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PPP Contract Design, Management & Monitoring Workshop

Dr Rupert Booth+974 7021 7320Rupert.Booth@atkinsglobal.com

Agenda

• PPP Route Map

• Identifying Stakeholder Expectations

• Top-Down Analysis of Risks

• Project Risk Assessment and Transfer

• Structuring the PPP

• Best Practices in Contract Design

• Contract Management

• Performance Monitoring

• Role of the PPP Unit

PPP Route Map

Decision to Consider PPP

Prepare Institutional Framework

Sector Development

Plan

Select Govt. Panel &

Consultants

Sector Stakeholder Consultation

PoliticalInitiative

SectorAnalysis

Define Policy Objectives

Project Lifecycle

PPP Project Lifecycle

Source: EPEC, Guide to Guidance

Potential Stakeholders and Interests

Source: ADB (2008), Public-Private Partnership Handbook

Mapping Stakeholder Dependencies

Source: Lahmeyer International GmbH

Engagement Model

Source: adapted from the International Association for Public Participation (IAP2) spectrum www.iap2.org (2007)

Stakeholder Interviews

• What do they want from PPP?

• What financial or political interest do they have?

• What is their immediate need?

• What is their current view of PPP, why, and is it likely to change?

• Whose opinions do they are they influence and who influences them?

• Can they can act as a Sponsor (or will they be the opposite)?

• Can they act as a Gatekeeper (and would they open the gate?)

• How can any negative attitudes be neutralized, mollified or contained?

• Does all of the above depend on key individuals (if so, who) or are they institutional characteristics?

Stakeholders set Risk Management Context

Multiple PPP Objectives

• Risk transfer

• Process excellence

• Transparency

• Private sector skills

• Public debt ratios

• Boost to economy

Perceptions become Reality

• Perceived risk (including risk of unknown) sets cost of capital

• Valuations based on expectedcash flows

• Public (mis)perception becomes actual political risk

• Perceptions can affect deal structure

e.g. GCCpriorities

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Top Down Analysis of Risks

Develop Construct Operate Exit

Political Risks•Expropriation•Change of law•Judicial challenge•Regulation (Environmental, Economics)•Reputation

Commercial Risks•Completion: Cost, Time , Quality•Availability•Demand: Price, Volume)•Supply: Availability, Cost

Financial Risks•Funding (timing)•Creditors•Currency convertibility•Currency transfer•Redeposit risks

Economic Risks•Inflation•Interest rates•Exchange rates•Devaluation•Taxes•Technological change

Sample Political Risks

Phase Risk Source Mitigation/Allocation

Development Planning consent State Prior consent, or transfer to state

Construction Residents’ opposition Community Stakeholder building

Operation Tightening labour laws

State Develop subcontracting network

Exit Tighterenvironmental legislation

State Due diligence on future legislation

Sample Commercial Risks

Phase Risk Source Mitigation

Development Land acquisitionDesign faults

Prior acquisitionEPC contractors

Stakeholder buildingContract

Construction Cost over-runsTime over-runsLabour disputes

EPC ContractorsEPC ContractorsUnions

ContractContractTerms & Conditions

Operation Asset performanceAsset availabilityLow demandSupply costs

EPC ContractorsEPC ContractorsTarget marketSuppliers

ContractContractNew buyersNew suppliers

Exit Asset damageAsset wear

VariousUsage

InsuranceAsset Management

Sample Financial Risks

Phase Risk Source Mitigation/Allocation

Development Open-ended, cash drain

Project management Project monitoring

Construction Liquidity (for overruns)

Project management Contingency funding arrangements

Operation Credit risk Creditors Guarantee

Exit Currency transfer/ convertibility

Change of law Contingency arrangements

Sample Economic Risks

Phase Risk Source Mitigation/Allocation

Development Key skill shortage Local labour Global recruitment

Construction Commodity supply Global markets Forward contracts

Operation InflationLow/negative growth

Economic cycleEconomic cycle

Forward contractsOffset with costreduction

Exit Asset valuation Economic cycle Examine timingoptions

Project Risk Assessment by Type

Business Construction Funding Delivery Revenues

New Build Finance(Investment, Refinance… )

Bulk Fee

Existing Refurbish User Tariffs

“We use terms such as privatization, divestiture, concession, lease, affermage, BOT, BOOT, ROT, BOO, ROO, DBO, RBO, DCMF, BTL, RTL, BTO, RTO, DBFO, PFI, outsourcing, delegation of services, management contract, operation and maintenance contract, service contract, operating contract, performance contract… there is no clear agreement on what these terms mean”. World Bank

Five-way Model:

Model excludes:Scope of work Design RiskAsset Handover Asset HandoverAsset Renewal Subsidies

Business

New

Benefits of:

• Defined Capex

• Ring fenced Operation

• New process design

Offset by some risks

• Data on costs & demand

Existing

Legacy risks:

• Social obligations

• Contractual (supplier, employee)

• Working practise

• Aged assets

Construction

New

Benefits:

• Appropriate design and technology

• Fewer site unknown affecting schedule and cost

Risks still include:

• Availability material, Labour, transport etc.

• Environmental unknowns

Existing

Additional risks:

• Asset conditions

• Regulations on existing works (e.g. heritage)

• Interface issues

• Site conditions (e.g. asbestos)

• Suitability of existing assets to output specification

Funding

Funding Demands

Funding required beyond project revenues, e.g.:

• Initial operating losses

• Upfront working capital

• Investment (land, project)

• Refinance debt

Funding Supply

Equity (risky, costly)

• Debt

• Senior, Subordinated, Non-Recourse

Minimize:

• cost of capital:

• fees

Delivery

Bulk

Commercial interfaces:

• Engineering, Procurement and Construction Contractor

• Operational & Maintenance Contractor

• Off take purchaser

• Input Suppliers

User

Additional scope for benefits:

• Distribution network

• Supply process, including billing & collection

Additional risk:

• Tariffs & regulation

• Social sensitivities

Revenue

Fee

• One source (e.g. local utility, authority)

• Many possible bases:

– Capacity, availability, usage

• May insulate projects company from demand risk

Tariff

• Revenue collected from customers

• Higher costs (billing) and risks (credit)

• May expose company to demand risk (unless offset by regulation)

Transfer: Role of the Public Partner

Project Risk

• Protect lenders from SPV default

• Demand/usage risk

• Construction Risk

• Technology Risk

• Sub-sovereign risk

• Policy risk

• Macroeconomic

• Residual value

Guarantees Offered

• Loan/refinancing

• Revenue/usage

• Service charge to cover debt

• Change of law/regulations

• Debt assumption on termination

• Sub-sovereign creditworthiness

Source: EPEC (2011), State Guarantees in PPPs

Financiers’ Perceptions of Risk by Phase

Pre-Operational Phases(% state very important/important)

Fitness for purpose of design, 100%

Delivery of design, 100%

Planning problems, 98%

Construction cost over-run, 98%

Planning approvals, 98%

Late delivery of design, 98%

(9 risks cited in all)

Operational Phases(% state very important/important)

Asset/service performance, 100%

Asset/service reliability, 97%

Employment laws, 93%

Security, 91%

Change in public partner requirements, 91%

Costs of latent defects in assets, 85%

(11 risks cited in all)

Source: SATER (2010), Public Private Partnership financiers’ perceptions of risk

Perceptions differ between Equity & Debt

Top Risks for Equity Providers(% state very important/important)

Risk transfer to subcontractors, 97%

Return on subord.debt/quasi equity, 91%

Target return on equity, 91%

Availability of insurance, 86%

Inflation on opex, 77%

Available insurance for construction, 74%

(9 risks cited in all)

Top Risks for Senior Debt Providers(% state very important/important)

Availability of interest rate swaps, 100%

Risk transfer to subcontractors, 97%

Availability of insurance, 91%

Interest margin on cost of debt 91%

Cover ratios, 91%

Due diligence on financial model, 88%

(13 risks cited in all)

Source: SATER (2010), Public Private Partnership financiers’ perceptions of risk

Structuring the PPP

Service Contracts

Strengths

• Low risk

• Repeated competition

• Low barrier to entry

Weaknesses

• No incentive to invest

• Poor operational integration

Features

• Outsourcing of specific service for a period (1- 3 yrs)

• Fee basis varies, e.g. fixed price, cost-plus, time/material

Management Contracts

Strengths

• Potential for efficiencygains

• Skill injection

Weaknesses

• Expansion responsibilities unclear

• Incentive payments need careful design

Features

• Handover of management control

• Private sector working capital (not fixed)

Lease & Affermage Contracts

Strengths

• Incentives for growth and efficiency

Weaknesses

• Perverse incentives for maintenance on contract end

• No capital injection

Features

• Full transfer of operating risk but not assets for a period

• Affermage based on pro-rated revenue not fixed fee

Concessions

Strengths

• Attract private finance:

– Construction

– Refurbishment

• Incentives for efficiency revenue and expansion

Weaknesses

• Complexity

• Long period (>25 yr.) and need to review

• Creation of monopoly

Features (Variable)

• Operator responsible for operations and investment

• Assets ownership typically public

BOT Contract (and variants)

Strengths

• Risk transfer between public and private

• Debt finance for new assets

Weaknesses

• Allocation of demand risk is problematic

• More expensive than public finance

Features

• Operator builds and operates assets for period

• Typically used for major greenfield investments

Best Practices in Contract Design

Focus on following areas:

• Risk Allocation

• Payment Mechanism

• Output Specification

• Flexibility & Duration

(Administration addressed later)

Initial Risk Allocation

• Guiding principles:– Allocate risk where it can be controlled and then to less risk adverse

– Distinguish control frequency and impact

• Limits to risk transfer:– Change of Law & Planning Consents

– Environmental liabilities

– Output mis-specification

– Changing public needs

– Essential services (last resort)

• Demand risk may be shared:– Capacity and usage charges, based on fixed/variable cost

– Recognise differences in short/long run cost elasticity and rising/falling demand

Payment Mechanism (‘PayMech’)

• User charges

• Usage payment

• Capacity/availability payments

• Quality/service:

– payments

– abatements

• Price reviews

• Monitoring/audit arrangements

Output Specification

1. State Authority’s objectives and constraints

2. Make explicit compliance with statutory requirements

3. Be unambiguous and concise

4. Be sufficient for bidders to estimate facilities & services

5. Make explicit bid evaluation criteria (across lifecycle)

6. Define performance measures, weights & monitoring

7. Co-ordinate design, construction and operation

8. Contain only necessary and affordable requirements

Flexibility & Duration

Flexibility

• Contract drafting

– Anticipate changes

– Cost reflective principle

– Benchmarking

• Unanticipated changes:

– Variation protocol

– Market test

– Independent assessment

• Freeze period

– Ownership& refinancing

Duration

Competitive Pressure vs. Incentive to Invest:

– Fixed term

– Endogenous (e.g. based on revenue)

• Unbundle services

– Core

– Ancillary

Contract Management

Formally begins after Financial Close, but ensure continuity with pre-Close project lifecycle

• Several Phases– Design and Construction Contract Management

– Operational Contract Management (longest and most complex)

– Post-contract Review

• Four Aspects:– Contractual

– Technical

– Financial

– Quality/Service

Codify in contract administration manual

Design and Construction Contract Management

Outputs defined in contract so Project company assumes risk but contract should allow monitoring of:

• fulfilment of contractual conditions and milestones

• conformance to schedule and standards (legal, technical, & documentary)

• use of public assets

• supervision by Independent Engineer

• raising of objections and initiating arbitration

• information necessary for financial management

Operational Contract Management

• Governance arrangements

• Measuring delivery performance

• Financial management

• Proactive risk management (discussed previously)– On-going risk register

• Manage changes– within the contract

– outside the contract

– renegotiation

• Disputes & Default

• Expiry

Governance Structures

Source: 4ps, A Guide to Contract Management

Partnership Board (Quarterly)

• Provide a strategic overview to consider and resolve long-term issues

• Ensure that the objectives of the contract are met and communicated over the full term of the contract

• Encourage an ethos of working in partnership is developed and maintained

• Ensure that the project is aligned with both parties’ business or service plans

• Agree proposed changes and efficiency targets

Source: 4ps, A Guide to Contract Management

Contract Management Board (Monthly)

• Review monitoring report

• Review payment report and agree payments due

• Identify efficiencies and necessary changes

• Record issues, e.g. compensation events, delays,

• Promote partnership working

• Ensure the Partnership Board is briefed and respond to actions

Source: 4ps, A Guide to Contract Management

Contract Team (Continuous)

Organisation Design:

• Structure, Roles, & Responsibilities

• Processes and Standard Operating Procedures

• Resources levels based on activities

• Skills and Knowledge

• Tools and Technology

Objectives:

• Identify issues early

• Produce monitoring reports and payment reports

• Resolve minor operational issues

• Discuss service provision with users and provider

• Clarify required service levels to all parties

• Promote partnership working

Measuring Contract Performance: Framework

StateVision

Department Objectives

Source: State of Victoria, Australia (Adapted)

Measuring Contract Performance: Mechanisms

• Operators to report required performance indicators and provide commentary on exceptions

• Independent audits and spot checks to verify

• Use of experts to confirm pass-through charges

• Use of consumer surveys and complaint mechanisms

• Publication of performance as permitted

• Exchange of information on costs and service levels, as permitted, with other authorities and regulators

• Engage consultants (e.g. with prior knowledge)

Financial Management Illustration:M25 Scorecard and PayMech

Safety

• Improve road user safety

• Improve road worker safety

Operations

• Maintain network

• Improve incident management

• User satisfaction

• Journey improvement

• Congestion reduction

• Network Availability

Management

• Continuous Improvement

• Management of Agreement

External

• Enhance the environment

• Technology adoption

Financial Management Illustration:Abatements

• Can be complex, e.g. London Underground

• May rise to 5%* rebate of charges and may be disclosed in financial accounts of operator, so:

– Apply with caution

– But ensure a waiver of abatement does not set precedent

* Source: State of Victoria, Australia

Change within the Contract

Variation protocols crucial:

• timescales should be defined for small changes and agreed individually for large changes;

• define funding options, if authority or company is liable, and when payment becomes due;

• define arrangements for verification of costs and retention of documentation

• define legal obligations, including intellectual property

Proactive Cost Saving Opportunities

– Audit of payment mechanism

– Examine insurance cost sharing provisions

– Increasing energy efficiency

– Review asset usage and sublet/hibernate spare capacity

– Check service specification still reflects requirements

– Benchmark cost/performance

– Consider services outside the PPP contract

– Assess benefits and costs of variation (using protocol)

Source: HMT

Change Outside the Contract

Renegotiation brings hazards:

• Uneven competitive field for re-tender

• Lenders may prevent changes that add risk to company

• Potential pass-back of risk to public, e.g. asset hand-over requirements, taking-on senior debt

• Debt-service ‘holidays’, debt-term extension, or unitary charge re-profiling can add to borrowing costs

Disputes: why they happen

Source: Service Works Intl. (2011), The Importance of Transparency & Auditability in PPPs

Cited reasons for contract dispute:

Disputes: What to Do

Be prompt and distinguish disputes of:– Fact, e.g. was the failure caused by the authority or the company?

– Legal interpretation, i.e. contract is ambiguous on requirements

Source: New South Wales Government (2008), Contract dispute resolution (Adapted)

Defaults

Defaults may be caused by:

• Failure to construct, i.e. ‘Abandonment’

• ‘Drawstop’ by lenders, i.e. stop in lending

• Insolvency of Project Company

• Service Availability Date beyond ‘backstop date’

• Non-payment of Liquidated Damages

• Abatements or (mal)Performance Points exceed threshold

• Recurrent breaches despite warning (‘Persistent Breach’)

• Breach of fundamental conditions, e.g. Insurance

However contract may continue , i.e. potential for ‘creative destruction’

Source: Yescombe (adapted)

Expiry

• Expiry: opportunity or threat?

• Plan in advance for re-tender, if required

• Supervise asset hand-back:

– Asset condition

– Documentary completeness

• Plan for supplier and employee continuity

• Prepare for discontinuities

Post-Contract Review

Prior to conducting review, define:

• Governance framework, e.g. PPP unit, national audit office, to ensure independence

• Objectives, e.g. review of policy, or types of project, or specific project

• Questions that requiring answers (to meet objectives)

• Availability of information to answer the questions

• Duration, resource and timing of review

• Form of output, e.g. report, workshop

• Level of publication

Proactive PPP Unit

• Inform future PPP policy development

• Promote use of PPPs according to current policy

• Identify potential use sector-by-sector

• Develop criteria for assessment of potential projects

• Issue guidance on design and implementation

• Act as Centre of Excellence to assist PPP project teams

Reactive Role of PPP Unit : Remedies

Source: PPIAF (2007) Gridlines

PPP Units: Some Successes

Source: PPIAF (2007) Gridlines

Summary

• Contract Management extends beyond start and expiry dates

• Context is crucial: what are the policy objectives and stakeholder requirements?

• Design contract to allocate risk and provide clear measurable output specification

• Ensure contractual compliance (of course) but obtain positive outcomes from shortfalls

• Strive to preserve partnership approach for flexibility and long-term gain