The Contractor will bid a Unitary Charge for the entire Contract term, based on forecast costs and returns. Whilst some of the Contractor's costs are fixed in nominal terms (principally the cost of servicing the debt raised to fund the construction and project development costs) other costs, including sub-contracted operational costs, may vary over time relative to the level forecast. The variation may arise either because:
• The duration of the sub-contract is less than the length of the Contract and hence will have to be renewed and re-priced at some stage; or
• The sub-contractor is unable to offer a fixed price for the duration of the Contract because its underlying costs (such as labour costs) cannot be fixed for such a long period.
Whilst indexation of the Unitary Charge to reflect general inflation partially addresses the issue there is still a risk that operating costs change in real terms (i.e. change at a rate different to that reflected in the general index). Given the disproportionate cost of fixing operating costs in real terms over a long-term contract it is usually in the interests of both the Authority and the Contractor to set out provisions for varying the Unitary Charge when underlying costs have changed in real terms due to certain specified circumstances.
The Contractor should always be incentivised to control its costs, but if there are mechanisms for adjusting the Unitary Charge to reflect changes in costs outside of the Contractor's control then the Contractor will not have to make provision for this risk in its bid price.
Whilst the Authority should ensure that it obtains a competitive price by holding a well-run competition, it will take additional comfort if there is some means of ensuring the price it has agreed to pay in future years is based on underlying costs not in excess of the market prices for such services.
There are three main contractual mechanisms by which real changes in underlying costs can be reflected in an adjustment to the Unitary Charge, including:
• Specific indexation arrangements;
• Benchmarking and market testing; and
The Contract must achieve the right balance between the provisions for change in law, indexation and any benchmarking and market testing arrangements, as these are inherently interrelated, particularly in relation to the allocation of operating cost risk. For example, if indexation is based on the Retail Prices Index (RPI), the Contractor must either bear any cost increases in excess of RPI, or pass these costs to sub-contractors either directly or by managing them (e.g. through market testing). In addition, a Contractor will be more willing to take risk in relation to certain changes in law
if they have some protection through the benchmarking or market testing provisions. The Authority should ensure that it considers such inter-relationships in negotiating its Contract. Further guidance is provided in Section 15 of SoPC4.