19.7.1 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. Effective calibration should prevent high levels of deductions from being applied when overall performance is actually good. Equally even a high performing Contractor may still incur deductions from time to time. This should be seen in the context of the overall quality of service over a reasonable period of time rather than a trigger for immediate intervention by the Authority.
19.7.2 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.19 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). Final calibration should be completed before the appointment of the Preferred Bidder, and the Preferred Bidder's letter should include a commitment not to seek a recalibration following their appointment as Preferred Bidder.
19.7.3 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.
19.7.4 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.
19.7.5 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
19.7.6 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 level of performance required, to justify a 100% payment;
• the level of performance at which no payment is justified; and
• to improve its understanding of how a proposed payment mechanism might work the Authority should always arrange for the construction of a model. The model can then be used to calculate what levels of deduction might result from any given scenario, Such a model also gives an insight into the economic incentives on the Contractor and helps the Authority understand the Contractor's position
• the frequency of measurement. A standard that can only be measured once a year (such as submission of an annual report) should attract a higher deduction than one that could be failed many times in one day.
19.7.7 Where the Authority is seeking to assess how likely it is that any particular scenario might arise it should consider seeking information from other successful projects, and also consider whether it has access to any historical data from existing services run by itself.
19.7.8 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.
19.7.9 Given that a key element of the expression of the Authority's requirements in a PF2 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
19.7.10 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.
19.7.11 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).
"Unavailable but Used"
19.7.12 The use of a definition of "unavailable but used" (see Section 19.5.8 (Service Unavailable but Used)), dealing with the situation where the Authority wishes to continue using a facility which is "unavailable" according to the contractual definition, 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. Typically the deduction is 50% of the full unavailability deduction.
"Consequential Unavailability"
19.7.13 It is sometimes appropriate for the unavailability of one element of the Facilities to automatically lead to the unavailability of another element that relies on it; i.e. a Sports Hall is of limited use for Sports if the Changing Rooms are out of action, likewise control rooms for Music or media rooms, However the link should be contingent on the practicalities of the use - i.e. a Sports Hall being used for exams might be available - even though there are no changing rooms, but if it was needed for sports it is unavailable.
"Weightings"
19.7.14 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.20 High weightings clearly strengthen the incentive on the Contractor to perform but also increase the risk on the Contractor and may encourage higher pricing. 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.
19.7.15 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 the Service need not significantly exceed the estimated cost of the Service, 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.
19.7.16 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).21 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. Any projects which include soft facilities management services may require lower weighting for failures as a percentage of the whole Unitary Charge, as the Unitary Charge will be higher due to the inclusion of soft facilities management services.
19.7.17 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.
19.7.18 Calibration should take account of the commercial structure used by the Contractor to provide the Services. Even for poor performance, the calibrated level of deduction should allow for the reality that the contractor still needs to pay staff and sub-contractors. If the deduction exceeds his profit, then the viability of his performance may be threatened and performance may actually get worse rather than better. One way of addressing this is to take account of a typical level of profitability when calibrating. A good Contractor should still be able to generate a profit (albeit reduced) whilst a poor Contractor may generate no profit, but still be able to pay his staff and contractors. It is better to address constant or repeated poor performance though the ratchet mechanism, warning notices and termination triggers which may be more effective measures. It is also helpful to understand that it is common for the payment mechanism to be cascaded through the supply chain, with an element of 'tightening' of the requirement, trigger point etc. This is to allow each layer time to react when the layer below fails a measure - thus the FM Sub-contractor will have a tighter termination trigger than the FM service provider which in turn will have a tighter trigger than the Contractor.
19.7.19 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 payment mechanisms were over-rigorous and overcomplicated when they were constructed, and were not then fully enforced. An over-rigorous payment mechanism combined with weak enforcement offers poor value for money. Authorities should aim to produce fair regimes and diligently enforce them.
Ratchet mechanisms
19.7.20 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 19.6.3 (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.22
Performance deduction caps
19.7.21 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.23 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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19 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.
20 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.
21 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.
22 The ratchet should be triggered by repeated performance failures even if they had different causes.
23 For example the standard Priority Schools Building Programme payment mechanism uses a cap set at a level equating to the value of Services (as opposed to capital works), including hard facilities management, insurance costs and Contractor administration costs. This cap does not apply to deductions for unavailability