19.4.1 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. For example in waste PF2 projects part of the unitary charge is based on a payment per tonne of waste by the Authority).7 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.
19.4.2 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,8 waste9 or housing10 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. In general incidental third party revenue in schools projects should be retained by the school unless additional facilities (e.g. sports facilities) have been added by the Contractor solely on the basis of the third party revenue.
19.4.3 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.
19.4.4 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 always assess whether these structures effectively ring-fence senior debt, since underwriting any significant part of the senior debt, should only be done where it results in better value for money through a reduction in the cost of that debt.11 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.
19.4.5 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.
Other implications of transferring usage risk
19.4.6 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 or where there are exceptionally high levels of third party income (as in waste treatment contracts)12 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 the loss and whether the compensation has any sensitivity to future revenue expectations.13 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.
19.4.7 Where the usage (demand) risk is material, it is the key determinant of the accounting treatment of the underlying asset. Authorities should consider the likely level of demand risk and the risk allocation, as part of their business case prior to commencing procurement. 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 their Private Finance Unit prior to commencing procurement.
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7 The Highways Agency 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.
8 Light rail projects 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.
9 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 "Residual Waste Treatment Contract", November 2010, from the Waste Infrastructure Delivery Programme at Department for Environment Food and Rural Affairs for further details. This is available on the Defra website at: http://archive.defra.gov.uk/environment/waste/localauth/funding/pfi/widp-contract.htm.
10 Some housing projects 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.
11 If an authority considers that underpinning an element of Senior Debt may offer value for money, it should seek HMT approval before agreeing any such scheme.
12 See "Residual Waste Treatment Contract", November 2010, from the Waste Infrastructure Delivery Programme at Department for Environment Food and Rural Affairs for further details see http://archive.defra.gov.uk/environment/waste/localauth/funding/pfi/widp-contract.htm.
13 See Section 23 (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 highe than-expected future revenue.