7.5.1 The economic characteristics and detailed design of the payment mechanism are central to the achievement of value for money. There are a large number of points of detail involved in assigning numbers to the various parts of the payment mechanism. This process is referred to as "calibration". The remainder of this section assumes an availability-based payment mechanism but the principles have wider application.
7.5.2 Authorities and their advisers should consider how to approach this issue during the procurement process, and how much input to seek from Contractors and at what point. An over-rigid approach during negotiations will reduce the scope for innovation by the bidders and so reduce the potential for best value for money to be achieved.129 However, it is normally appropriate to include a significant level of detail relatively early in the process so that the maximum benefit is taken for development while under competitive tension. Under the Competitive Dialogue procedure there is no scope for making significant alterations to the payment mechanism after completion of the dialogue (though fine tuning is still permitted). Where final calibration is still to be completed at the time of appointment of the winning bidder, the winning bidder's letter should include an obligation to recalibrate with the final details. It is essential that the process is not undermined by last-minute re-calibration following lender due diligence (as has sometimes happened in the past).
7.5.3 The Authority should understand how the various responsibilities relating to the drafting and calibration of the output specification and payment mechanism are allocated amongst its advisers, and ensure that all issues have a clear allocation of responsibility.
7.5.4 There are many variables in a payment mechanism, including the following:
• the definitions of availability and performance standards (i.e. how demanding the requirements are);
• response and rectification periods (i.e. how quickly problems have to be addressed);
• the scope (in practical terms and under the contract) for the Contractor to provide (temporary) alternative services/locations instead of having deductions applied, giving them greater flexibility to avoid deductions, or for allowing 'unavailable' facilities to continue to be used;
• levels/weightings of deductions for unavailability or poor performance;
• ratchet mechanisms for repeated or widespread failures; and
• caps on performance deductions.130
7.5.5 The degree of risk transfer depends on all of these parts; heavy deductions for poor service might not imply a harsh mechanism if the Service requirements are not overly demanding, there are long periods in which the Contractor can respond, the Contractor can provide alternative accommodation or the unavailable accommodation is likely to continue to be used with lower deductions applying. On the other hand a scheme with small cash deductions might provide strong incentives to perform and significant risk transfer if the definitions give tightly-defined high standards and the time requirements are short or ratchet up.
Calibration methodology
7.5.6 Authorities should consider the following calibration issues:
• the level of deductions should be considered in the light of the importance of the Services to the Authority (i.e. large deductions for the unavailability of important parts of the Service). The incentives on the Contractor are also important (i.e. large deductions for types of failure which could be expensive to remedy and therefore require a strong incentive);
• the Authority should determine what level of performance is required, and this should then serve as the benchmark at which 100% or close to 100% payment is achieved; and
• there are a range of approaches available to an Authority to improve its understanding of how a proposed system might work. These approaches range from consideration of a limited number of specific potential scenarios to the construction of complex models or Monte Carlo simulations. A calibration model can be used to suggest what levels of deduction might result from a given specification and payment mechanism, give an insight into the economic incentives they give rise to, and also help an Authority understand the level of contingency which a Contractor might incorporate in its price.
7.5.7 Where the Authority is seeking to simulate how the mechanism is likely to work, it might seek information from other successful projects, and also consider the use of historical data from existing services run by itself.
Standards
7.5.8 The payment mechanism should give clear economic incentives to the Contractor to perform to the required standards. Availability and performance standards should be defined to meet the requirements of the Authority, but should also be set at a realistic and achievable level to avoid unnecessary risk pricing by the Contractor and Sub-Contractors.
7.5.9 Given that a key element of the expression of the Authority's requirements in a PFI Contract is the output specification, significant parts of the output specification frequently feature in, or are linked to, the payment mechanism. The Contract will be easier to manage, and to change in the event of Contract variations, if these relationships are clearly laid out, and the role of any output specification requirements which do not feature in the payment mechanism should be challenged (or they should be brought into the payment mechanism). The use of specification requirements in the payment mechanism must be clear. Units should be provided where appropriate - for example, a requirement for maintenance to be performed, together with a deduction of £10 for service failure, requires a clear linkage in terms of how many poorly-maintained rooms, over what period, attract a single deduction of £10.
Time periods for repair/rectification
7.5.10 Time periods for repair and/or rectification are not applicable to all types of failure (for example, they do not apply to staff being recruited without required qualifications). Where a period is applicable, such as for the repair of a broken window, the Authority should ensure that repair periods are challenging but realistic, without entailing costs to a level which does not represent value for money (for example, by requiring excessive standby provision of labour and resources). An Authority might consider what resources may be available on-site and thus at short notice, and what types of problems might most cost-effectively require outside resources and thus perhaps warrant longer periods for repair. For significant problems, "rectification plans", to be agreed on a case by case basis and to include agreed rectification periods, may be used.
7.5.11 For some failures a concept of "temporary repair" can be appropriate, and some payment mechanisms make a distinction between a response period, being the time within which a temporary solution should be found (for example, a temporary window repair), and a rectification period, being the time within which the problem should be properly remedied (for example, a new window). Immediately at the start of operations, an Authority may allow slightly longer periods for "bedding in" the regime.131
"Unavailable but used"
7.5.12 The use of a definition of "unavailable but used" (see Section 8.8), dealing with the situation where the Authority wishes to continue using a facility which is technically "unavailable", can be appropriate (for example, a classroom which is needed for teaching). In some projects it will be common for elements to be unavailable but used so this can be a significant part of the regime.
Weightings
7.5.13 In many payment mechanisms the maximum notional deduction for unavailability exceeds 100% of the Unitary Charge. The maximum financial deduction is however capped at 100% of the Authority's payment (e.g. the total Unitary Charge for a given month), so the Contractor may receive zero payment before the facility becomes entirely unavailable (or when it is entirely unavailable but only for part of the period e.g. month), but should not be obliged to make payments to the Authority when notional deductions are higher than the Unitary Charge payment.132 High weightings clearly strengthen the incentive on the Contractor to perform but also increase the risk on the Contractor and may encourage higher pricing.133 134 If the weighting is too heavy, perverse incentives may arise. For example, if the Contractor is receiving zero payment for only one-quarter of service provision there is little incentive to increase to one-half service provision if payment will remain zero at that level.
7.5.14 There is little point in using weightings so low that it is cheaper overall to the Contractor to under-perform. Deductions in respect of poor performance of services need not significantly exceed the estimated cost of those services, so long as the many elements of performance are appropriately weighted. The calibration of deductions in respect of the physical fabric of a building is more complex as the causes of unavailability can vary from causes which the Contractor could fix at relatively little cost (thus requiring relatively little incentive) to wider failures requiring significant expense. Authorities should consider the overall weighting in the light of the detail of the output specification, the other variables of the mechanism and the facility/facilities in question.
7.5.15 A benchmark for standard accommodation projects is that the overall weighting of unavailability deductions should be in the range 150-200% (assuming a standard approach to the overall construction of the payment mechanism). For non-accommodation projects such as equipment projects (most of which have been in the defence sector) it is more difficult to generalise. Factors suggesting a lower level, even below 150%, include a project having a range of separate project outputs which are not interdependent (such as geographically-dispersed social housing provision or equipment projects with a number of independent and independently-useful vehicles).135 Factors suggesting a higher level within that range, or above 200%, are complexity and interdependence of outputs, for example a large hospital where a number of rooms or areas have interdependencies and each requires an appropriate deduction regime, or a training project where a piece of equipment and a classroom facility each requires the other in order for the project to deliver the desired outcome. A project which excludes soft facilities management services may require heavier weighting for failures as a percentage of the whole Unitary Charge, as the Unitary Charge will be lower through the exclusion of soft facilities management services.
7.5.16 The payment mechanism should not however be designed simply on the basis of broad economic assumptions such as these. These weighting recommendations are designed as a sense check for the regime. Performance regimes should be constructed initially from the bottom-up with weightings for the different output components designed to incentivise good performance. The aggregate figure should then be given a top-down sense check to ensure that the overall economics of the Project offer value for money.
7.5.17 Potential Contractors and Sub-Contractors will model the behaviour of the payment mechanism in order to examine the risks they will face, and base their pricing on the results (noting that for Sub-Contractors the deductions for unavailability may be regarded as of less day-to-day significance than deductions relating to the performance measurement system). Similarly, the riskiness of the Contract will affect the level of interest from funders and the terms they offer. An onerous output specification and payment mechanism may lead to higher pricing or put off credible bidders and funders. Some early regimes were over-rigorous and overcomplicated when they were constructed, and were not then fully enforced. An over-rigorous Contract combined with weak enforcement offers poor value for money. Authorities should strive to produce fair regimes and diligently enforce them. Section 8.4 (Payment for Availability and Weighting of Critical Areas) provides further comment on this area of the calibration.
Ratchet mechanisms
7.5.18 Many payment mechanisms include "ratchets" whereby a long delay in fixing a problem, or its repeated recurrence, or its widespread occurrence in a number of areas across a project, leads to higher deductions. Ratchets help ensure that systematic problems are properly dealt with. See further Section 9.5 (Consequences of Poor Performance). The use of ratchets should be considered carefully: a low initial deduction together with a ratchet may simply encourage a reactive rather than pro- active approach to performance management, but on the other hand, without ratchets the incentives may not be effective (for example it may turn out that without a ratchet the deduction is not heavy enough to give an economic incentive to good performance). Ratchets are likely to be useful in most payment mechanisms.136
Performance deduction caps
7.5.19 In some sectors it is common for there to be a cap on the amount of deductions which can be made in respect of poor performance.137 The Sub-Contractor's maximum exposure in any year may be limited to receiving zero payment from the Contractor (i.e. they may lose all their income but they do not reimburse the Contractor for deductions which exceed their fee but are due to their failings as a Sub-Contractor). The risk of additional availability deductions then stays with the Contractor. It is important for the Authority always to preserve the principle of no-service no-fee and in an availability-based payment mechanism there should be no payment if the facility is unavailable. The capping of deductions for poor performance of Services may be acceptable if the Authority considers that there is little further benefit from further performance deductions which cannot be either passed down or absorbed by the Contractor on a value for money basis. However, any cap should not be used simply to insulate equity investors from risk. In any event, if a Sub-Contractor is losing a significant portion of its fee for poor performance it is likely to be in default of its own Sub-Contract and the Contractor has a clear motive to replace it before it puts the availability of the facilities and hence the full Unitary Charge at risk. Authorities should ensure that the Contractor is incentivised to manage Sub-Contractors effectively, and should not concede a cap on deductions without advice from their advisers. Any performance deduction cap must always be justified on value for money grounds.
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129 In establishing a suitable system, the Authority should be aware of the effects a particular system has on the solution offered by a bidder. For example, a bid solution that is capital intensive up-front with reduced life-cycle costs may have one optimum approach and one with lower initial costs but higher life cycle costs another, because the financial structure of the Contractor will be different. It is crucial for the Authority to understand what system will best achieve the result it seeks.
130 This is not a complete list of every potential feature of a payment mechanism and other features may be appropriate to particular projects.
131 Some projects also make additional allowances regarding deductions and/or termination during a bedding-in period. The use of such arrangements should be considered carefully and a balance should be struck between the reasonable expectations of the Authority and the potential for unnecessary risk-pricing.
132 Some payment mechanisms have allowed Authorities to "carry forward" any deductions greater than 100% to apply in the following period. This is unlikely to be value for money and is not recommended. The scope for retrospective deductions (where the Authority later discovers a performance failure has existed undetected for a period) should be subject to a cap, as the Contractor and the Senior Lenders may not have been aware of the failure and therefore not have taken steps to remedy it.
133 As an example, the Department of Health in England has in December 2006 issued guidance on performance mechanisms stating that the total notional deduction should not exceed 200%, having previously seen much larger maximum deductions in some projects (e.g. 500%). There is a two-stage approach in the standard health payment mechanism, with the Project being split into "Functional Areas" each comprising of a number of "Functional Units". The unavailability of all Functional Areas can provide a maximum notional deduction of 200%, capped at a 100% actual deduction. The unavailability of all Functional Units in one Functional Area could provide a notional deduction of 150% for that area, again with a 100% actual deductions cap. Therefore, if two-thirds of the units in one area were unavailable, there would be zero payment for that area. If this occurred in half the areas, the Unitary Charge payment would be zero.
134 Another example is the standard BSF calibration guidance, which states that the weighting should be in the region 100-200%. For housing projects it tends to be at the lower end e.g. 100%.
135 Thus a lack of inter-connectedness, from the perspective of the utility of a facility, suggests a lower impact on the Authority of a single element being unavailable. Note that this is not the only driver of weighting - the deductions must still suffice to incentivise the Contractor. At the same time, if the elements are independent from the perspective of the service provider, there can be a "portfolio effect" meaning that a higher weighting might be tolerable by the Contractor. For example, in a street lighting project the Contractor can plan and price for the risks of individual lanterns being damaged in accidents in a sophisticated way, and might tolerate a higher weighting because the chance of substantial numbers of accidents is low. If greater risk transfer can be achieved with relatively little cost impact then in principle that should be pursued.
136 The ratchet should be triggered by repeated performance failures even if they had different causes.
137 For example the standard BSF payment mechanism uses a cap set at a level equating to the value of Services (as opposed to capital works), including soft facilities management, insurance costs and Contractor administration costs. This cap does not apply to deductions for unavailability.