYMENTS ................................................................................................................... 36

VI. SERVICE PERFORMANCE PAYMENTS ........................................................................................... 40

INTRODUCTION ................................................................................................................................................. 40 USE OF SERVICE PERFORMANCE PAYMENTS .................................................................................................... 41 PERFORMANCE MONITORING ........................................................................................................................... 41

VII. FINANCIAL ISSUES........................................................................................................................... 43

INTRODUCTION ................................................................................................................................................. 43 INDEXATION ..................................................................................................................................................... 43 BENCHMARKING AND MARKET TESTING.......................................................................................................... 44 VARIATIONS ..................................................................................................................................................... 45 PASS THROUGH COSTS ..................................................................................................................................... 45 TRANSFER OF ASSETS....................................................................................................................................... 45 REVENUE SHARING .......................................................................................................................................... 46 REFINANCING ................................................................................................................................................... 47 PAYMENT OF DESIGN COSTS ............................................................................................................................ 47

VIII. CONCLUSIONS AND RECOMMENDATIONS ............................................................................. 48

INTRODUCTION ................................................................................................................................................. 48 DEVELOPING A PAYMENT MECHANISM ............................................................................................................ 48 APPLICATION OF USER CHARGES ..................................................................................................................... 48 PAYMENT MECHANISMS................................................................................................................................... 49 GUARANTEES ................................................................................................................................................... 50 FINANCIAL ISSUES ............................................................................................................................................ 51



APPENDICES..................................................................................................................................................... 53

A. PUBLIC PRIVATE PARTNERSHIP GUIDANCE NOTES ................................................................................. 53



I. Introduction


1.1 This Guidance Note provides guidance for Central and Contracting Authorities in relation to the development of payment mechanisms for Public Private Partnership projects in the roads, water and waste sectors. The purpose of the Guidance Note is:

• To introduce the principles underlying a range of different types of payment mechanisms and to examine their application to Public Private Partnership infrastructure projects;

• To review the issues that influence the structuring of payment mechanisms for Public Private Partnerships and to identify the advantages and disadvantages of different payment mechanism structures; and

• To provide detailed advice on the development of payment mechanisms for infrastructure projects in the roads, water and waste sectors.


1.3 The Guidance Notes are designed to be informative rather than prescriptive and the aim is to reflect good practice. They are generic in that they provide guidance on the use of Public Private Partnerships across a range of projects in the roads, water and waste sectors. However, different projects will give rise to different issues and the guidance provided will have to be reviewed in the context of each individual project. For this reason it is important that Central and Contracting Authorities obtain expert advice in order to help them to make best use of the Guidance Notes and to complete a successful Public Private Partnership procurement.


1.4 The Guidance Note provides an introduction to the use of payment mechanisms in the context of Public Private Partnership infrastructure projects. It then describes in detail the two principal forms of payment mechanism, namely user charges and unitary payments. User charges are paid directly by the users of a particular service whilst unitary payments are made by the Contracting Authority to the Contractor. Unitary payments typically comprise one or more of the following elements - usage payments, availability payments and service performance payments.

1.5 The key payment mechanism issues addressed in the Guidance Note are as follows:

• Section Two - describes the basic elements and principles underlying payment mechanisms for Public Private Partnership projects and describes a process by which effective payment mechanisms may be developed;



• Section Three - describes the principles and characteristics of user charging and discusses its potential application to Public Private Partnership projects;

• Section Four - describes the principles and characteristics of a usage payment and discusses its potential application to Public Private Partnership projects;

• Section Five - introduces the principles and characteristics of an availability payment within the context of a Public Private Partnership project;

• Section Six - sets out the principles and characteristics of service performance payments within the context of a Public Private Partnership project; and

• Section Seven - identifies the main issues that may give rise to a change in cost over the life of a Public Private Partnership project.

1.6 The final Section provides a summary of the main conclusions and recommendations that are identified and discussed within this Guidance Note.


1.7 The process of project development and implementation changes significantly when a project is taken forward as a Public Private Partnership. For this reason a Public Private Partnership Route Map has been developed.

1.8 The Public Private Partnership Route Map sets out the main stages in the development and implementation of a Public Private Partnership project that must be undertaken by the Central Authority and the Contracting Authority. The Route Map is presented in the diagram shown overleaf.


1.10 The detailed payment mechanism should be developed as part of the overall process of preparing the contract documentation. In this context, it is important to note that the development of the payment mechanism cannot be undertaken in isolation. As a result, this Guidance Note should be read in conjunction with the separate Guidance Notes entitled Risk Assessment, Output Specifications and Contract and Performance Management.





Project Appraisal

PPP Assessment





If PPP recommended



Project Management



Tendering Process


Statutory Process

Tendering Process



and Operation




Key



and Operation



II. Payment Mechanisms

Introduction

2.1 Under a Public Private Partnership contract, the main way of allocating risk between the public and private sectors is through the payment mechanism. It is therefore important that the payment mechanism reflects both the levels of service required, and the most cost-effective transfer of risk to the private sector. The payment mechanism should give the Contractor an incentive to perform well and should provide the Contracting Authority with remedies in the event that the Contractor does not meet its obligations.

2.2 Traditionally, the construction and operation of a new infrastructure project has required the Contracting Authority to provide significant up-front capital funding during the construction phase, followed by reduced levels of revenue funding during the operational phase. As a consequence the Contracting Authority has commonly borne the risks associated with cost and time overruns. A typical expenditure profile for a traditional project is presented in the diagram below.

Figure 2: Expenditure Profile for a Traditional Infrastructure Project

£

Years

1 2 3..... .....25

Estimatedcapitalcost

Estimated running costs

Cost overrun

Cost overrun

Tim

e ov

erru

n

2.3 There is some scope for transferring construction and operating risks to the private

sector under Design and Build and Design, Build and Operate contracts. Capital payments are likely to be fixed under these arrangements and staged throughout the construction period. Operating costs are also likely to be fixed under Design, Build and Operate contracts and phased throughout the operational period. The mechanisms used to pay for Design and Build and Design, Build and Operate contracts will be structured in a similar way to those for traditional infrastructure projects, and for this reason they are not considered further in this Guidance Note.



2.4 Public Private Partnership contracts that introduce private sector finance provide an opportunity for the public sector to translate the large up-front capital expenditures associated with traditional projects into a flow of recurring service payments. For example, under Design, Build, Operate and Finance contracts, the private sector contractor is responsible for financing the up-front capital expenditure, and usually recovers its costs through a unitary payment from the Contracting Authority. The typical expenditure profile for an infrastructure project procured using such a contract is presented in the diagram below.

Figure 3: Typical Expenditure Profile for a DBOF Contract

£

Years

1 2 3..... .....25

no paymentUnitary payment

2.5 For projects involving the provision of new infrastructure, the unitary payment does

not usually commence until the start of the operational period, once the required services are being provided to an acceptable standard. This increases the amount of risk transferred to the private sector and provides a significant incentive for the Contractor to complete construction as early as possible.

2.6 However, where a project involves the continued provision of an existing service (e.g. the upgrading of a major road), then some payments may be made to the Contractor during the construction period to reflect the continued availability of the existing service. In addition, where statutory process risk is being transferred to the Contractor, then some payments may be made to the Contractor during the course of the statutory process period to reflect the detailed design work being undertaken.

2.7 Concession contracts may be financially free standing, but where public subvention is required the public expenditure profiles are similar to those for Design, Build, Operate and Finance contracts, except that any payments required from the Contracting Authority will be smaller. This reflects the fact that under a Concession contract, the Contractor recovers its costs either through direct charges on private users of the asset (e.g. road tolls), or through a mixture of user charging and public subventions.

2.8 The typical income stream for a Contractor under a Concession contract is presented in the diagram shown overleaf.



Figure 4: Typical Income Stream for a Concession (with subvention)

£

Years

1 2 3..... .....25

no payment

Contracting Authority Subvention

User charges

2.9 Design, Build, Operate and Finance contracts and Concession contracts provide

significant scope for using the payment mechanism to transfer risk to the private sector. For example, by making no payments until services are provided to an acceptable standard, the payment mechanism transfers significant design and construction risk and provides significant incentives for the faster implementation of infrastructure projects. This is highly relevant in the context of the National Development Plan 2000-2006.

2.10 This Guidance Note therefore focuses on the provision of advice for Contracting Authorities on the preparation of payment mechanisms for Public Private Partnership projects involving private finance.

Basic Elements of a Payment Mechanism

2.11 There are a variety of elements that can be used in isolation or, as is more likely, in combination to provide payment mechanisms for a Public Private Partnership infrastructure project. In general, payment mechanisms are likely to include one or more of the following basic elements:

• User charges – payments received by the Contractor directly from private users of the infrastructure or service (e.g. road tolls);

• Usage based payments – payments from the Contracting Authority to the Contractor that vary according to how much the infrastructure or service is used;

• Availability based payments – payments from the Contracting Authority to the Contractor for making infrastructure or services available for use at an acceptable standard; and

• Performance based payments – payments from the Contracting Authority to the Contractor that vary according to the quality of service provided.



2.12 The suitability of the above elements for use in a payment mechanism for an infrastructure project will depend on the particular characteristics of the project concerned, and in particular, the desired allocation of risk between the public and private sectors. A detailed discussion of the principles underlying each of the above elements, and their potential application to infrastructure projects in the roads, water and waste sectors, is provided in the sections of this Guidance Note that follow.

Underlying Principles

2.13 Under a Public Private Partnership contract, the public sector is interested in the delivery of the service rather than the construction of the asset. Therefore, when developing the basic structure of a payment mechanism, the following principles should be addressed:

• the services to be delivered should be measurable, both in terms of quantity, and in terms of quality. The services to be delivered should be defined in the output specification;

• payments should not commence until the full service is available to the required standard. As described previously, an exception to this is when the project includes the continuation of an existing service (e.g. the upgrading of an existing road that is to remain open during the period of the works). Also, where statutory process risk has been transferred to the Contractor, then some payments may be made to the Contractor during the statutory process period to reflect the detailed design work being undertaken;

• the payment mechanism should be based on measures such as usage, availability and performance, and not on the inputs needed to deliver the service;

• usage payments should be related to measures that can be forecast, such as traffic volumes along a road, or flows volumes through a water treatment works;

• availability payments should be based on objective measures, such as number of road lane kilometres available;

• performance payments should be based on the achievement of standards that are practical to measure over the entire contract period. It is important that any practical difficulties in monitoring, measuring and auditing the basis for performance payments are carefully thought through;

• the payment mechanism should make deductions for unsatisfactory performance;

• the payment mechanism should not, in principle, contain any fixed element, as the intention is to pay for results;



• Contractors should be capable of managing the risks which are being transferred;

• the payment mechanism should be bankable insofar as private sector bidders and their financiers must be able to model their probable revenue and expenditure streams with reasonable certainty, and the public sector should be able to model and cap its own costs; and

• the payment mechanism must be simple to understand, and any change from existing systems (or in the case of the pilot projects, systems used elsewhere in Europe) that are well understood and accepted by the private sector should as far as possible be evolutionary.

2.14 A well structured payment mechanism should exhibit, as far as possible, the following features:

• simplicity;

• measurable project deliverables;

• strong and appropriate incentives for the private sector to perform;

• flexibility;

• bankability (the ability of the Contractor to finance the project given the risks allocated to them in the payment mechanism);

• affordable to the public sector; and

• accountability (the ability to resolve any disputes that may arise over the level of payments).

Developing a Payment Mechanism

2.15 The development of a payment mechanism is commenced at the start of the Procurement stage of the Public Private Partnership Route Map. An initial output specification and preliminary risk assessment will already have been prepared at the Option Appraisal stage and included in the Public Private Partnership Assessment. In addition, the most relevant procurement procedure will have been selected, and a decision will have been taken on the potential to transfer statutory process risk to the Contractor.

2.16 The requirements of the payment mechanism should first be considered during the Option Appraisal stage. In undertaking the procurement procedure selection, the Central Authority should think carefully about whether the risks associated with a project, and the private sectors willingness to accept them, are likely to be sufficiently well defined to enable a payment mechanism to be developed in sufficient detail to permit prior overall pricing by tenderers.



2.17 For example, in the case of a Design, Build, Operate and Finance contract, the Contracting Authority will be seeking to achieve through the payment mechanism optimal risk transfer in the context of the introduction of private finance. Where the restricted procedure is followed in Design, Build, Operate and Finance projects, it may lead to the pricing of projects based on private sector costs of equity and debt without sufficient scope for innovation and an efficient allocation of risk to the private sector.

2.18 A Contracting Authority can improve its judgement on the appropriate allocation of risk through regular and structured market sounding of private sector appetite for various types of project and the spectrum of risks and rewards they represent. However, any such market sounding may be unlikely to elicit responses which involve significant proposals for innovative, technical, commercial or financial solutions as the private sector may be likely to guard those proposals until such time as they have a realistic opportunity to commercially exploit their own innovative ideas. Thus, the Contracting Authority may not, having undertaken such market sounding, achieve its aim. It will then be in the position that it would be desirable to adopt the negotiated procedure.

2.19 Detailed guidance on the selection of procurement procedure is set out in the separate Guidance Note entitled Procurement Procedure Selection.

Indicative Approach

2.20 There are a number of basic steps to follow when designing an efficient payment mechanism for a Public Private Partnership project. If these are not followed then the Contracting Authority will run the risk that the payment mechanism will not transfer risk effectively and will not provide appropriate incentives to the private sector to perform to the standard required. An indicative approach to designing a payment mechanism is set out in the diagram shown overleaf.



Figure 5: Indicative Approach to Developing a Payment Mechanism

Understand the characteristics of the project

Establish objectives for thepayment mechanism

Develop the structure of thepayment mechanism

Evaluate the payment mechanismagainst objectives

Obtain views on paymentmechanism structure

2.21 The main features of this indicative approach are discussed in the paragraphs that

follow.

Understand the Characteristics of the Project

2.22 The payment mechanism should reflect the underlying characteristics of the project. For example, a payment mechanism based almost entirely on usage payments would be inappropriate for services with a highly stable demand profile as the risk transferred (and hence incentive given) to the private sector will be small. Payment mechanisms need to have regard to:

• the economic fundamentals of the project (supply, demand, cost and timing characteristics);

• legal and economic viability of user charges;

• the economic characteristics of the Contracting Authority. For example, the project must be affordable over the term of the Project Agreement; and

• the underlying project risks, including the most cost effective allocation of these risks between the public and private sectors.



Establish Objectives for the Payment Mechanism

2.23 The payment mechanism is the principal method of transferring risk to the Contractor. It is also one of the most difficult aspects of a Public Private Partnership project to develop. It is essential that the objectives of the payment mechanism reflect the desired allocation of risk on the project (as defined by the detailed risk assessment), as the objectives will determine the structure of the payment mechanism, and the extent to which risk is actually transferred to the private sector.

2.24 The basic objectives of the payment mechanism will vary from one project to another. Generally they will include:

• delivering value for money;

• allocating risks to the party best able to manage them;

• providing incentives to the private sector to deliver services to the required standards of performance in defined time scales;

• providing incentives for the private sector to continue to deliver high quality services over the life of the contract;

• rewarding the private sector for efficiency gains; and

• making the scheme affordable to the Contracting Authority.

2.25 The objectives of the payment mechanism are highly dependent on the requirements set out in the Output Specification and the results of the risk assessment. These items are closely related, and it will be important to establish mechanisms to facilitate iteration between these three important elements of a Public Private Partnership.

2.26 For example, the decisions to be taken during the development of the payment mechanism will be informed by the Output Specification and risk assessment. Similarly, the process of developing the payment mechanism may also lead to further refinement of the Output Specification and risk assessment.

2.27 Guidance on preparing output specifications and undertaking detailed risk assessments is provided in the separate Guidance Notes entitled Output Specifications and Risk Assessment. It is strongly recommended that these Guidance Notes are read before the payment mechanism is developed.



Develop the Structure of the Payment Mechanism

2.28 The development of payment mechanisms should be evolutionary, and Contracting Authorities should draw on the experience of similar projects taking into account differences in project objectives and project scope.

2.29 A common approach to developing a payment mechanism is to first consider the most cost-effective allocation of demand risk between the Contracting Authority and the Contractor. The allocation of demand risk is a determining factor in the identification of the most appropriate payment mechanism structure.

2.30 The importance of demand risk in the identification of the most appropriate payment mechanism structure for an infrastructure project is highlighted in the diagram shown below.

Figure 6: Identification of the Most Appropriate Payment Mechanism

Key issues:

Allocation ofDemand Risk

User Charges

UsagePayments

AvailabilityPayments

Private Public

Apply usercharges within

payment mechanism?

Shared

Yes No

Payment mechanismprincipally based on:



2.31 If demand risk is fully transferable to the private sector, and private users of the service are to be charged for its use (e.g. road tolls), then as indicated in the diagram above, the payment mechanism is likely to be structured principally on user charges. If, however, demand risk is to be shared between the Contracting Authority and the Contractor, then the payment mechanism is likely to be structured principally on usage payments. If the Contracting Authority is to retain demand risk, then the payment mechanism is likely to be structured principally on unitary payments involving availability and service performance measures.

2.32 Service performance can be taken into consideration in the unitary payment by means of a separate performance related payment, or as is more common, through performance related deductions within a usage or availability based unitary payment. On this basis, the main elements that could be used to comprise the payment mechanism in each of the circumstances described above are summarised in the table that follows.

Table 1: Main Elements Comprising a Payment Mechanism

User Charges Usage Based Unitary Payment

Availability Based Unitary Payment

User charges

or

User charges plus subvention comprising one or more of:

Usage payment

Availability payment

• Performance payment

• Capital grant

• Revenue support

• Guarantees

Usage payment less deductions in relation to:

Availability; and/or

Service performance

Availability payment less deductions in relation to

Usage; and/or

Service performance

2.33 As presented in Table 1 above, unitary payments are based primarily on either usage or availability, and deductions are made from the unitary payment in respect of the performance of the Contractor in relation to other elements.

2.34 A more detailed explanation of user charges, usage payments, availability payments and service performance payments is provided in Sections Three, Four, Five and Six of this Guidance Note respectively.



Example:

For road projects in Ireland, the primary objectives may be to improve the quality and capacity of inter-urban roads as soon as is reasonably practicable, so that the economic development of the region is not hindered by unsatisfactory transport infrastructure, and to achieve value for money for public expenditure.

The secondary objectives of the roads projects may be to introduce user charges (tolls) on key routes, and to transfer usage related risk to the private sector

These objectives will influence the structuring of the payment mechanism, and in particular a decision on the application of user charges involving options such as:

• The Contractor receiving toll income, possibly augmented by capital and/or revenue subvention from Government; and

• The Government setting tolls and receiving toll income, and paying the Contractor a unitary payment based on availability and service performance, possibly including a usage element.

Obtain Views on Payment Mechanism Structure

2.35 The procurement procedure selected will have a direct impact on the way in which the payment mechanism is developed, and on the extent to which it can be discussed with short listed tenderers in particular.

2.36 If the restricted procedure is selected, then the payment mechanism will need to be fully developed prior to the issue of the Invitation to Tender. Under the restricted procedure, there is limited scope for obtaining the views of short listed tenderers on the proposed structure of the payment mechanism prior to the issue of the Invitation to Tender, but no scope for negotiation after the Invitation to Tender has been issued. The Contracting Authority should seek advice from its appointed legal advisers in relation to the discussion of the payment mechanism with short listed tenderers.

2.37 If the negotiated procedure is selected, then there is scope for negotiating the structure of the payment mechanism with short listed bidders after the Invitation to Negotiate has been issued. However, in order to keep the scope and duration of negotiations to a minimum, it is recommended that the payment mechanism is developed as far as possible prior to the issue of the Invitation to Negotiate. Further advice is provided in the separate Guidance Note entitled Procurement Management.

Evaluate Payment Mechanism against Objectives

2.38 Based on the views expressed by short listed tenderers, the payment mechanism may be refined to provide a more cost effective allocation of risk between the Contracting Authority and the Contractor. Care should be taken to ensure that in refining the payment mechanism, the Contracting Authority does not inadvertently take back risks that it had intended to allocate to the Contractor.



2.39 Finally, the payment mechanism should be evaluated against its original objectives to ensure that all objectives are achieved in a cost-effective way, and to verify that the structure of the payment mechanism represents best value for money.



III. User Charges

Introduction

3.1 The application of user charges to infrastructure projects in the roads, water and waste sectors must reflect Government policy on user charges and the application of the polluter pays principle to fund the construction and operation of infrastructure projects in these sectors. Therefore in devising payment mechanisms for projects in these sectors, the principal objective should be to attribute an appropriate proportion of the costs of constructing and operating the project to its users if the project is suitable for the application of user charges.

Suitability of Projects to User Charges

3.2 User charges can take different forms in each of the sectors under consideration. Some examples of the use of user charges in each sector are as follows:

• Roads - tolling of bridges, tunnels or motorways;

• Waste - waste charges including gate fees; and

• Water - industrial and non-domestic charges.

3.3 To date, user charges have only been applied to infrastructure projects in limited circumstances, such as the East Link or West Link bridges. These two concessions are both operated by the same business, National Toll Roads. The Roads Act 1993 gives the National Roads Authority (for national roads) and Local Authorities (for regional and local roads) the power to introduce user charges on roads projects.

3.4 In assessing the suitability of different projects for the application of user charges, some consideration needs to be given to the following factors:

• Availability of alternatives - the application of user charges on a project may discourage potential users and result in them using available alternatives. This could have a significant impact on the ability of the project to deliver the benefits for which it was designed.

• Elasticity of demand - this considers the extent to which user charges would dissuade potential users from using the project. It considers the relationship between user charges and expected level of use, and can be used to predict, for example, the level of user charge that maximises project revenues, or the level of user charge that best delivers the objectives of the project (e.g. reducing traffic congestion).

• Practicality of applying user charges - in some instances it may not be practical to apply user charges. For example, it may not be cost effective to apply user charges to a road with many points of entry and egress.



• Ability to forecast demand - the ability to forecast demand will determine the extent to which a Contractor is likely to accept demand risk on the project, and the extent to which the private finance can be secured in a cost effective way. This in turn will influence the decision as to whether it is cost effective for the Contractor to recover its costs through user charges, or whether another mechanism should be used to pay the Contractor.

• Government policy - the application of user charges to a Public Private Partnership project must reflect government policy on user charging, including for example government policy not to charge domestic users for water supply. It must also reflect government policy on the application of the polluter pays principle to fund the construction and operation of infrastructure projects in the roads, water and waste sectors.

• Legality - the application of user charges to Public Private Partnership projects in the roads, water and waste sectors will be dependent on the legal powers of Contracting Authorities and private sector contractors to charge users of services in these sectors. Further advice is provided on this issue in the separate Guidance Note entitled Legal Context.

Applying User Charges

3.5 In order to determine the best way of applying user charges to Public Private Partnership infrastructure projects, the following issues must be considered in detail by Central and Contracting Authorities:

• Should the Contractor recover its costs directly through user charges? (i.e. should the payment mechanism be based in user charges?)

• How should user charges be set?

• What form of subvention should be used by the Contracting Authority to pay the Contractor, in the event that user charges are unlikely to be sufficient to meet the full cost of the project?

• Should the Contracting Authority provide guarantees to the Contractor in relation to minimum levels of income, and should the Contracting Authority include mechanisms to prevent the Contractor from making excessive profits?

3.6 Each of the above issues is discussed in detail in the remainder of this section of the Guidance Note.



3.7 It is envisaged that, for major road and waste projects in particular, Contractors will recover their costs directly through user charges. This is in accordance with Government policy on user charges and the application of the polluter pays principle. However, even when user charges are not considered to be a cost-effective means for Contractors to recover their costs, the Contracting Authority may still apply them to a project. Under such circumstances the Contracting Authority would take responsibility for setting user charges, and could either collect the revenues itself, or ask the Contractor to collect them on its behalf.

3.8 There are two advantages to the Contracting Authority setting user charges and receiving associated revenues, and then paying the Contractor based on usage, availability or service performance payments. Firstly, because lenders and other providers of capital are not so directly exposed to usage risk, the cost of capital should be lower and thus the amount of support needed to be provided by the Contracting Authority (net of the revenues it will receive from user charges) will be lower. Secondly, this sort of arrangement will allow the Contracting Authority to set user charges at a level that maximises economic and social benefit and provides the greatest contribution to the project objectives.

3.9 However, the user charge set by the Contracting Authority could directly affect the level of use of the road. Therefore, if the Contractor was to be paid by means of a usage payment, then it may require input into the setting of user charges to minimise any adverse effect of user charges on its revenues. A detailed description of usage payments is provided in the next section of this Guidance Note.

Basing a Payment Mechanism on User Charges

Key Issues

3.10 One of the simplest forms of payment mechanism is a system of user charges, where the Contractor recovers its costs either through direct charges on private users of the asset (e.g. road tolls), or through a mixture of user charges and public subventions.

3.11 Payment mechanisms that are based on user charges provide Contracting Authorities with the opportunity to maximise the extent to which demand risk is transferred to the Contractor. They also reduce the requirement of the Contracting Authority to monitor the performance of the Contractor, as the Contractor has a direct incentive to improve its performance to encourage greater use and to maximise revenues.

3.12 User charges are a cost-effective means of reimbursing a Contractor when the Contractor is able to forecast demand and revenues with relative certainty. Where a Contractor is unable to forecast demand with relative certainty, the revenues generated from user charges will be less certain and the cost of financing the project will increase.



3.13 Under such circumstances, other forms of payment mechanism that reduce the extent to which demand risk is transferred to the Contractor may represent a more cost effective method of payment. The Contracting Authority can either reduce the proportion of the revenue of the Contractor that comes from user charges, or reimburse the Contractor through other means such as usage, availability and performance payments.

Advantages

3.14 The main advantages associated with payment mechanisms that involve user charges are as follows:

• the public in general are not providing a subsidy to the users of the new infrastructure;

• user charges are a practical option, provided that payments can be collected efficiently. They are also simple to understand and consistent with Government policy;

• user charges can vary, for example by vehicle type and time of day on a road project, so that the demand for the service can be managed through the pricing policy;

• Contracting Authority finances are unencumbered;

• private sector efficiency is brought into what has traditionally been a public sector activity; and

• user charges contribute to more economically efficient use of infrastructure (and roads infrastructure in particular).

Disadvantages

3.15 The main disadvantages associated with payment mechanisms involving user charges are as follows:

• the level of charge required to fully amortise the capital expenditure on a project may be so high that it would discourage potential users, and reduce the benefits that the project had sought to deliver. Under these circumstances the Contracting Authority may need to cap user charges and provide a subvention to the Contractor;

• the application of user charges raises the issue of equitable treatment. This is a key issue that must be taken into consideration when selecting projects for the application of user charges, and when setting the levels of charge to be applied;



• user charges can only effectively be used within a payment mechanism when the private sector is able to forecast demand and revenues with a reasonable degree of certainty; and

• users may have to pay more for a project on which the private sector is reimbursed through user charges, because the risk transferred to the private sector is greater than for a project whose revenues come directly from the Contracting Authority.

Risks

3.16 The principle of user charges is simple in theory. However, in practice, the application of user charges to finance infrastructure projects in the roads, water and waste sectors is complex, and it introduces a number of risks to a project. These include:

• Demand risk – Concession contracts are often awarded to the Contractor that has the highest demand forecasts, expects to generate greater revenue through user charges, and therefore requires the lowest subvention from the Contracting Authority. However, demand forecasting is subject to a high degree of uncertainty and there is a significant risk that the lowest priced tender will have over estimated demand, and therefore will be unable to make a commercial return on the project.

• Collection risk - collection risk is the risk that users of the service try to avoid paying the user charge. Collection risk increases in line with user charges. Therefore the higher the user charges are set, the greater the collection risk will be.

• Protestor action risk – the risk of protestor action may increase as a result of the application of user charges. However, it is unlikely to be significant as generally protestor action comes from two sources, those with a proprietary interest in the land in question and those who protest on environmental/heritage grounds. In neither of these cases is protestor action likely to be influenced by the application of user charges.

3.17 The use of user charges to finance infrastructure projects in the roads, water and waste sectors can also give rise to a number of practical difficulties. For example, in the roads sector, practical difficulties arise from the diversionary impact of user charges, and detailed market research and demand modelling is required to examine the elasticity of demand relative to the level of charge that is set.



Skye Bridge

The objectives of the Scottish Office Development Department (the “Department”) in taking forward the Skye Bridge project were:

early delivery of a privately tolled crossing to solve the problems of congestion and delay associated with the existing ferry service;

satisfactory design of the crossing, taking into account the sensitivity of the environment;

to finance the bridge through user tolls, set at an amount no greater than the existing ferry fare linked to inflation, with Government funding the approach roads; and

to achieve value for money through a tender competition for a DBOF contract for the provision of the crossing, including the design and build of approach roads.

The Department signed a contract with Skye Bridge Limited consortium in 1991. Under the terms of the PPP contract, Skye Bridge Limited is responsible for constructing and maintaining the crossing, and is reimbursed though the collection of toll revenues. The Department is responsible for the capital and maintenance costs of the approach roads (capital cost of £6 million at 1991 prices), and for covering the cost of design changes and time delays resulting from the public inquiry (£3.8 million at 1991 prices).

The contract period is limited to a maximum of 27 years, or as is expected to be the case, for a shorter period (currently expected to be some 14 to 18 years) until the total toll revenue collected by Skye Bridge Limited amounts to some £24 million (measured in constant 1991 prices and discounted to 1991 base year over the lifetime of the project). The 27 year maximum concession period was established as the period required for the company to collect enough revenue to recover its total forecast costs, on the conservative assumption that traffic levels remained unchanged at 1990 levels.

Skye Bridge Limited has accepted demand risk on the understanding that tolls may be increased by up to 30 per cent more than the rate of inflation should actual toll revenue fall below an agreed threshold after 1997. However, in the first year of operation to October 1996, traffic levels were some 16 per cent greater than the previous year’s ferry traffic. It is therefore considered very unlikely that toll revenues will need to be increased by more than the rate of inflation during the period of the concession contract.

Under the terms of the concession, Skye Bridge Limited must supply the Department with annual revenue forecasts and quarterly reports on actual toll revenues and traffic flows. The Department has access rights to inspect and to audit the company’s financial procedures. Skye Bridge Limited is also required to maintain the bridge in a serviceable condition, having regard to its 120 year design life, for the duration of the concession. The Department’s engineers have access rights to the bridge to check its condition and to verify that the agreed inspection and maintenance programmes are being conducted to the agreed standards. In the event of a serious deterioration in the financial viability of Skye Bridge Limited, or its failure to comply with any of its obligations, the Department is entitled to terminate the agreement and to take control of the bridge. Ownership of the bridge is vested with the Secretary of State throughout the duration of the contract.



Setting User Charges

3.18 The setting of user charges is a complex issue that will require detailed consideration by Central and Contracting Authorities. There are a number of factors that need to be considered when determining the level at which to set user charges:

• Elasticity of demand - the extent to which user charges would dissuade potential users from using the project. The relationship between user charges and expected level of use should be investigated, to predict, for example, the level of user charge that maximises project revenues, and the level of user charge that best delivers the objectives of the project (e.g. reducing traffic congestion).

• Objectives of Contractor - if user charges are to be used to reimburse the Contractor, then the Contractor will want user charges to be set at the level that maximises its operating revenue.

• Objectives of the project – there will be a level of user charge that maximises the social and economic benefits of the project.

• Government policy – user charges should be set at a level that reflects government policy on user charges and on the application of the polluter pays principle to fund the construction and operation of infrastructure projects in the roads, water and waste sectors.

• Equity of treatment - Central and Contracting Authorities need to consider is the issue of equitable treatment with regard to the application and setting of user charges. For example, should there be a national toll that applies to all toll roads in Ireland, or should tolls be set independently to reflect the economics of the project concerned, and to avoid cross-subsidisation from one project to another.

3.19 Detailed consideration of the above issues will help Central and Contracting Authorities to determine a preferred approach to the application of user charges at a national level within each sector, and at a project specific level. The development of national policy on user charges is outside the scope of this Guidance Note.

3.20 There are a number of approaches that could be considered by Central and Contracting Authorities for the setting of user charges at a national level and for specific projects. These approaches include:

• Setting a national rate – a national rate is set for each type of user charge within a sector (e.g. a national toll rate for motorways). This rate would be specified within the contract documentation for the procurement, and private sector contractors would then specify in their tender the amount of additional subvention required from the Contracting Authority.



• Setting a national maximum rate – a national maximum rate is set for each type of user charge within a sector. This maximum rate would be specified in the contract documentation for the procurement, and private sector contractors would then specify in their tender a user charge at or below the maximum rate, and also the amount of additional subvention required from the Contracting Authority.

• Setting a project specific rate – user charges are set at a project level rather than at a national level. The project specific rate would be specified within the contract documentation for the procurement, and private sector contractors would then specify in their tender the amount of additional subvention required from the Contracting Authority. The project specific rate could be set by the Contracting Authority at or below the level of the national maximum rate.

• Setting a project specific maximum rate – a maximum level of user charge is set for a specific project. This maximum rate would be specified within the contract documentation for the procurement, and private sector contractors would then specify in their tender a user charge at or below the maximum rate, and also the amount of additional subvention required from the Contracting Authority. The project specific maximum rate could be set by the Contracting Authority at or below the level of the national maximum rate.

• Rate set through tendering – private sector contractors specify in their tenders the user charges that they would require to obtain a commercial return on their investment. This approach is of greatest relevance to financially free-standing projects. It is best used in conjunction with the negotiated procedure, which enables the Contracting Authority to cap user charges and negotiate additional subventions in the event that the user charges specified in tenders are significantly greater than anticipated.

3.21 It should be noted that, in addition to setting maximum rates as set out above, Contracting Authorities could set minimum rates to reflect government policy and to ensure that the objectives of the project are achieved. Minimum rates would ensure that an appropriate proportion of the costs of constructing and operating the project is borne by its users.

3.22 For road schemes involving tolling, the Roads Act requires the making of a toll scheme by the National Roads Authority, to be confirmed by the Minister, setting the estimated level of toll for a project. In practice, this limits the scope for tendering of the appropriate market price, where this significantly exceeds the toll set. Ultimately, the existing approach permits competitive tendering on the basis of a toll rate that is either lower, or at any rate not significantly greater than that approved by the Minister. In the event that the toll required by Contractors to make a commercial return is significantly greater than the estimated level of toll, then the Contracting Authority may be required to cap the toll level and provide revenue subvention.



3.23 Many of the world’s privately financed road projects involve payment mechanisms based on user charges (tolls). Tolls are commonly collected in one of two ways: cash payments at toll booths set up at intervals along a road and at on- and off-ramps, or through a cashless monitoring system. Cashless systems typically involve a registration scheme that requires users to display a visually recognisable pass, or to carry an electronic system that can be monitored remotely. Whether the system of toll collection is based on cash payments or a cashless system, the road user pays directly for the infrastructure they use.

Melbourne City Link

This £720 million project is the largest road project in Australian history. It links existing motorways that terminate at the city fringe and its aim is to significantly reduce journey times into the city centre and divert through traffic out of the city centre area. It comprises 22 kilometres of road works, an elevated six lane bridge, and two three lane tunnels. The project is a Build, Own, Operate, Transfer scheme, and the Contractor is to finance the capital costs of the project through the collection of tolls from users of the facility.

The project includes the world’s largest electronic tolling system, with frequent users requiring a tagging device that will be used to deduct tolls from a pre-paid account. Occasional users will be able to buy day passes at garages and other retail outlets. Tolls for cars are less than 50 pence for the shortest journey and are capped at £1.50 for a single continuous journey irrespective of length. Tolls may be increased each quarter, but are capped at the lower of either 1.065 per cent or the increase in the general inflation index.

There are no government operating or debt subsidies and the concessionaire has accepted the risk of reductions in traffic volumes and associated toll revenues arising from incorrect traffic flow projections, adverse economic conditions, changing travel patterns and habits, and increases in the price of petrol. However, this risk is to some extent mitigated by State undertakings that it will not build a competing road system, and that associated freeways and principal traffic routes will be managed in a manner that maintains City Link as a central part of the road network.

Subventions

3.24 In order to gain access to private sector finance, Contracting Authorities will have to augment user charges with public subvention where:

• user charges are unlikely to generate sufficient revenues to enable the Contractor to recover its costs and make a commercial rate of return within the period covered by the contract; and/or

• where user charges are capped below the level required by the Contractor to make a commercial rate of return, in order to achieve the objectives of the project or to reflect social and public interests.



3.25 It is expected that Contracting Authorities will be required to provide subventions for some Public Private Partnership projects in the roads, water and waste sectors in Ireland. The subvention could take a number of forms depending of the level of additional risk that the Contracting Authority wishes to transfer to the private sector. Options include usage related payments, availability related payments, performance related payments, capital grant and revenue support. Usage related payments, availability related payments and performance related payments are discussed in the following sections of this Guidance Note. Capital grant and revenue support are discussed in the paragraphs that follow.

3.26 It is important to note that Contracting Authorities may also wish to provide subvention directly to users in the form of rebates. This form of subvention may be applied to all users or to certain groups of users such as pensioners. As such rebates are not part of the mechanism for paying the Contractor they are not discussed further in this Guidance Note.

Capital Grant

3.27 Capital grants may be offered to a Contractor to cover that part of the capital cost of a project that cannot be met by user charges. The main advantage associated with the use of capital grants is that capital grants will reduce the cost of private sector finance. This in turn will reduce the overall cost of the project and should result in lower costs to users. However, the provision of capital grants may also reduce the extent to which risk is transferred to the Contractor. Other advantages of providing a capital grant are as follows:

• it enables a project to maintain user charges at an acceptable level;

• it enables a project to go ahead despite its failure to generate sufficient user charges;

• it is a simple mechanism of support that can be structured on a project by project basis; and

• the extent of the financial commitment to be provided by the Contracting Authority is generally certain.

3.28 However, the payment of a capital grant also has a number of disadvantages associated with it and these are set out below:

• it results in an immediate impact on the budget of the Contracting Authority;

• the payment is not in any way dependent on the performance of the private sector supplier; and

• the grant is a sunk cost which may not be refunded in the event of project termination.



Revenue Support

3.29 Revenue support may be offered to a Contractor to improve overall cashflow. Revenue support can be a simple flat payment set at a level sufficient to cover debt service obligations, or it can be sufficient to reduce toll levels to a level considered reasonable or economically optimal levels.

3.30 Revenue support can be structured in many ways. For example, it could reduce over time to incentivise the Contractor to increase usage levels, it could reduce as usage (and hence revenue from user charges) increases, or it could arise only in years where revenue from user charges falls below a set level.

3.31 The main advantages associated with revenue support are as follows:

• it enables user charges to be maintained at an acceptable level;

• it enables a project to go ahead despite its failure to generate sufficient user charges;

• it is a simple mechanism of support that can be structured on a project by project basis; and

• the extent of the financial commitment to be provided by the Contracting Authority is generally certain.

3.32 The main disadvantages associated with revenue support are as follows:

• it results in an immediate and continuing impact on the Contracting Authority’s budget over the operation of the project; and

• the payment is not in any way dependent on the performance of the private sector supplier.

Guarantees and Excessive Profits

Guarantees

3.33 Guarantees limit the exposure of the Contractor to certain risks. Internationally, guarantees have been provided on some Public Private Partnership projects where, on base case revenue forecasts, sufficient revenue is generated to fully amortise the debt (or other forms of capital used to finance the project), but where the risk inherent in those base case projections are such that funders will not provide the full amount of funding without further financial support.

3.34 However, in certain circumstances, the provision of financial guarantees to reduce the degree to which risk is transferred to the private sector is akin to the Contracting Authority borrowing capital finance from the private sector.



Sydney Harbour Tunnel

The Sydney Harbour Tunnel is a four lane carriageway extending 2.3 kilometres between the northern and southern sides of Sydney Harbour. The tunnel was constructed between 1988 and 1992 by a joint venture company, which has a concession to operate the tunnel until 2022 when ownership will revert to the New South Wales (NSW) Government.

The joint venture company receives the toll revenue collected from both the tunnel and Sydney Harbour Bridge less toll collection costs. The Road and Traffic Authority (RTA) ensures the joint venture company’s revenue stream, and is obliged to make top-up payments if inflation rates or traffic volumes are lower than projected.

The project has been criticised by the NSW Auditor-General because the RTA retains much of the project risk through the ensured revenue stream. The RTA also carries the primary financing risks because, although finance for the project was raised by issuing bonds fully underwritten by the private sector, the responsibility for those bonds rests with the State.

3.35 There is therefore a significant risk that by providing guarantees to gain access to private finance, the Contracting Authority can inadvertently assume risks that it has intended to allocate to the Contractor. This can result in a project costing significantly more than expected, and so result in poorer value for money than traditional procurement.

Wijker Tunnel Project, Netherlands

The Wijker tunnel project, completed in 1993, was one of the first projects undertaken in the Netherlands using private finance. The risk transferred to the private sector was limited by a government guarantee in relation to traffic flows. The guarantee resulted in the public sector providing much greater funding than was originally anticipated, and the project became regarded as a failure as it did not offer value for money.

3.36 In Ireland it is not appropriate for the State to give guarantees in the context of Public Private Partnership projects. Nevertheless, it is in the interest of Central Authorities to ensure, in so far as is possible, that private funders have confidence in the competence and capacity of sub-sovereign bodies to fully engage in the PPP process.

3.37 Non-financial guarantees may, however, be applicable in certain circumstances. For example, a Contractor may only be willing to accept demand risk on a road project if the Contracting Authority guarantees that it will not construct a competing road. The implications of any guarantee that is sought by the private sector should however be considered in detail. For example, in the situation described above, the Contracting Authority should review the expected growth in traffic levels in future years, and consider its ability to stand by a guarantee not to build another road if traffic levels rise and traffic congestion becomes a problem for the local economy.



Excessive Profits

3.38 Under certain circumstances, for example in the event of a significant increase in user demand, Contractors may generate excessive profits from user charges. Payment mechanisms should therefore take into account the generation of excessive profits by way of a reduction in the charges applied to future users or a rebate provided to existing users.

3.39 The extent to which the private sector can generate excessive profits from user charges may be limited by means of a cap on the equity rate of return of the Contractor, or by the Contracting Authority taking a royalty on turnover. The most appropriate arrangements will depend on the characteristics of the project. Whatever arrangement is used to cap excessive profits, the overall payment mechanism should still provide an incentive to the Contractor to enhance overall efficiency.

3.40 Further discussion of possible profit sharing arrangements is provided in Section Seven of this Guidance Note.



IV. Usage Payments

Introduction

4.1 Usage payments, where the Contractor is paid according to a pre-determined schedule of charges for usage, are one of the main ways of sharing the risk that actual usage of the project may be more or less than envisaged. Usage payments can be expressed in a variety of different ways based upon the characteristics of the project. The most obvious form of usage payment is payments based on the actual number of users of the project in any given period.

4.2 Usage payments are analogous to user charges, but differ in that the Contracting Authority makes the payment to the Contractor. In most cases where usage payments have been implemented they have been banded, to reduce the amount of usage risk transferred to the Contractor. In such cases, the cost of utilising private finance is cheaper because the revenue stream of the Contractor is exposed to a lower degree of risk.

Use of Usage Payments

Principles

4.3 The basic principle of usage payments is that it is the Contracting Authority, and not the user, who makes the payment to the Contractor. Payments are related to usage volumes and are often made in accordance with a banded payment mechanism.

4.4 Banding can be used at higher usage levels to cap the number of users for which the Contracting Authority pays, thereby limiting the financial liability of the Contracting Authority. Banding can also be used at lower usage levels to reduce the risk to the Contractor that usage volumes are lower than expected, and to provide sufficient comfort to satisfy financial institutions. A typical banding structure for a usage based payment mechanism is presented in the diagram below.

Figure 7: Typical Banding Structure

Usa

ge

Years

1 2 3..... .....25

no paymentBand 1

Band 2

Band 3

Band 4 = zero



4.5 In the example presented in the diagram above, the lower band is typically set at the lowest expected level of use, and provides the Contractor with a relatively certain minimum usage payment to cover debt service requirements (but not sufficient to provide a return on equity). The upper band is set to zero to ensure that the maximum liability of the Contracting Authority is capped.

Example

On an integrated waste project, the private sector operator could be paid for each tonne of contract waste received. The rate payable per tonne is likely to be banded, with the rate payable falling as the volume of waste increases. This allows the payment mechanism to reflect the marginal increases in cost to the Contractor of handling the additional waste.

Additional payments may be made for each tonne of waste diverted from landfill. Different payment rates may be applied to each form of waste recovery to reflect the costs incurred by the Contractor and the environmental objectives of the Contracting Authority. The payment rates fall as the volume of waste recovered increases so that the Contracting Authority is protected in relation to its overall cost exposure.

Minimum targets are set for overall waste recovery and for waste recycling in particular. A fixed rate per tonne is deducted in the event that the minimum targets are not achieved. The Contracting Authority retains the option to terminate the contract if actual recovery or recycling rates are below an agreed percentage of the minimum targets.

The Contracting Authority will need to consider whether it should provide the Contractor with a minimum guaranteed payment. In doing so, it will also need to determine the level of payment that may be required to reduce the risk to the Contractor associated with reductions in demand so as to enhance the bankability of the contract.

Advantages

4.6 The main advantages associated with payment mechanisms involving usage payments are as follows:

• the banding structure dampens the financial effect of usage risk, reducing the return on capital required by the Contractor, and in turn reducing the amount of Contracting Authority contribution required;



Roads Projects in Portugal

Over recent years, Portugal has initiated a large road building programme through the use of private finance. Two roads projects, the West and North Concessions, have already been commenced using private finance, and Contractors will be reimbursed through user tolls. These projects are being followed by seven Design, Build, Operate and Finance roads projects, for which the Contractors will be reimbursed by the State using a payment mechanism based on shadow tolls (usage payments). Following those will be a further five real toll roads.

The real toll and shadow toll projects will be part funded by the European Investment Bank (EIB), with the European Investment Fund providing guarantees on the EIB loan. From the EIB’s perspective, one of the big differences between the real toll and the shadow toll projects is that the guarantees on its loan are able to fall away much faster on the shadow toll projects. This results in lower financing costs, and is due to the lower risk profile associated with the shadow toll projects.

• the use of usage payments defers Contracting Authority expenditures, and the variability of the payments is likely to be such that they are not perceived as a disguised form of Contracting Authority borrowing;

• usage payments are likely to be easier to implement as they are more consistent with existing practice, where infrastructure projects are paid for out of public funds;

• it is generally more bankable than user charges, as bands can be used to ensure that the risk transferred to the private sector is more manageable, and the usage payments are underwritten by the public sector rather than the user; and

• they are very flexible, in that there are multiple combinations of usage, availability and performance measures that can be applied to determine the level of the payment from the public sector to the private sector.



Example

For a project involving the design, construction, operation and financing of a waste water treatment works, the payment mechanism could be based on usage payments relating to either the volume of flow or the effluent load.

Linking the payment to volume of flow means that the payment received by the Contractor is subject to significant fluctuations arising from, for example, variations in rainfall. Flow volumes are therefore difficult for the Contractor to forecast and the payment mechanism will be less attractive to financiers (i.e. it will be costly to transfer demand risk on this basis).

Effluent loads, on the other hand, are much more predictable as they are a function of the population. Payments linked to effluent loads are therefore likely to be more attractive to the private sector, and they can be linked directly to the cost of treatment. Problems may arise however if there are industrial users whose effluent levels are likely to be highly variable and difficult to forecast.

Disadvantages

4.7 The main disadvantages associated with payment mechanisms involving usage payments are as follows:

• the level of risk retained by the Contracting Authority is usually greater than for well structured payment mechanisms based on user charges;

• although the banding mechanism means there will be a cap on the contribution of the Contracting Authority, the amount paid will be uncertain, and this can cause difficulties in budget planning; and

• users do not pay for the economic cost of infrastructure provision. As a consequence, users are subsidised by the general public, and infrastructure investment is not rationally allocated.

Risks

4.8 The risk transferred to the Contractor under a usage based payment mechanism is likely to be less than for a project in which the private sector generates its revenues from user charging. For example, the financial risks associated with low usage levels can be mitigated by the use of banded usage payments.



Almond Valley, Seafield and Esk Valley Wastewater Treatment Works

In March 1999, the East of Scotland Water Authority entered into a £100 million, thirty year concession contract with the Stirling Water Seafield consortium to implement improved wastewater treatment and disposal facilities in the River Almond, the Firth of Forth and the Esk Valley areas. The project includes alternatives to the practice of sewage sludge disposal at sea, and enables the achievement of standards imposed by European wastewater purity and sewage sludge disposal regulations.

The East of Scotland Water Authority proposed to transfer risk to the private sector through the use of a payment mechanism based on the volume of waste water flowing through the three distinct catchments. To address the concerns of financiers regarding fluctuations in waste water volumes, a banded payment mechanism was used, with payment bands relating to price and volume. Payments within the bands were set so as to reduce the financial risks associated with significant reductions in wastewater flows.

The payment mechanism also included an adjustment for availability. To cater for the multi-site nature of the project, which includes five wastewater treatments works, the contract allows payments to commence at partial completion, with payments increasing as more elements come into service. The multi-site nature of the project is also reflected in terms of performance related payments, which vary according to importance of each site as reflected by the capital and operating expenditure involved.

Partial Usage Payments

4.9 The term partial usage payment applies to payment mechanisms that are based on usage payments, but also include other sources of revenue for the Contractor. For example, the Contractor may also receive revenue from user charges, or from other forms of payment from the Contracting Authority that are not directly related to usage, including, for example, availability. Alternatively the payment mechanism may be based on usage payments, but include deductions in respect of availability and service performance.

4.10 Partial usage payments provide a number of advantages, over and above those set out previously for usage payments. The additional advantages of partial usage payments are as follows:

• if there are to be user charges, then partial usage payments can enable the user charges to be set at an affordable rate, thus ensuring that the socio-economic benefits of the infrastructure project are realised; and

• if user charges are applied to the project, then usage will be influenced by the level at which user charges are set. The use of a payment mechanism based on partial usage payments (rather than a payment mechanism based solely on usage payments) will therefore lessen the extent to which payments to the Contractor are affected by variations in user charges.



Shadow Toll Roads Projects

The shadow toll roads projects in the UK, Finland and Portugal are all based on a similar payment mechanism structure, which involves usage related payments according to the number and type of vehicles using the road, and is subject to performance adjustments. Adjustments might relate, for example, to lane closure and safety performance.

Usage payments - The usage payments (or “shadow tolls”) are banded, with different bands relating to different traffic volumes and different costs per vehicle kilometre. Bidders set the lowest and middle bands based on their own assessment of traffic levels. Contracting Authorities set the upper band. Bidders commonly set usage payments in the lowest band, which applies when traffic levels (and hence vehicle kilometres per annum) are much lower than forecast, at a level that would cover debt service requirements (but not provide a return on equity). Contracting Authorities set usage payments in the upper band (which applies when traffic levels are much higher than forecast) to zero to limit their financial liability on the project.

Availability – the usage payments described above are commonly subject to adjustment for availability. In the case of the construction of a new road, this means that usage payments will not commence until construction is complete (although on large projects a partial payment may be made when the road is first opened to traffic but is not fully complete). On roads projects that involve the upgrading of an existing road, usage payments may be made during the construction period to reflect the existing level of traffic on the road.

Performance – in the UK there are two aspects of performance payments: safety performance payments and lane closure charges. Safety performance payments apply to upgraded roads and are based on a percentage of the economic cost of each accident avoided over a five year period. The number of accidents avoided is calculated by comparing the actual number of accidents on the upgraded road with historical records. Lane closure charges apply when lanes are closed. The size of charge is dependent on the number of lanes closed, the duration and distance of closure, the expected traffic at the time of closure, and the estimated economic value of user delay. Lane closure charges only apply when the closure is within the control of the Contractor.



Hereford and Worcester Integrated Waste Management Project

In 1996 Hereford and Worcester County Councils decided to let a contract with a private sector partner to develop and implement an integrated waste management system. The principal aim was to reduce the amount of household rubbish and achieve the UK Government’s targets for the recycling of waste and recovery of value from waste.

Focsa Services (UK) Limited (now known as Mercia Waste Management Limited and hereinafter referred to as “Mercia”) was selected as the preferred bidder in November 1997 and financial close was achieved on 23 December 1998. Under the terms of the 25 year contract (valued at over £500 million), the Councils will retain responsibility for collecting household waste and Mercia will take delivery of all such waste for treatment to achieve optimum recycling/recovery. The main facilities and services to be provided are as follows:

Introduction of kerbside collection of recyclables with separation at source;

Construction and operation of three pre-sorted material reclamation facilities;

Construction and operation of a mixed waste material reclamation facility;

Construction and operation of seventeen household waste sites;

Refurbishment and operation of four transfer stations;

Refurbishment and operation of two green waste composting plants;

Construction and operation of a 10 MW waste to energy plant; and

Operation of the existing Hill and Moor Landfill site.

Mercia is paid a base line fee per tonne of waste received under the contract, plus:

An availability payment for managing the household waste sites;

Supplements per tonne of waste recycled/recovered, which vary according to the process the waste is subjected to (e.g. incineration or composting); and

Reimbursement of the Councils’ share of the landfill tax.

To protect Mercia from significant changes in the quantity of household waste, the base line price paid to Mercia is banded and is inversely proportional to the amount of waste received (i.e. if tonnage falls the price per tonne increases, and vice versa). Payments to Mercia are reduced if the services or facilities do not meet the required performance standards, and this could ultimately lead to the termination of the contract.

In addition to payments from the Councils, Mercia will gain additional revenues from the treatment and disposal of commercial waste and it will enter into a power purchase agreement for the electricity produced at the waste to energy plant once it is operational in year five of the contract. To take into account revenue generating potential of the project, the payment mechanism also includes adjustment for the sharing of “net excess revenues” between Mercia and the Councils.



V. Availability Payments

Introduction

5.1 Availability payments relate to the capacity of a service in that, irrespective of whether there is a demand for that service, the Contractor will be paid subject to meeting the terms and conditions in the Output Specification and providing the specified level of performance. In other words, where availability payments are concerned the private sector is rewarded for making the facilities (the service) available even if the available capacity is not actually used.

5.2 Availability payments can relate simply to the mere provision of an item of infrastructure. However, in Public Private Partnership projects elsewhere in the world the definition of availability is being broadened to include the provision of the ongoing services that are core to the requirements of the Contracting Authority.

5.3 Projects for which availability is a key consideration are generally those that involve the provision of public infrastructure, without which the required services cannot be provided. Availability payments are therefore very suitable for projects in the roads, water and waste sectors, and may relate for example to lane availability on roads, or available capacity at water treatment works and waste separation and recycling plants.

Example

For a project involving the private sector in the management and operation of existing municipal waste sites, the payment mechanism could be based primarily on availability payments. The availability payments could then be supplemented with usage payments relating to the volume of waste received at each site.

Deductions would be made to the contractual payments when municipal waste sites are not available to receive waste. Deductions are likely to be made in accordance with an agreed rate per hour for each facility, with the agreed rate reflecting the relative importance of the waste site to the Contracting Authority.

Use of Availability Payments

Principles

5.4 One of the fundamental principles of availability based payment mechanisms is that payment should not commence until the full service is available. This principle should be applied to all new infrastructure projects in which availability is a key criterion. However, where a project involves the continued provision of an existing service (e.g. the upgrading of a major road), then some payments may be made to the Contractor during the construction period to reflect the continued availability of the existing service.



5.5 A common characteristic of availability based payment mechanisms is the recognition that the capital costs incurred by the private sector operator are generally fixed at the outset. Accordingly, it is this amount that is often associated with the deduction for failing to make the facility available.

5.6 It is also important to recognise that without the facility, it is likely that many of the required services cannot be provided. Therefore, many availability based payment mechanisms are constructed so that the whole of the unitary payment is subject to deduction for unavailability, even though the private sector is capable of delivering some of the services.

5.7 In considering a payment mechanism which is related to the availability of a facility to provide the services required, the Contractor will focus on the events, or criteria which can lead to the facility not being available.

5.8 Bearing in mind the potential for financial deduction, the tests applied in order to measure unavailability need to be objective. The Contracting Authority will need to take into account the unit to be measured and the factors affecting availability.

5.9 The definition of unavailability is of great importance and should be developed as early as possible in the process. The definition will depend heavily on the characteristics of the project concerned, but there will always be different degrees of unavailability that can be incorporated into the payment mechanism.

Example

The definition of unavailability on a road could include a number of measures. They are listed below in descending order of the level of deductions made and the amount by which the Contractor can manage the risk.

Road closed due to planned maintenance

Road closed due to emergency maintenance

Road closed due to planned works by utilities

Road closed due to emergency work by utilities

Lane blocked due to broken down vehicles

Lane blocked due to accident

Lane blocked due to congestion

Traffic slowed due to congestion

As one includes more items from the above list, the Contractor becomes subject to deductions over which it has questionable levels of control. For instance, the Contractor would have limited control over utilities. Further to this, while it may be possible for the Contractor to manage traffic within the confines of the network that it controls, congestion could be caused by other parts of the network. For instance, if traffic is queuing to leave a motorway at an intersection because the adjoining road is closed, then the Contractor would suffer a loss because of congestion for which it was not responsible.



5.10 The main factors that influence the structure of an availability based payment mechanism are:

• Importance of space - it is important to include a criticality factor within an availability based payment mechanism to adjust payments according to the importance of the areas or services that become unavailable;

• Time of unavailability - clearly the length of the period of unavailability needs to be factored into an availability based payment mechanism. This should include a definition of the commencement of an unavailability incident;

• Maximum availability payment deductions - there may need to be a cap on availability payment deductions in any one year; and

• Rectification periods - there may be a need to include grace periods or rectification periods during which, if incidences of unavailability are put right, then availability payments are not effected.

5.11 There will also be events where the Contractor is excused payment deduction even though availability requirements have not been met. Such exceptions commonly apply in the following circumstances:

• if suitable alternative provision (determined by the Contracting Authority) is made available;

• if the facility would not have been used anyway during the period of unavailability for other reasons;

• default by the Contracting Authority;

• a variation instigated by the Contracting Authority;

• vandalism (depending on the cause); and

• maintenance conducted in accordance with an agreed maintenance programme (e.g. where available capacity is reduced, such as lane closures on a motorway, to facilitate maintenance but a level of service is still available available).

Advantages

5.12 The main advantages associated with payment mechanisms involving availability payments are as follows:

• availability is largely under the control of the Contractor. The Contractor is therefore likely to seek a lower return on its capital than if the payment mechanism was based on usage payments, which the Contractor is less able to control;

• the Contracting Authority does not pay until the full service is available;



• it encourages the Contractor to respond quickly and efficiently to incidences of non-availability;

• it is generally a bankable system, as the Contractor should be able to forecast revenue and expenditures streams with reasonable certainty; and

• payments are spread over the life of the contract. This allows the Contracting Authority to pay the Contractor based on the performance of the asset, and not simply on completion of construction.

Disadvantages

5.13 The main disadvantages associated with payment mechanisms involving availability payments are as follows:

• unless the charges for non-availability are highly ratcheted, or the payment mechanism also includes usage payments, there is a limited ability to transfer risk to the private sector and encourage high levels of performance;

• monitoring availability may not be straightforward (for example, for major roads projects). Sometimes the only realistic option is self reporting by the Contractor augmented by random audit checks by the Contracting Authority; and

• a payment mechanism based solely on availability payments has very little variability in it, and so the contractual arrangements may be seen as akin to Contracting Authority borrowing.

5.14 Whilst a significant proportion of a payment mechanism could be based on availability payments, it is recommended that an element of user charges or usage payments should be included to improve the variability of the payment. This would increase the incentives given to the private sector, and at the same time reduce the risk of the contractual arrangements being viewed as Contracting Authority borrowing.

5.15 A further important consideration in the development of any payment mechanism is the issue of bankability. This is because the manner is which Public Private Partnerships are financed means that often, but not always, a substantial amount of the finance required to construct a facility comes from a senior lender. Under an availability based payment mechanism, for example, servicing of bank debt will be generated from a proportion of the unitary payment, which is susceptible to deduction for failure to make the facility available.

5.16 This is a key consideration when devising a payment mechanism, and the Contracting Authority should at an early stage give consideration to the ability of the private sector operator to finance the transaction on favourable terms, or indeed at all. However, not all transactions involve a third party funder, in which case the Contractor may have some flexibility in this area.



VI. Service Performance Payments

Introduction

6.1 As well as the initial provision and long term maintenance of a facility over the contract period, a Public Private Partnership project may also include the provision of other services, for example the operation of a water treatment works or the provision of an integrated waste management service. For such services, payment is usually based on the ability of the Contractor to meet predetermined performance standards. Deductions are made if the performance of the Contractor falls below these standards.

6.2 Service performance can be taken into consideration in the unitary payment by means of a separate performance related payment, or as is more common, through performance related deductions within a usage or availability based unitary payment.

Example

For a project involving the private sector in the provision of an integrated waste management scheme, the contract will define a range of minimum performance criteria, against which the standard of service provided by the Contractor is measured. These performance criteria may be split into a number of categories, including for example:

Waste acceptance and treatment failures;

Environmental failures;

Transportation failures; and

Staffing and administrative failures.

A financial penalty is set for each criterion, together with a rectification period within which the Contractor must remedy the defect. If the Contractor fails to satisfy any of the minimum performance criteria and the failure has not been remedied within the rectification period, then deductions are made from the contractual payments.

This provides an incentive for the Contractor to ensure that services are provided to the required standards, and if not, that any shortfall is rectified as soon as possible. It also enables the Contracting Authority to set differential performance periods and rectification periods to target those elements of the service that it considers most important.



Use of Service Performance Payments

6.3 When structuring payment mechanisms that are based on service performance, care needs to be taken to ensure that the payment mechanism is both simple and flexible, and is based on measurable objectives and outcomes. Measurement of performance is often one of the most difficult areas of a payment mechanism to develop, as it is not always obvious how to specify standards of performance in way that can be measured and monitored.

6.4 The payment mechanism must set out clearly the consequences of any failure by the Contractor to perform to the standard required by the Output Specification. A common approach is for a specified number of performance points to be attributed to the Contractor each time its performance falls below the required standard. The number of points attributed to the Contractor would depend on the seriousness of the failure.

6.5 The payment mechanism should establish a direct link between the seriousness of failure, the number of points attributed to the Contractor, and the financial deduction taken from the unitary payment to the Contractor. A schedule setting out the number of points that will be attributed to the Contractor for failure to meet a specified performance output should be included in the Project Agreement. Commonly financial deductions are only made once a certain level of points has been accrued by the Contractor within a defined period.

6.6 Where the Contracting Authority is seeking enhanced levels of performance under a Public Private Partnership contract, the payment mechanism can be structured so that additional payments are made if the enhanced levels of performance are achieved. However, care is needed to ensure that value for money is not compromised by establishing a payment mechanism that provides additional payments for levels of service that are higher than those required by the Contracting Authority.

6.7 Furthermore, in addition to paying for the quality of the performance supplied by the Contractor, it may also be appropriate for a service performance based payment mechanism to take into account the quantity of service delivered. For example, for a waste management project, payments could be based on the both quality of waste management (for example, in terms of recycling targets), and on the quantity of waste processed.

Performance Monitoring

6.8 A performance monitoring system is required to determine the quality of the service that is actually provided by the Contractor. This can be measured by defining either a minimum or a range of service levels, which are monitored continuously or by sample.



6.9 In most cases the Contractor will be responsible for providing and maintaining performance monitoring, quality management and information systems. All records of performance, maintenance responses and customer feedback should be maintained by the Contractor and made available for verification by the Contracting Authority and its advisers.

6.10 A common difficulty with monitoring performance criteria (sometimes referred to as “performance indicators”) is the ability to measure definitively whether a given criterion has actually been met or not. With objective performance criteria, such as water quality measures (e.g. pH levels), definitive measurements can be made and failure is unquestionable.

6.11 The difficulty arises with subjective performance criteria, for example in respect of the condition of an asset. In cases such as these, judgement can be made by reference to benchmarks which can be supported by photographic evidence of what is, and what is not, considered to meet the agreed performance criteria. In relation the condition of an asset, condition schedules can be formulated that describe, with photographic evidence, the condition regarded as acceptable in a given of area. Monitoring would then look for defaults against the acceptable condition.

6.12 Specific guidance on performance monitoring is included in the separate Guidance Note entitled Contract and Performance Management.



VII. Financial Issues

Introduction

7.1 The value of the user charges or unitary payment underlying a Public Private Partnership contract will be subject to change during the course of the contract. The main circumstances that could result in changes to the payment mechanism during the course of the contract are described in this section of the Guidance Note.

Indexation

7.2 It is usual practice for a Public Private Partnership contract to take account of the impact of inflation through a suitable indexation arrangement. The indexation formula used will be dependent on the nature of the project, and will be arrived at by considering the nature of the risk allocation arrangements between the public sector and the private sector in relation to inflation. For consistency between projects being undertaken by different Contracting Authorities, the relevant index may be selected for all Contracting Authorities by the Central Authority.

7.3 Selection of the appropriate index to be used will also be dependent on the nature of the project. The most commonly used index is the Consumer Price Index. Industry specific indices can also be adopted. For example there is the possibility of using labour market indices for part of the payment to reflect the rise in the underlying costs of the private sector. In addition, there are complex formulae available, which will pass through to the public sector the rise in underlying construction indices, such as the Construction Materials Index. The benefits of including complex indices such as these in the payment mechanism will be reduced if there is a benchmarking or market testing regime in place.

7.4 Consideration should also be given to the degree to which the whole of the user charge or unitary payment is indexed. This will be a significant factor when the Contracting Authority is considering the economic characteristics of the project, and in particular its ability to afford the project over the contract life.

7.5 Indexation arrangements can also be used as a mechanism to derive pre-agreed efficiency savings by the Contractor which give rise to a reduction in the unitary payment. For example, the following formula can be used if the Contracting Authority does not want the user charge or unitary payment to increase by the full amount of the Consumer Price Index. The increase in unitary payment is diluted through the use of an X factor. If the Contracting Authority also wishes to see efficiency savings by the Contractor, then this can be reflected in a price reduction, by a Y factor.

CPI – Y X

where Y represents an efficiency factor (the Efficiency Factor) and X represents an inflation adjustment factor (the Inflation Factor).



Benchmarking and Market Testing

7.6 It is widely recognised that a payment mechanism that offers no flexibility in price over a long period of time, perhaps 25 or 30 years, is unlikely to offer best value for money for the Contracting Authority. This follows the principle that risk should be managed by the party best able to do so, and the fact that for certain services, it is not possible for either the public sector or the private sector to accurately predict pricing over such a long time frame. If the private sector were requested to do so then it is likely that it would build into its pricing structure a substantial risk premium for taking this risk.

7.7 The services to which this relates are often referred to as ‘soft facility management services’ and cover such requirements as catering and cleaning, where changes in the method of service delivery are not expected to remain stable over the life of the project. To deal with this the contract could provide for these services to be periodically benchmarked and/or market tested.

7.8 Under benchmarking arrangements, the Contractor would carry out a benchmarking exercise to compare the cost of carrying out the soft facility management services against the cost of providing similar services. Such a benchmarking exercise may involve obtaining price quotations from alternative providers, and should be carried out in an independent and objective manner by ensuring that the similar services are in a relevant sector and are also delivered to a similar specification.

7.9 If either the benchmarking exercise proves to be inconclusive, or the Public Private Partnership contract does not provide for benchmarking, then it is likely that the soft facility management services will be market tested, i.e. the Contractor will re-tender those soft services that are subcontracted to third parties. Conflicts of interest may arise where the sub-contractor is an equity stakeholder in the special purpose vehicle established to undertake the contract. In such circumstances, the involvement of the Contracting Authority in market testing and benchmarking is essential in ensuring a fair and equitable outcome. The criteria for undertaking a market test will be the same as those for a benchmarking exercise.

7.10 For Public Private Partnership contracts that contain the provision of accommodation, it is usual for the maintenance element to be excluded from the benchmarking/market testing provisions. This is because such services cannot be easily separated from the provision of the facility itself, and the Contractor takes on the risk of making the facilities available over the life of the project. Benchmarking and market testing may therefore be less relevant for projects in the roads, water and waste sectors due to the preponderance of hard services.

7.11 Once a benchmarking/market testing exercise has been undertaken, and if the price of the services tested is different from that which is currently paid by the Contractor, then the payment mechanism will be adjusted to take this into account. The extent of the adjustment will be a matter for inclusion in the contract. It will not always be the case that the payment mechanism will be adjusted by the whole of the variation.



7.12 The intervals between testing arrangements will depend on the nature of the service being delivered, but is usually no more frequently than every five years. These arrangements provide for some element of risk sharing between the contracting parties, whereby the Contractor can offer the best value for money because it is, in part, protected by this arrangement as well as the indexation provisions.

Variations

7.13 Inevitably during the course of a long term contract there are likely to be occasions when the service delivery requirements change. As a result, the Public Private Partnership contract needs to be flexible to take into account any adjustments to the payment mechanism when they arise. The manner in which any cost implications are shared between the parties needs to be specified within the contract documentation and this will depend on:

• who initiated the variation;

• who is responsible for a variation event when it takes place; and

• the implications of a change in law causing a variation event (see separate Guidance Note entitled Key Contractual Issues).

Pass Through Costs

7.14 For certain projects there will be items of work which the Contractor is best placed to undertake, but where a transfer of risk from the Contracting Authority to the Contractor is not considered appropriate as it does not provide value for money. The Contracting Authority may treat the costs associated with these items of work (e.g. utility costs) as pass through costs, whereby the costs incurred by the Contractor may be reimbursed.

Transfer of Assets

7.15 It may be desirable for assets that are required by the Contractor to provide the contracted services to be transferred at nil value. This avoids the additional financing costs that would result from the Contractor purchasing the assets from the Contracting Authority. The actual market value of asset should be reflected in the payment mechanism in terms of a reduction in user charges or a reduction in the payments made by the Contracting Authority. The ability of the Contracting Authority to transfer assets at nil value should however be considered in terms of relevant legislation. This issue is discussed further in the separate Guidance Note entitled Legal Context.



7.16 It may also be desirable for assets that are surplus to requirements to be transferred at nil value in return for a reduction in user charges or a reduction in the payments made by the Contracting Authority. However, in the case of surplus assets, consideration should be given to the income generating potential of the assets, and mechanisms may be required to limit the potential for the private sector to make excessive profits. In addition, the ability of the Contracting Authority to transfer assets at nil value should be considered in terms of relevant legislation.

7.17 The Contracting Authority should ensure that the assumptions made by tenderers in relation to the treatment of transferred assets should be clearly stated in tender submissions. It is important that the Contracting Authority is provided with sufficient information to establish that the treatment of transferred assets represents value for money. In particular, any tax implications of the asset disposals must be clearly identified.

Revenue Sharing

7.18 In addition to delivering the core service requirements of the Contracting Authority, there may be opportunities for the Contractor to derive additional income by using the facilities/assets for other uses. In such circumstances, the payment mechanism should reflect the additional revenue generating potential of the project by way of:

• a reduction in the charges applied to users;

• a reduction in the payments made by the Contracting Authority;

• a profit sharing mechanism; or

• a combination of the above.

7.19 The extent to which the Contracting Authority shares additional profits may be determined by means of a cap on the equity rate of return of the Contractor, or by the Contracting Authority taking a royalty on turnover. The most appropriate arrangements will depend on the project’s characteristics.

7.20 Whatever arrangement is used to cap excessive profits, the overall payment mechanism should still provide an incentive to the Contractor to enhance overall efficiency and to identify new opportunities for to generate additional income. Care should be taken to ensure that the activities undertaken by the Contractor to generate additional income do not conflict with the Contracting Authority’s core service delivery objectives.



Refinancing

7.21 Most risks in a project are concentrated during the construction phase and once this is successfully completed, it may be possible for the project to be refinanced on more favourable terms. This would result in a reduction in the cost of the project to the Contractor, and, if the benefits of refinancing are shared, could in turn lead to a reduction in the payments made by the Contracting Authority (or by users in the case of user charges). The Contracting Authority should therefore normally allow refinancing by the Contractor on the understanding that benefits are shared.

Payment of Design Costs

7.22 In the event that responsibility for carrying out the statutory process is transferred to the Contractor, then the payment mechanism should facilitate the reimbursement of design costs in the event that the project is terminated at the statutory process stage. Further discussion of this issue is provided in the Guidance Note entitled Statutory Process Assessment.



VIII. Conclusions and Recommendations

Introduction

8.1 This section provides a summary of the main issues discussed in this Guidance Note and provides recommendations on the development of payment mechanisms for infrastructure projects in the roads, water and waste sectors.

Developing a Payment Mechanism

8.2 In general, payment mechanisms are likely to include one or more of the following basic elements:

• User charges – payments received by the Contractor directly from private users of the infrastructure or service (e.g. road tolls);

• Usage payments – payments from the Contracting Authority to the Contractor that vary according to how much the infrastructure or service is used;

• Availability payments – payments from the Contracting Authority to the Contractor for making infrastructure or services available for use at an acceptable standard; and

• Service performance payments – payments from the Contracting Authority to the Contractor that vary according to the quality of service provided.

8.3 The suitability of the above elements for use in a payment mechanism for an infrastructure project will depend on the particular characteristics of the project concerned, and in particular, the desired allocation of risk between the public and private sectors.

Application of User Charges

8.4 The application of user charges to infrastructure projects in the roads, water and waste sectors must reflect Government policy on user charges and the application of the polluter pays principle to finance the construction and operation of infrastructure projects in these sectors. Therefore in devising payment mechanisms for projects in these sectors, the principal objective should be to attribute an appropriate proportion of the costs of constructing and operating the project to its users if the project is suitable for the application of user charges. It is therefore envisaged that, for major road and waste projects in particular, Contractors will recover their costs directly through user charges.



8.5 There are a number of approaches that could be considered by Central and Contracting Authorities for the setting of user charges for Public Private Partnership projects. These approaches include setting a national rate for user charges for each type of project, setting user charges independently for each individual project, and setting user charges for each individual project through a competitive tendering process.

8.6 For road schemes involving tolling, the Roads Act requires the making of a toll scheme by the National Roads Authority, to be confirmed by the Minister, setting the estimated level of toll for a project. In practice, this limits the scope for tendering of the appropriate market price, where it significantly exceeds the toll set. Ultimately, the existing approach permits competitive tendering on the basis of a toll rate that is either lower, or at any rate not significantly greater than that approved by the Minister. In the event that the toll required by Contractors to make a commercial return is significantly greater than the estimated level of toll, then the Contracting Authority may be required to cap the toll level and provide revenue subvention.

8.7 When considering the suitability of different projects for the application of user charges, consideration should be given to a range of factors including the objectives of the project, the legal viability of charging, the availability of alternatives services (or routes), the elasticity of demand, the practicality of applying user charges, the ability of the Contracting Authority or the Contractor to forecast demand, the level of charge that should be set, and the most appropriate methods of revenue collection. Consideration of the above issues will enable Central and Contracting Authorities to determine whether or not user charges should be applied to a project, and if so, whether or not they should be used as a basis for paying a Contractor.

Payment Mechanisms

8.8 Payment mechanisms for infrastructure projects in the roads water and waste sectors are usually linked directly to usage, either through the application of user charges or the use of usage payments. As described above, payment mechanisms for such projects must reflect Government policy on user charges and the application of the polluter pays principle, and also the ability of the private sector to manage demand risk.

8.9 The structuring of a payment mechanism for use on an infrastructure project in the roads, water or waste sectors is therefore highly dependent on two key issues:

• the application of user charges; and

• the ability to transfer demand risk cost effectively.

8.10 It is recommended therefore that for those projects which are considered suitable for user charges, and for which there is sufficient historical information to enable demand risk to be cost effectively transferred to the private sector, consideration should be given to developing a payment mechanism based primarily on user charges. It is envisaged that this will be the case for major road and waste projects in particular.



8.11 For those projects for which there is insufficient historical data on which to base demand forecasts, or for which user charges are not considered appropriate, consideration should be given to developing a payment mechanism based primarily on usage payments. Usage payments are likely to be banded to limit the exposure of the Contractor to demand risk.

8.12 If however market soundings suggest that there is no likelihood of transferring demand risk cost effectively, even on a shared basis, then the payment mechanism could be based primarily on availability and performance payments.

8.13 In practice, it is expected that all payment mechanisms that involve public expenditure should include an element of availability and performance payments and, if at all possible, the transfer of some demand risk. For example, road projects are currently being undertaken in the United Kingdom, Portugal and Finland use payment mechanisms based on a mixture of usage, availability and performance payments. Commonly somewhere in the region of 60 per cent of the payment is determined with reference to usage, and the balance is determined with reference to availability and performance. The balance between the two can vary, depending on the particular characteristics of the road. For example, an inter-urban route might tend towards usage payments, while an urban route might tend towards availability payments.

Guarantees

8.14 There is a significant risk that by providing guarantees to gain access to private finance, the Contracting Authority can inadvertently assume risks that it has intended to allocate to the Contractor. This can result in a project costing significantly more than expected, and result in poorer value for money than traditional procurement.

8.15 In Ireland it is not appropriate for the State to give guarantees in the context of Public Private Partnership projects. Nevertheless, it is in the interest of Central Authorities to ensure, in so far as is possible, that private funders have confidence in the competence and capacity of sub-sovereign bodies to fully engage in the PPP process.

8.16 Non-financial guarantees may, however, be applicable in certain circumstances. For example, a Contractor may only be willing to accept demand risk on a road project if the Contracting Authority guarantees that it will not construct a competing road. The implications of any guarantee that is sought by the private sector should however be considered in detail.



Financial Issues

Indexation

8.17 It is usual practice for a Public Private Partnership contract to take account of the impact of inflation through a suitable indexation arrangement. The indexation formula used will be dependent on the nature of the project, and will be arrived at by considering the nature of the risk allocation arrangements between the public sector and the private sector in relation to inflation. The most commonly used index is the Consumer Price Index. For consistency between projects being undertaken by different Contracting Authorities, the relevant index may be selected for all Contracting Authorities by the Central Authority.

Benchmarking and Market Testing

8.18 It is widely recognised that a payment mechanism that offers no flexibility in price over a long period of time, perhaps 25 or 30 years, is unlikely to offer best value for money for the Contracting Authority. For this reason, Public Private Partnership contracts may provide for those services that cannot be priced accurately over the duration of the contract to be periodically benchmarked and/or market tested to ensure that value for money is provided over the duration of the contract.

8.19 However, for contracts that contain the provision of infrastructure, it is usual for the maintenance element to be excluded from the benchmarking/market testing provisions. This is because such services cannot be easily separated from the provision of the infrastructure itself, and the Contractor takes on the risk of making the facilities available over the life of the project. Benchmarking and market testing may therefore be less relevant for projects in the roads, water and waste sectors due to the preponderance of hard services.

Transfer of Assets

8.20 It may be desirable for assets that are required by the Contractor to provide the contracted services to be transferred at nil value. This avoids the additional financing costs that would result from the Contractor purchasing the assets from the Contracting Authority. The actual market value of asset should be reflected in the payment mechanism in terms of a reduction in user charges or a reduction in the payments made by the Contracting Authority. The ability of the Contracting Authority to transfer assets at nil value should however be considered in terms of relevant legislation. This issue is discussed further in the separate Guidance Note entitled Legal Context.

Revenue Sharing

8.21 In addition to delivering the core service requirements of the Contracting Authority, there may be opportunities for the Contractor to derive additional income by using the facilities for other uses. In such circumstances, the payment mechanism should reflect the additional revenue generating potential of the project by way of a revenue sharing arrangement.



8.22 Whatever arrangement is used to share additional revenues, the payment mechanism should still provide an incentive to the Contractor to enhance overall efficiency and to identify new opportunities for to generate additional income. Care should be taken to ensure that the activities undertaken by the Contractor to generate additional income do not conflict with the Contracting Authority’s core service delivery objectives.

Refinancing

8.23 Most risks in a project are concentrated during the construction phase and once this is successfully completed, it may be possible for the project to be refinanced on more favourable terms. This would result in a reduction in the cost of the project to the Contractor, and, if the benefits of refinancing are shared, could in turn lead to a reduction in the payments made by the Contracting Authority (or by users in the case of user charges). The Contracting Authority should therefore normally allow refinancing by the Contractor on the understanding that benefits are shared.



Appendices




Public Private Partnership Guidance Notes

The Public Private Partnerships Policy Framework comprises a series of fifteen individual Guidance Notes, the titles of which are as follows:



• Legal Context








• Risk Assessment




