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Sector: State Highway  |  Module 2: Work through the PPP process

Other issues related to contract management

Contract amendment

No contract can accurately predict how the costs of PPP projects and the demand for their services will develop over long periods of time. There will be a need for a mechanism to review some of the contract terms, in particular the allowed tariffs and user charges, and to amend these if necessary.

The main principle for amending PPP contracts is the need to maintain the balance of risk and reward between service users, the private concessionaire and the public sector Sponsor.

Contract amendments should be fair to both parties to the contract. They should recognise the need for certainty in contract terms.
The private sector will tender for PPP projects on the basis of their own forecasts of the project’s costs and demand for its services. In general, the selected private partner should bear the risk that these forecasts are wrong, and be allowed to earn an appropriate return on their investment given these risks.

However, the private sector should not be expected to bear risks that are outside their control and that are large enough to severely affect the profitability of the PPP project. If this was required, private sector bidders would increase the return they require on their investment to levels that are financially and politically unacceptable. Contracts should therefore include provision for reviews and amendment, in a manner fair to both parties.

Examples of the risks that should be managed by contract reviews include:

  • The impacts of major macro-economic shocks such as a financial crisis, which can lead to large changes in income growth, interest rates and exchange rates
  • Increases in costs as a result of delays caused by the public sector such as failures to provide permits in a timely manner, to carry out obligations such as resettlements or to allow the implementation of contract provisions
  • Changes in law or other legal requirements which significantly increase the costs of the PPP
  • Uncertainties over future costs due to a lack of information on the level and condition of existing infrastructure and the need for rehabilitation and new investment
  • Errors in forecasting the demand for infrastructure services due to inadequate information on existing demand levels and how demand responds to changes in user charges and income

Reviews of certain contract terms also need to recognise the need to protect users of the services provided by the PPP. It is often the case, particularly where PPP experience is limited, that the public sector will underestimate the efficiency improvements that the private sector can achieve, and therefore overstate expected costs. If this is the case then user charges may come to greatly exceed the actual costs of the concessionaire. Such a situation may be unsustainable in the long-term. If user charges consistently exceed costs, then public pressure can force contract changes or even contract termination in an arbitrary manner if there is no review mechanism allowing the resetting of allowed user charges closer to actual costs.

Types of Contract Amendment

Two types of contract amendments are common:

  • Extraordinary Reviews - All contracts need to include provisions for contract amendment in response to changes in circumstances that were not expected at the time of contract signature.
  • Regular Reviews - There may also be provisions in some PPP contracts for reviews of particular elements of the contract at predetermined intervals and in accordance with principles set out in the contract.
Extraordinary reviews

Extraordinary reviews take place when there is a major change in the costs of or demand for a PPP project resulting from factors outside the control of the concessionaire, and involve amendments to the contract to restore its previous balance.

All PPP contracts should include provision for extraordinary reviews. The PPP contract will set out the triggers to initiate an extraordinary review. These may include:

  • A defined list of changes in circumstances, such as changes in law
  • A change in costs exceeding a predetermined level, such as 10% of annual revenues under the PPP
  • At the agreement of both partners

If user charges need to be adjusted, the change should generally be made over the remaining life of the PPP rather than through a large one-off adjustment. This will ease the transition to the new charges and increase their predictability, while allowing the concessionaire to recover the present value of the change in costs during the rest of the PPP.

Regular reviews

Regular reviews take place at preset intervals of three or more years, and involve the resetting of user charges to better match the efficient costs of providing the infrastructure services under the contract. These will only apply to a limited set of PPPs.

Regular review of PPP contracts should provide investors with comfort that they will be allowed reasonable returns and for the principles governing such reviews to be included in the PPP contract itself.

The use of regular reviews is best limited to those PPPs where the nature of the service provided and the lack of certainties over the cost of this service expose users and investors to significant risks. These will generally be those that:

  • Are most ‘visible’ to service users, and so public pressure for amendment is most likely. These will be PPPs where users pay charges directly to the private sector contractor.
  • Involve the provision of a monopoly service, so that users do not have the alternative of switching supplier and so there are no competitive pressures on the concessionaire to reduce prices to its match costs.
  • Involve the greatest scope for improvements in the efficiency of operations and where operating costs form a large part of total costs. Unlike capital investments, operating costs are ongoing. Therefore, reductions in costs below user charges will be more visible and persistent and pressure for change will be greater.
  • Cover a range of services rather than a single asset. It is easier to forecast the costs associated with a single asset, such as a water treatment plant, and to construct appropriate cost indices than it is for the provision of a range of services, for example, a water distributor. For a single asset there is, therefore, a smaller likelihood that user charges and efficient costs will significantly deviate.
  • Are large-scale, so that the costs of doing regular reviews are only a small part of the total costs of the PPP and of user charges. For smaller PPPs, the costs of regular reviews, both direct and in the form of increased risk to private sector contractors, may well exceed any resulting benefits to service users.

Regular reviews should be held at pre-determined intervals over the life of the contract. The period between each review should be a minimum of three years and, in most cases, should be longer. Longer periods reduce risks for private sector concessionaires, enhance stability in user charges and increase the incentives for contractors to reduce costs—the benefits of which can be passed through to consumers at the next regular review.

 

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