7.4.1 An alternative to availability-based payment is for the level of the Unitary Charge to be determined by usage (also referred to as 'volume' or 'demand'), or to combine these approaches within a single payment mechanism. The early road projects relied on usage payments (where payment was based on a shadow toll - payable by the Highways Agency).122 Normally, where usage is relevant the Unitary Charge is only partly dependent on usage (for example, some waste projects). Payments linked to usage can bring advantages when the Contractor's performance can influence the level of usage, since customers can "vote with their feet" on the availability and quality of the Service; in this way payment will be linked to performance through this automatic feedback.
7.4.2 It is important to differentiate between regimes where the Unitary Charge itself (payable by the Authority) is adjustable by reference to usage, and regimes where the Unitary Charge is based on availability and performance principles, but the Contractor separately takes the risk on the amount of "third party revenue" which can be generated from the facilities (and in respect of which the Authority may seek some gain share). Third party revenue may range from relatively small amounts, e.g. on schools projects, to larger amounts which may be generated on light rail,123 waste124 or housing125 projects. Third party revenue may be derived from the core service or peripheral activities such as a canteen or car-parking, and can exist alongside a predominantly availability-based payment mechanism.
7.4.3 Third party revenue should be assessed as part of the value for money evaluation of the proposed structure as a whole; if it provides a benefit to the Contractor this should in principle reduce the required return from other activities. The Unitary Charge may be reduced as a result of Contractor access to third party revenue, with a revenue-sharing arrangement for revenue above the amount assumed in the Unitary Charge reduction. The value for money benefit of allowing third party revenue to fall to the Contractor will depend on the Contractor's ability to forecast and influence it (and Authorities should be wary of over-optimistic assumptions on these points). In many projects the scope for recognising significant third party revenue in the financial model, and thus reducing the Unitary Charge, is limited as the demand is difficult to predict; in these cases upside sharing is particularly important.
7.4.4 In some projects (for example training projects) a measure of usage risk may be transferred such that profitability is only affected at the margins. Where there is a mixture of availability and volume-based principles, some "take-or-pay" minimum volume amounts may be used. Authorities must ensure that these structures do not mutate into structures which simply ring-fence senior debt, since underwriting any significant part of the Contractor's costs, such as senior debt, is contrary to basic PFI risk transfer principles.126 Where take-or-pay arrangements exist, the mechanics of availability are likely still to be required, since the Authority should not pay for the minimum level of usage where the facilities are unavailable. Take-or-pay principles should not protect payment streams where Services are unavailable because of Relief Events, Force Majeure events or Contractor failures.
7.4.5 In some circumstances performance regimes which are dependent on levels of usage may not in fact transfer true usage risk to the Contractor. This is the case where the increase in payments corresponding with an additional unit being used is equal to the marginal cost to the Contractor of providing the unit. For example, where an extra tonne of waste will cost a Contractor an extra £10 to process, increasing the payment by £10 per tonne will not affect the Contractor's profitability.127
7.4.6 The factors which determine whether it is value for money to transfer usage risk tend to be project-specific or sector-specific, and the transfer of usage risk has in practice tended to focus on certain sectors, e.g. roads, leisure centres. Genuine transfer of all usage risk to the Contractor, making its profit (i.e. revenue less costs) dependent on usage, is rarely appropriate and should only be considered in cases where the Contractor can forecast and influence future usage. Usage risk transfer may be appropriate where the Contractor is satisfied with predictions of the level of demand for the Service, or where reductions in Authority usage can be offset by third party revenue. A part of usage risk can be transferred in some cases, but many Projects cannot transfer any usage risk, even where services such as catering facilities are being provided. Transferring usage risk in inappropriate cases is likely to result in poor value for money. Senior Lenders tend to have strong concerns over the transfer of usage risk, and "take-or-pay" or other devices such as a reduction in gearing or increase in lender protection ratios may be required.
Evaluation and other implications of transferring usage risk
7.4.7 Where the Unitary Charge is sensitive to usage or there is third party revenue, bid evaluation (i.e. in terms of the potential costs of alternative proposals) is made more complex. Moreover it may be difficult to predict the likely level of termination payments which would result should the Project in due course be terminated. From the perspective of flexibility for the Authority, this is particularly relevant to Authority voluntary termination (where equity investors look for some compensation for their lost opportunity to make returns from future revenues). Areas of the Contract which may require special attention where volume-based payments are significant are Compensation Events, Qualifying Change in Law, Authority Step-in, Authority change in Service, Force Majeure, the setting of the Threshold Equity IRR in the refinancing Clauses, and the various different termination scenarios. The basis for compensation may vary according to the type of event leading up to loss and whether the compensation has any sensitivity to future revenue expectations.128 For example, following Qualifying Change of Law and in other no-fault scenarios the appropriate measure should be the lower of base case (i.e. the original forecasts) and actual usage levels, and Authorities may also wish to seek to apply this principle to compensation on termination for Contractor Default where there is no liquid market and/or Authority voluntary termination.
7.4.8 The volume of usage (demand) risk is, where the risk is material, the key determinant of the accounting treatment of the underlying asset. Authorities should consider, as part of their Business Case prior to commencing procurement, the likely materiality of demand risk, and the allocation of it. Where they have a high level of certainty in the need for the asset, and the volume of usage in relation to it (for example, the number of pupils expected to attend a school, or the throughput of a hospital, over a number of years ahead) is predictable, Authorities may often demonstrate that the risk in relation to demand is immaterial. As transfer of usage risk is rarely appropriate, as described above, Authorities should generally retain this risk but, it will commonly be immaterial for the reasons described. Where this is not the case, and the Authority is planning to retain material demand risk, Authorities should consult SIB prior to commencing procurement to ensure that the accounting implications are appreciated.
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122 The Highways Agency and Roads Service in Northern Ireland now in most cases uses an availability-based mechanism, since the Contractor is not able to control demand, neither is demand clearly linked to the level of service.
123 Light rail projects in England have to date tended to pass the fare box revenue to the Contractor, although in practice the level may only suffice to cover operational costs.
124 Waste projects can include a range of sources of third party revenue, including sales of electricity generated from 'energy from waste' plants, sale of excess capacity to users other than the Authority, and sale of recyclates (products from a recycling process which can be used in industrial or agricultural processes, for example). See "Standardisation of Waste Management PFI Contracts: Guidance on SoPC Derogations", May 2006, from the Department for Environment Food and Rural Affairs for further details.
125 Non-Housing Revenue Account housing projects in England to date tend to involve the rental income as part of the Contractor's revenue; this is in effect third party revenue and a transfer of usage risk.
126 In certain circumstances, however, underpinning an element of Senior Debt may offer value for money, but HMT approval must always be obtained for any such scheme.
127 Authorities should also consider their approach to energy usage. For energy usage the general principle is for the Authority to take pricing risk and the Contractor to take volume risk since this is largely dependent on design. However, the Authority therefore has an interest in the price so the selection of service provider should not be entirely for the Contractor, moreover the Authority may have greater purchasing power than the Contractor. On the other hand the Contractor may not be entirely in control of volume and in any event it may not be value for money to ask the Contractor to price volume over a long period of time. One approach, which has been developed in detail by the Department of Health in England, is to derive a mechanism for generating a central volume expectation, and pay the Contractor on the basis of that volume with a sharing mechanism should volume be lower or greater than that central expectation. This is also an important element of street lighting contracts which have developed in England, and the street lighting standard form has detailed provisions whereby an electricity charge is usually paid by the Authority to the Contractor in addition to the Unitary Charge (and can be as large as the Unitary Charge). Detailed provisions have been developed to deal with, for example, savings derived from technological advances.
128 See Section 21 (Early Termination). In the case of third party revenue and the termination of the Project, the facility may continue to be operated by the Authority and this may mean that the Authority's exposure to higher-than-expected costs of termination is offset by higher-than-expected future revenue.