5.2.3.1 The Unitary Charge may need to be adjusted if the Compensation Event concerned involves an additional cost or a time delay which has cost or loss of revenue implications. The Contract must contain an appropriate method for dealing with any changes that arise as a result of a Compensation Event. Section 5.2.3.3 below sets out the required drafting. The treatment of issues here is equally applicable to costs arising as a result of an Authority change (see Section 13.2 (A Typology of Changes) and a Qualifying Change in Law (see Section 14.8 (General Change in Law as a Shared Risk)).
5.2.3.2 One common way of dealing with such events is to rely on the financial model to deal with the issue and for both parties to use this to calculate how and when compensation should be paid. Typically this would require the Authority to agree that the senior debt loan life cover ratio77 and equity return are to remain unchanged. Whilst there is no objection in principle to the parties referring to a financial model (provided both parties fully understand all of its various aspects), there are three principal problems that can arise in using a financial model to calculate compensation payable for Compensation Events (and for that matter the effects of an Authority change in Service (see Section 13.2 (A Typology of Changes)) and Qualifying Changes in Law (see Section 14.8 (General Change in Law as a Shared Risk)):
• the financial model may obscure the process being followed in reaching the answer, unless there is clarity on all sides on how the relevant formulae used in the model work. For example, if something has happened which was not originally modelled for and audited, there could be conflict arising on how to model it, which could impact on the calculation concerned;
• if the Authority has access to a financial model in sufficient detail and to all of the internal costs, returns and other assumptions (to the level of detail required), then more information than is relevant simply to value the consequences of the event may have to be provided by the Contractor, which may not be acceptable to it (and, in addition, certain of the assumptions may need to be updated); and
• the result of preserving the ratios and equity return can be achieved in a number of different ways (these are referred to in Section 5.2.3.4).
The guidance requires that as simple an approach as possible is followed as the only concern of this Section is to ensure fair compensation for a limited number of events which can be calculated in a straightforward manner. If the Unitary Charge is to change, then financial advice is likely to be needed.
5.2.3.3 The approach taken in the drafting to the various events that may lead to a change in the Unitary Charge is as follows:
• if the event concerned requires Capital Expenditure (whether before or during the Service Period), then in most cases, it will be more practicable to deal with this by a lump sum reimbursement (subject of course to the possibility of staged payments)78 (see Clause 5.2(c)(ii)); and
• if the event concerned requires a change in operating costs, then an alteration in the Unitary Charge is the appropriate means of payment (see Clause 5.2(c)(iii)).
Although the issue is dealt with in this way in the drafting, it is important to stress that for Authority breach it is also perfectly acceptable for the Authority simply to reimburse the Contractor on the basis of costs incurred (for example, as a result of any delay in giving an approval).
5.2.3.4 The approach referred to in the drafting and Section 5.2.3.3 ensures that a minimum of additional financing costs are incurred. Other reasons, including affordability constraints may, however, mean that an Authority wishes to reserve the right to ask the Contractor to use reasonable endeavours to finance the event where Capital Expenditure is required. If this is done79 then careful scrutiny of the value for money implications should be undertaken.
5.2.3.5 Where the compensation involves an increased obligation to incur Capital Expenditure, other possibilities80 to that referred to in the drafting and Section 5.2.3.3 include:
• a lump sum payment from the Authority paid immediately on Service Commencement, the amount payable to exceed the amount of the relevant increase in Capital Expenditure by any incremental increase in financing costs consequent on a more rapid drawdown of Senior Debt and/or Junior Debt than originally anticipated and the agreed costs incurred in arranging any such financing;
• an adjustment to the Unitary Charge to take account of the Contractor's additional funding outstanding for the event concerned. This adjustment would reflect the actual terms and conditions of the funding, which would have been agreed between the parties at the outset, and be applied on the basis that the financiers are no worse and no better off, from the perspective of risk and return, then they would have been had the increase in Capital Expenditure not arisen. As stated above, in practice this generally means that an increase is made to the Unitary Charge (over the term of amortisation of the additional dedicated funding) to restore the senior debt loan life cover ratio and equity return to their values had the additional funding not been required. This calculation can only be made by using the financial model (as to which see Section 5.2.3.2 above). The Authority should not seek a grace period on paying higher Unitary Charge even if this would satisfy the senior debt loan life cover ratio and equity return (as this could cause inappropriate distortion to the cash flow profile); or
• particularly if the Authority cannot afford to pay compensation in the form of a lump sum but wishes to avoid having to use a financial model, it may offer to pay a supplementary Unitary Charge over a period of its choosing as an annuity equivalent of the Capital Expenditure. If this approach is adopted, the discussion can be reduced to a single issue, namely the annuity rate to be applied. In this case, the Authority need not be concerned with how and at what cost the Contractor has arranged additional dedicated funding, if any.81
5.2.3.6 If the event concerned involves a Capital Expenditure reduction (e.g. cancellation of a wing of a building), this would involve:
• a reduction in Unitary Charge. The size of reduction will depend upon not only savings in Capital Expenditure but also consequent savings in finance and operating costs. The decision on whether or not to cancel any excess committed finance prior to project completion (if this is possible with the financing structure concerned) will be taken jointly with the Contractor and its financiers. The concept of lump sum payment (or refund), whether single or by instalment, does not arise as a possibility in this context.
• there are two alternative approaches to determining the appropriate reduction in Unitary Charge: either to use the financial model (see Section 5.2.3.2 above); or to determine the annuity equivalent reduction. With an annuity equivalent reduction the term of the annuity should be the term of the Contract, unless the parties otherwise agree.
5.2.3.7 If the compensation arises only because of a change in operating costs then appropriate changes in the Unitary Charge should be by negotiation and may be possible without reference to the financial model, even where the impact on operating costs is periodic or irregular over time. The change in Unitary Charge should be made at the time of the Compensation Event to reflect forecast operating costs changes, as to amount and timing. The use of lump sum compensation payments or annuity equivalents are also inappropriate for changes in operating costs.
As many of the above issues have complicated financial consequences, financial advisers should be consulted as to the most appropriate approach for a particular project.
5.2.3.8 In any event, (even if this approach is taken in relation to Authority changes and Qualifying Changes in Law) it is not appropriate in any circumstances for breach by the Authority of its obligations to give rise to an obligation on the Contractor to finance any Capital Expenditure consequences.82
5.2.3.9 In assessing the consequences of a Compensation Event, other causes of delays to the Service Commencement Date will be relevant as to whether the Contractor will receive relief from its obligations and/or compensation. The Contractor's losses should be calculated as accurately as possible at the time and payment made as appropriate.
Required drafting is as follows:
5.2 Delays in Service Commencement Due to a Compensation Event
(a) If, on or before the Service Commencement Date,83 as a direct result of the occurrence of a Compensation Event:84
(i) the Contractor is unable to achieve Service Commencement on or before the Planned Service Commencement Date, or, following the Planned Service Commencement Date, the Long Stop Date;
(ii) the Contractor is unable to comply with its obligations under this Contract; and/or
(iii) the Contractor incurs costs or loses revenue,85
then the Contractor is entitled to apply for relief from its obligations and/or claim compensation under this Contract.
(b) Subject to sub clause (d) below, to obtain relief and/or claim compensation the Contractor must:
(i) as soon as practicable, and in any event within [21] days after it became aware that the Compensation Event has caused or is likely to cause delay, breach of an obligation under this Contract and/or the Contractor to incur costs or lose revenue, give to the Authority a notice of its claim for an extension of time for Service Commencement, payment of compensation and/or relief from its obligations under the Contract;
(ii) within [14] days of receipt by the Authority of the notice referred to in paragraph (b)(i) above, give full details86 of the Compensation Event and the extension of time and/or any Estimated Change in Project Costs and/or loss of revenue claimed;87 and
(iii) demonstrate to the reasonable satisfaction of the Authority that:
(A) the Compensation Event was the direct cause of the Estimated Change in Project Costs and/or loss of revenue and/or any delay in the achievement of the Planned Service Commencement Date and/or breach of the Contractor's obligations under this Contract; or, following the Planned Service Commencement Date, delay in achieving Service Commencement before the Long Stop Date; and
(B) the Estimated Change in Project Costs and/or loss of revenue, time lost, and/or relief from the obligations under the Contract claimed, could not reasonably be expected to be mitigated or recovered by the Contractor acting in accordance with good industry practice.88
(c) In the event that the Contractor has complied with its obligations under paragraph (b) above, then:
(i) in the case of a delay, the Planned Service Commencement Date or, following the Planned Service Commencement Date, the Long Stop Date, shall be postponed by such time as shall be reasonable for such a Compensation Event, taking into account the likely effect of delay;89
(ii) in the case of an additional cost being incurred or revenue being lost by the Contractor:
(A) on or before the Service Commencement Date; or
(B) as a result of Capital Expenditure being incurred by the Contractor at any time
the Authority shall compensate the Contractor for the actual Estimated Change in Project Costs as adjusted to reflect the actual costs reasonably incurred and, without double counting, for revenue actually lost (to the extent it could not reasonably have been mitigated), within [30] days of receipt of a written demand by the Contractor supported by all relevant information;90
(iii) in the case of a payment of compensation for the Estimated Change in Project Costs and/or without double counting, loss of revenue that does not result in Capital Expenditure being incurred by the Contractor referred to in paragraph (B) above but which reflects a change in the costs being incurred by the Contractor after the Service Commencement Date, the Authority shall compensate the Contractor in accordance with paragraph (f) below by an adjustment to the Unitary Charge; and/or
(iv) the Authority shall give the Contractor such relief from its obligations under the Contract, as is reasonable for such a Compensation Event.
(d) In the event that information is provided after the dates referred to in paragraph (b) above, then the Contractor shall not be entitled to any extension of time, compensation, or relief from its obligations under the Contract in respect of the period for which the information is delayed.91
(e) If the parties cannot agree the extent of any compensation, delay incurred, relief from the Contractor's obligations under the Contract, or the Authority disagrees that a Compensation Event has occurred (or as to its consequences), or that the Contractor is entitled to any relief under this Clause, the parties shall resolve the matter in accordance with Clause 28 (Dispute Resolution).
(f) Any payment of compensation referred to in paragraph (c) (iii) above shall be calculated in accordance with [Section 5.2.3 (Calculation of Compensation) above].92
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77 If this is being calculated during the Service Period and no further drawings are possible, then this is arrived at by dividing:
(a) forecast net revenues until the final maturity date of the loan (including any payments from the Authority, any business interruption insurance receipts, as well as other similar payments (such as additional shareholder contributions) that any person is obliged to pay to the Contractor), discounting back future revenues to the date of calculation (at the interest rate payable under the Senior Debt (including hedging))
by
(b) the Senior Debt outstanding (having deducted credit balances on bank accounts) on the date of calculation.
If further drawings are possible, then the above calculation will have to take into account the forecast level of Senior Debt up to the maximum committed debt.
78 Significant Authority changes are likely to be acceptable to the Contractor only if compensation is paid by the Authority, so as to match the timing of the agreed costs of the change.
79 As stated in Section 5.2.3.3 this approach should not be used for Authority breach, but will be a common option to include, for example, for Authority changes and Qualifying Changes in Law (see Sections 13 (Change in Service) and 14 (Change in Law)).
80 Particularly to avoid the time and expense of engaging advisers for what may be minor compensation sums (if this approach is used), it is recommended that the parties agree and record in the Contract the incremental impact on Unitary Charge of minor capital expenditure and operational expenditure changes.
81 If the original Unitary Charge over the chosen annuity payment period is profiled, then the supplementary Unitary Charge should similarly be profiled. Annuities being based upon nominal discount rates would be excluded from any indexation provisions of the Unitary Charge.
82 See Section 13 (Change in Service) and 14.8 (Qualifying Change in Law) which provide for the approach set out in the second bullet point to Section 5.2.3.5.
83 This provision may also be applied during the work of a construction nature (such as on an insurance reinstatement following total or partial destruction of an asset) (see Section 5.2.1.4). The concept can also be extended in respect of an Authority obligation to be performed during the Service Period, particularly if there are non-payment obligations on the Authority (again see Section 5.2.1.4). Subject to the reinstatement point, however, the principal obligations in the Service Period will be payment related and can often be dealt with through provisions dealing with interest on late payment (see Clause 30.6 (Interest on Late Payments))
84 In the event of a delay to the Planned Service Commencement Date the construction costs will most likely increase, due to a longer financing period. The Contractor is under a duty to mitigate its other costs associated with any delay (for example, by delaying recruitment, if this can be done) (see Clause 5.2(b)(iii)).
85 This loss means not only out of pocket costs but also a claim for loss of profits (including a lost completion bonus) caused directly by the Compensation Event.
86 The Authority and the Contractor may wish to specify in the Contract precisely what details are required.
87 This figure will not calculate the compensation payable, but it gives an indication of the seriousness of the breach and so what steps should be taken by way of mitigation.
88 This will depend on the industry concerned.
89 Since the Long Stop Date is linked to the Planned Service Commencement Date, where (prior to the Planned Service Commencement Date), the Planned Service Commencement Date is put back, the Long Stop Date will automatically be put back too. If the Contractor is required to pay the Authority liquidated damages for failure to achieve Service Commencement by the Planned Service Commencement Date, the Authority and its advisers should consider how the Contractor's obligation to pay will be relieved if a Compensation Event occurs after the Planned Service Commencement Date but prior to actual Service Commencement.
90 This payment can be in the form of a monthly payment as expenditure is incurred (or staged payments against milestones) and invoiced if the delay is for a significant period of time. In the event that the Authority wishes the Contractor to increase its financing to pay for the consequences of a Compensation Event (other than an Authority breach), then Section 5.2.3 (Calculation of Compensation) should be reflected.
91 Some early Contracts provide that to the extent procedures are not followed here that no extension of time, payment or relief is given. This approach should not be used for new projects.
92 Authorities should not enter into arrangements whereby after the relevant effects of the Compensation Event has been calculated there is a reconciliation if the costs are greater or lesser than those agreed or estimated.