Notes - Asian Development Bank · The quote on this slide identifies that the launch of four PPP road projects in Kazakhstan was not successful because: • Preparations were rushed

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Results Management for Public Sector Excellence – Public-Private Partnerships for Development Results

PPP Implementation – Preparing to Tender the Project

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ADBs PPP Handbook includes a section on PPP preparation. Important further work, building on the business case, might be required before government commences the formal tender process, which generally occurs with the initiation of the formal prequalification process.

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ADB’s PPP Handbook outlines what happens during the tender process. These activities are largely sequential. However some of the preparatory work continues through into the tender process.

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PPP tender processes should be carefully planned. Significant thought should be given to which project preparation activities must be completed before the tender process commences, and which can overlap with the tender process.

If government commences the formal prequalification process too early, and then asks pre-qualified bidders to wait a long time before government issues its detailed tender documents, there is a risk that the pre-qualified bidders’ circumstances have changed. They may no longer meet the prequalification requirements or they may no longer be interested in bidding for the project.

To mitigate this risk, government should work out how long it will take to develop a complete set of bidding requirements and tender documentation, and then work backwards to determine the timing of the pre-qualification process.

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The quote on this slide identifies that the launch of four PPP road projects in Kazakhstan was not successful because:

• Preparations were rushed to meet political deadlines.

• The bid times were unrealistically short.

• The tender process was launched over the New Year holidays.

As a result of these factors, the government was unable to attract suitable competitive fields to these projects.

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The key tasks that occurred during the project development phase include the following:

• Putting together the team - Typically a government project team is established within the line agency responsible for delivery of the project, and its skills and capability are supplemented through the appointment of external technical, commercial and legal advisers.

• Establishing the project governance arrangements - A senior responsible owner is appointed within the line agency. The project director reports on a day-to-day basis to the senior responsible owner. A steering committee, comprised of representatives of the line agency and key project stakeholders (including the central PPP unit), is established as a key consultation and decision-making body for the project.

• Finalising the procurement strategy – Some matters relevant to the conduct of the procurement process will not have been fully considered at the time the business case was approved, and must be finalised before the tender process commences.

• Development of the commercial principles – The commercial principles that will underlie the project contract should be developed before the tender process commences.

• If the proposed project site is not already owned by government, it should be secured at this stage.



This quote illustrates the reality that, initially, government may need to “buy in” external expertise to assist with projects, but government should look to build its internal expertise over time.


PPP Implementation – Preparing to Tender the Project 8

Securing the project site is another important task during the project development phase. If government does not already own the site, it may need to purchase the site on commercial terms or acquire it under legislative powers of compulsory acquisition. Alternatively, in some projects, it may be appropriate to leave the choice of site and its acquisition up to the winning bidder. However, that strategy can create significant cost and time risks for government, as bidders will cost into their bids a premium for taking the risks associated with site acquisition. (In some other countries, site acquisition is generally the private party’s responsibility, and occurs after contract execution.)

Whatever method is to be used for securing a site, government should consider the impact that the site acquisition process will have upon timing of the project, and risks associated with site condition and availability.

Government also needs to consider what form of tenure the contractor will receive. Different forms of tenure will affect the rights of the parties to the contract, and will also have different taxation consequences, which may affect project costs. The tenure given may be freehold title, a lease of the site for the term of the contract, or a licence to enter the site during the contract. In early PPPs in Australia, a lease was generally considered the appropriate form of tenure to provide the contractor's financiers with adequate security over the project assets, while protecting government’s rights of step in and termination. In some more recent projects, the contractor and its financiers have been comfortable only receiving a licence to enter the site in order to perform the contract.

At this stage of the project, site related interfaces also need to be understood.

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This is the site on which the Casey Hospital, a PPP in Victoria, Australia, was built. It was, literally, a "greenfield" site. Consequently, there were relatively few site related risks and interface issues. However, for some greenfields sites, there can be significant issues associated with connecting utility services (such as water and electricity) to the site.

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This is a photo of the old Spencer Street Station in Melbourne, Australia, which was demolished and redeveloped under a PPP contract to become the Southern Cross Station. As the site had seen significant previous use, it was what is known as a "brownfield” site. As is the case with many brownfield sites, there were issues in relation to existing contamination on the site and the impact of the PPP construction works upon neighbouring infrastructure and properties.

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Toll roads, many rail projects, and some water projects have linear sites that involve or cross many different properties and land titles. This photo shows part of Melbourne's EastLink project, which was a 39 km PPP toll road project.

Linear projects have significant site related challenges, both as a result of the need to acquire rights to a large number of properties, and as a result of the fact that the project will inevitably interface with a large number of surrounding roads, rail lines, utility services etc.

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For many projects, market engagement is an important element of the project identification and development process.

Market engagement sometimes commences informally at the options analysis stage. At this stage, the focus of market engagement is on gather information to assist in assessing the different project options.

Market engagement is often an important input to the procurement strategy. It can provide information both on the market appetite for the project under different procurement methods, and on risks and issues that might be relevant to the choice of procurement method.

Once the project has been approved and funded, further informal market sounding during the project development phase may assist government in better structuring the project.

Of course, the most extensive form of market engagement occurs formally though a tender process.

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Informal market sounding at the procurement strategy and project development stages is a two-way process:

• The market needs to understand the potential future project pipeline

• Government needs to understand the market’s capability when evaluating options and developing procurement strategies and the project structure

Informal market sounding requires prudence if the project has not yet been approved by government.

Care is also needed to ensure that the informal market engagement process does not unfairly advantage any potential bidder or create perceptions of bias.

It is best to carefully plan how the informal market engagement will be conducted. Simply asking potential bidders if the project is of interest to them is likely to result in many “Yes” responses that may give a false impression of how many bids will be received. More carefully crafted questions (for example, “What would you see as the key risks and challenges in this project?”) generally produce more informative responses.

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This quote demonstrates the approach to market sounding taken in the Philippines, and the benefits of that approach.


PPP Implementation – Preparing to Tender the Project 15

The PPP Contract is at the center of the partnership, defining the relationship between the parties, their respective rights and responsibilities, allocating risk, and providing mechanisms for dealing with change.

Detailed contract design takes significant time and resources—including from expert advisors. Approval is often required—based on an initial structure and project appraisal—before embarking on detailed design and investing these resources. Key areas of PPP contract design include:

• Performance requirements—defining the required quality and quantity of assets and services, along with monitoring and enforcement mechanisms, including penalties

• Payment mechanisms—defining how the private party will be paid, and how bonuses and penalties can be built in

• Adjustment mechanisms—building in to the contract mechanisms for handling changes, such as extraordinary reviews of tariffs, or changing service requirements

• Dispute resolution procedures—defining how contractual disputes will be resolved, such as the role of the regulator and courts, or the use of expert panels or international arbitration

• Termination provisions—defining the contract term, handover provisions, and circumstances and implications of early termination.

The draft PPP contract is typically included with the Request for Proposals (RFP) sent to prospective bidders. In some cases, the PPP contract issued with the RFP cannot be changed. In others, it may be changed as a result of interaction with bidders during the transaction process.

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Included in the case study materials for this course are the tables of contents of two standard PPP road contracts from India, one for toll roads and one for roads government makes annuity (availability) payments. The full contracts are available on the Internet.

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The project agreement includes information from a variety of sources. There may be:

• Commercial and financial content initially prepared by commercial and financial advisers (for example, the payment mechanism and provisions dealing with financing arrangements and termination payments)

• Technical content initially prepared by technical advisers (for example, the specification and details of completion/commissioning requirements)

• Legal content initially prepared by legal advisers (for example, the operative clauses of the contract)

This content is commonly brought together by the lawyers at the end of the contract development process.

It is important that there is extensive interaction between all of the project team members and advisers involved in developing the different parts of the contract to ensure that the different parts “talk to each other” where necessary – in other words, they work as an integrated suite of documentation.

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In a PPP, government transfers significant risk to the private party. The private party in turn transfers much of this risk to its construction subcontractor and operations/maintenance subcontractor. The construction subcontractor may pass a small amount of risk to its design team. Any residual risk that remains with the private party ultimately becomes a risk to the financiers, as that risk affects the ability of the private party to repay its financiers.

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Early PPPs were relatively simple arrangements under which the commercial incentives to drive performance generally fell into two categories. Some incentives were a relatively light touch, represented here by the feather, while other incentives were severe, represented here by the bomb. For example, in the case of inadequate performance by the contractor, government might initially be entitled to provide a notice to the contractor advising the contractor that it is failing to meet the contractual requirements. If performance deteriorated further, government’s key mechanism for dealing with this would (at least in theory) be to terminate the contract. Terminating the contract is a very severe penalty that does not necessarily resolve underperformance and may undermine any benefits that the project has delivered. Termination is also sometimes seen as politically unpalatable, as it can be viewed as an admission of failure by government.

Theoretically these PPP contracts required a specified level of performance by the contractor, but the lack of an appropriate range of incentives made it difficult to adequately incentivise proper performance.

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Modern PPPs are more likely to contain a series of graduated commercial incentives that enable the public sector to respond appropriately to private sector underperformance. For example, payments by the public sector to the PPP contractor may be reduced on a basis proportional to the underperformance, and more serious underperformance may result in the PPP contractor being obliged to develop a cure plan, setting out how the underperformance will be remedied or avoided in the future.

These intermediate “sticks” provide a better focus on delivery of the expected benefits of the PPP, and are less susceptible to political interference.

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In addition to the PPP contract between government and the private party, PPPs involve an extensive suite of contractual arrangements between the private party, its sub-contractors and its financiers.

These contractual arrangements include detailed provisions that determine how the private party’s revenue is utilised. This is known as the payment waterfall.

If the project is proceeding according to plan in its operational phase, the payment waterfall typically provides that revenue is first applied to any current payments required under the debt financing arrangements. After that, the operating and maintenance costs are paid. If there is any revenue left over after meeting these costs, it is available for payment to the equity investors.

The payment waterfall is supplemented by extensive provisions in the subcontracts and financing documents that govern payments between the private party, its sub-contractors, and its financiers when any sort of problem arises.

By determining the priority of the various private sector party’s entitlements to payment, the payment waterfall plays an important role in risk allocation amongst those consortium members, and in determining the extent to which they are aligned to the public sector.

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One problem that can arise in a PPP is that the private party fails to deliver some of the outputs required under the PPP contract. This results in a reduction in the payments made by government or users to the private party. In most cases, a failure by the private party to deliver the required outputs is a consequence of a subcontractor failing to perform under its sub contract with the private party.

The private party’s financiers will not want to face the risk that results from the failure to deliver the outputs. The financiers therefore ensure that the sub contract passes down the risk of payment reductions to the subcontractor. If there is a reduction in the payments received by the private party under the PPP contract, there is a corresponding reduction in the payments made by the private party to the subcontractor under the sub contract.

Financiers will also generally require the subcontractor to commit to higher levels of service than those required by government in the PPP contract. This further reduces the risk of that the outputs will not be delivered in accordance with the PPP contract.

To ensure that particularly serious failures by the subcontractor do not compromise the private party’s ability to make the payments required of it under the finance documents, financiers will also require the subcontractor to pay liquidated damages or provide security to the private party.

A consequence of these complicated contractual arrangements is that there is not necessarily a complete alignment between the interests of the public sector and the interests of the private party under the PPP contract. The private party is protected to some extent from the impact of output delivery risk. The financiers are also protected. The primary alignment in respect of output delivery risk is between the public sector and the subcontractor – if the outputs are not delivered, the public sector suffers from poor service outcomes, and the sub contractor suffers the financial consequences of the payment reductions.

This example demonstrates that different members of the private sector consortium in a PPP will have different interests, and the public sector may be aligned with different members of the consortium in different circumstances.

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As a general rule, the financiers in a PPP project have little exposure to risks that are only of minor concern to government, and therefore are subject to the less drastic commercial levers. The financiers have a greater exposure to risk in cases of severe underperformance, particularly if the impact is so great that it cannot be fully absorbed by the responsible subcontractors. The financiers will therefore have a much greater involvement in dealing with underperformance where government is in a position to use the more significant commercial levers.

The nature of the financier’s exposure to risk results in the financiers having little alignment with government in relation to minor underperformance issues, but significant alignment (at least in principle) in respect of serious underperformance.

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The previous slides have illustrated how the majority of risks in a PPP are allocated to specific parties, rather than being shared by the parties, and how this influences the commercial alignment between the parties.

However, not all risks are best managed by allocation to a specific party in this way. There are some risks that are best shared. An example of such a risk is the risk that the project site is contaminated, and that this contamination was unidentified prior to construction commencing. If the contamination is identified during construction, there may be additional construction costs as a result of the need to remove the contamination and the consequential impacts this has on the timely completion of construction.

Government cannot manage this risk, as the site is under the control of the private sector. If the risk is allocated to government (so that government pays the costs that the private sector incurs in removing the contamination and the costs resulting from the delay in construction), the private sector will have no incentive to minimise the cost – this is a bad outcome for government

If government transfers this risk to the private sector, the private sector may require a large risk premium so that it can meet any costs for removing contamination. Therefore allocating the risk to the private sector results in a poor value for money outcome.

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Because unidentified pre-existing site contamination discovered during construction is a risk that cannot be easily managed by either party, in Australian PPPs it is often a shared risk on the basis that government will pay 80% of the cost and the private sector will pay 20% of the cost. As government is taking most of the risk, the private sector will not require a large risk premium. However even this small exposure means that the private sector has an incentive to minimise the cost – this in turn reduces the risk for government.

The key feature of unidentified pre-existing site contamination that results in it being a risk best shared, rather than allocated to a single party, is the fact that neither party can mitigate probability of the risk occurring, although the private sector can mitigate the cost impact of the risk if it does occur.

Some other risks exist for which neither party can fully mitigate the probability of the risk occurring and neither party can mitigate the cost impact. An example seen in Australian PPPs is the risk of indigenous artefacts being discovered during construction. Finding such artefacts typically results in construction works ceasing while the artefacts are identified, assessed and recovered. This can delay construction and increase construction costs. For a risk like this, it may be preferable to have the private sector bear the impact up to a certain threshold, with the public sector meeting any costs above that threshold. This approach ensures that the private sector does not come to government seeking compensation for minor delays, which would be an inefficient process, while avoiding the need for the private sector to build in a large cost premium in case the cost impact is very high.

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The different risk sharing mechanisms that I have described result in different alignment between the parties, but the alignment is appropriate to reflect the ability of these parties to mitigate the impacts of these risks.

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In summary, three key features of risk allocation and commercial incentives in PPP contracts are as follows:

• PPP contracts should contain a graduated set of “sticks” or “levers” to provide commercial incentives for private sector performance

• Most risks are allocated (by the private sector) to specific members of the private sector consortium – there is no single alignment between the public and private sectors. However, the various consortium members are aligned with the public sector to differing extents in differing circumstances.

• Some risks should be shared, rather than allocated to an individual party, in order to drive alignment

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In a PPP where government makes regular payments to the private sector contractor, the output specification is usually linked to requirements that measure both the availability of the infrastructure and related services, and the quality of the infrastructure and the services. The private sector’s performance against these requirements is measured and feeds into a payment mechanism that determines how much the government must pay the private sector.

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New Zealand’s Wiri prison PPP provides an example of how availability can be measured and linked into a PPP payment mechanism.

The contract for this PPP requires the private sector to provide 960 “Available Prisoner Places”. An Available Prisoner Place exists if there is a cell that meets certain safety and security requirements and if the other essential items necessary to house a prisoner are available – for example, meals, bedding and clothing.

The payments that government will make to the private sector under this PPP will be reduced pro rata if less than 960 places are available.

Although the PPP contractor is only required to provide 960 Available Prisoner Places, it is building more than 1000 cells in the prison, as it expects that some cells will, from time to time, be unavailable due to maintenance needs or damage.

This example illustrates that, by paying based on availability, a PPP can be structured so that the costs to government is proportional to the benefits or service outcome is obtained by government.

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Paying based on availability alone is not sufficient to align the private sector with government. In the Wiri Prison PPP, the PPP Contractor must provide a safe and secure environment (for example, preventing assaults) and must provide programs to reduce recidivism. To provide an appropriate commercial incentive for these quality factors, quality based adjustments are made to the PPP payments.

Developing a payment mechanism that includes reductions related to quality can be more challenging than a payment mechanism that focuses on availability alone. This is primarily because the impact of part of the infrastructure being unavailable is more readily understood than the impact of poor quality infrastructure or service delivery.

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It is important that the PPP payment mechanism is appropriately calibrated to provide the right level of payment reduction for both availability failures and failures to meet quality based KPI’s.

If the payment mechanism is too “soft”, the PPP contractor will not have a strong commercial incentive to fully deliver on the output specification

If the payment mechanism is too “harsh”, the PPP contractor may:

• Charge an excessive risk premium, compromising value for money

• “Gold plate” the project, over-delivering but at a higher price, compromising value for money

• Respond to under-performance by behaving in an adversarial manner, rather than seeking to resolve the underperformance issue.

Appropriately calibrating the payment mechanism is therefore essential to ensure that risk is effectively transferred under the PPP contract, at a price that offers value for money to government and on a basis that is sustainable over the long term.

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A common approach to calibrating the payment mechanism starts by considering the private sector contractor’s cost structure during the operational phase of the PPP. This cost structure typically includes operating and maintenance costs, payments to equity investors, and debt service payments.

Government’s payments under the PPP contract will, provided the contractor meets the performance requirements and is entitled to full payment, be sufficient to meet all of the PPP contractor’s costs. The payment mechanism is then calibrated so that minor underperformance results in the private sector contractor receiving sufficient revenue to meet its payment obligations to its debt and equity financiers, with operations and maintenance subcontractors receiving reduced payments (as described earlier in this presentation, the payment reductions would be passed through to the subcontractors in most instances, as they are the party most likely to be responsible for the underperformance).

Where there is more serious underperformance, the reduction in payment is calibrated so that not only does the contractor receive insufficient revenue to pay operating and maintenance costs, but there is also a potential loss to the equity investors. Where there is critical underperformance, payments to debt investors may also be at risk.

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The key reason for calibrating the payment reductions to reflect the private sector’s cost structure is the fact that this calibration will provide appropriate behavioural incentives for the private sector. Minor under performances will have the financial impact on the subcontractor, who will be incentivised to remedy the problem. More serious under performances will also have a potential impact on financiers and they will therefore also act to improve performance in these situations.

However, proportionality between the payment reduction and the loss of service is also important to government. As a general rule, the greater the impact of a particular kind of underperformance upon government, the greater is the payment reduction should be. This needs to be considered in calibrating the payment mechanism, and may require some departures from the principle that the payment reduction should be related to the private sector’s cost structure.

It is important to bear in mind that, while government may calibrate the payment mechanism having regard to the contractor’s cost structure, a private sector consortium may structure their own arrangements so that all of the risk of payment reductions is transferred to subcontractors, even in cases of critical underperformance. Nevertheless, the need for the financiers to seek reimbursement from subcontractors in these circumstances will give the financiers a degree of alignment with government. In addition, the financiers will always face the risk that the sub contractor is unable, by reason of insolvency, to protect them against this risk.

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This chart shows a generalised profile of payments over the operating term of a social infrastructure PPP, such as projects in the education, health or prisons sectors.

The operating and maintenance costs typically increase over time, reflecting the impact of inflation. The operating and maintenance costs also have some peaks in particular years, reflecting the cost of replacing major pieces of plant and equipment. These factors result in changes to the proportions of the various components of the contractor’s cost structure over the life of the PPP. This must be considered in calibrating the payment mechanism.

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Social infrastructure has high operating and maintenance costs relative to its capital costs. This creates some challenges in calibrating the payment mechanism in social infrastructurePPPs.

If the payment mechanism is calibrated to provide strong incentives for the operations and maintenance sub-contractor to respond to minor performance failures, more serious performance failures may result in disproportionately high losses for financiers.

The financiers will seek to push this risk back onto the sub-contractor, which may result in the sub-contractor charging an excessive risk premium, responding in an adversarial manner to performance issues, or ceasing to be a sustainable service provider.

Alternatively, if the subcontractor is unable to bear this high level of risk, financiers may be unwilling to participate in the project – the project will be “unbankable”.

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This chart shows a generalised profile of payments over the operating term of a capital intensive PPP, such as projects in the roads sector.

As is the case with social infrastructure, the operating and maintenance costs typically increase over time and have some peaks in particular years, reflecting the cost of major maintenance activities (such as resurfacing the road ). However, as the capital cost of projects in sectors such as roads are so high, relative to the ongoing operating and maintenance costs, the split of the payments between finance related costs (equity and debt service) and operating and maintenance costs is very different to that for social infrastructure.

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PPPs in capital intensive sectors present different calibration challenges to PPPs in social infrastructure sectors. If the payment mechanism for a capital intensive project is calibrated so that it is not unduly harsh on the operations and maintenance sub-contractor in respect of minor performance failures, even very serious performance failures may only result in financiers losing a small proportion of their investment. As a result, the financiers may not be incentivised to conduct robust due diligence on the project and ensure good sub-contractor performance.

Payment mechanisms for PPPs in capital intensive sectors therefore must be calibrated differently to those in social infrastructure sectors to ensure that there is not too much risk transfer in respect of minor under performances, but enough risk transfer in respect of serious and critical under performances.

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In summary, in setting SMART performance measures in PPP projects with government payments, the following factors must be considered:

• The PPP payment mechanism should be linked to both availability and the quality of service delivery

• The payment mechanism should be calibrated with reference to both:

• The private sector’s cost structure; and

• The impact of under-performance on the public sector.

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In some PPPs, it is necessary for government to provide guarantees to the private sector so that the project is “bankable”. This slide sets out two key forms of guarantees seen in PPP projects.

Guarantees create contingent liabilities for the government entity giving the guarantee. There should be processes in place for the government entity to monitor and report upon these liabilities.

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Documents

Notes - Asian Development Bank · The quote on this slide identifies that the launch of four PPP road projects in Kazakhstan was not successful because: • Preparations were rushed