23.2.5.1 One question that may be asked is why compensation should be paid to the Contractor when it has failed to perform in accordance with the Contract. Under a typical service contract, not only would no compensation be paid but the non-performing party could expect the innocent party to bring claims for damages. The reason that compensation is paid is that a failure to compensate could unfairly benefit the Authority. This would be the case, for example, where a particular asset is developed to deliver a particular service and the Authority is entitled to have the asset transferred to it on a termination without compensating the Contractor for its value. The question that is then relevant is how best to assess what an appropriate level of compensation is for Contractor Default.
23.2.5.2 The amount of compensation payable on Contractor Default termination is one of the key commercial issues for all parties concerned. The market value approach described below is the required approach for all PF2 projects.
23.2.5.3 In order to understand why the market value principle has been adopted, and accepted by the PF2 market, it is helpful to understand the variety of alternatives which preceded it. These ranged from early roads projects, which provided for no compensation for Contractor Default, prisons projects, which offered no compensation for termination during the construction period, early accommodation, schools and hospital projects, which were based on a wide range of calculations usually linked during the construction period to capital costs less rectification costs and during the Service Period to the NPV of future cashflows, and some contracts which virtually guaranteed (implicitly or explicitly) full payout of Senior Debt.
23.2.5.4 The market value approach represents a balance between protecting the Authority's interests and not imposing unreasonable deductions on the Contractor for its default. It also encourages the Senior Lenders to step-in and rescue the Project instead of simply relying on the termination payment to pay their outstanding debt (see Section 26 (Funders' Direct Agreement)).
23.2.5.5 The "no compensation" models have been driven by a proper concern that, on Contractor Default, Senior Lenders should be encouraged to step-in and work the Project out. They do expose, however, the public sector to the charge that it is seeking a possible windfall gain in the event that termination occurs (e.g. if it takes over a valuable asset), although this may be refuted by the Authority agreeing to pay the market value for any assets to be transferred to it. They may also serve to increase the cost of projects to the public sector by forcing bidders to take a conservative approach to risk pricing, liquidated damages and the limits on liability they require from their Sub-Contractors.
23.2.5.6 On the other hand, calculations based on the NPV of future cashflows proved extremely complex and difficult to negotiate. In practice, they are unlikely to take full account either of the performance history of the defaulting Project (and so expectations of future performance), the extra costs accruing to the Authority over the period of the Contract or of the risk transfer to the Contractor (particularly in relation to whole life costing). Equally, if payments based on NPV calculations were sufficient to pay Senior Debt in full, the Senior Lenders would have less incentive to rescue the ailing Project. This might well result in terminations which would otherwise have been avoidable and would be to the detriment of Authorities and Contractors.