The most obvious way to build greater flexibility into a PPP contract is to include in the contract a broad power to order variations, similar to the variation power found in most construction contracts. This power allows government to direct changes to works and services that are to be provided under the contract, on the basis that government will compensate the SPV for any additional costs or loss of revenue arising from the change.
But the law ordinarily implies a limitation of reasonableness on this power. The courts have said that extent of variations ordered must be reasonable having regard to the extent of the additional work, the time at which it is ordered, and any changes in circumstances since the date of the contract. They have also said that the changes cannot go beyond what the parties ought reasonably to have contemplated at the time the contract was signed. But like all implied terms, this implied limitation of reasonableness can be over-ridden by clear words to the contrary. If the PPP contract clearly states that the government can direct the SPV to build and/or operate a significant extension to an infrastructure facility, the courts will give effect to this. This explains why the variation power in the Canberra light rail PPP contract expressly permits the ACT Government to direct the SPV to build, operate and/or maintain all or part of an extension to Canberra light rail system. It also explains the inclusion of similar powers in the Sydney light rail PPP contract.
Having an express power to order variations of this nature only gets government so far. The real challenge for government is getting certainty and value for money on the price and other consequences of exercising the power.
Government should consider 'pre-priced variations' for changes that are likely and can be priced by tenderers during the bidding process, subject to also considering the impact that this will have on bidding costs. But pre-priced variations are only feasible if government can specify during the tender process exactly what it wants, and when it will require it. For possible future extensions of, say, a rail network, government is rarely able to provide all the details needed to obtain a fixed price for the construction, operation and maintenance of the extension during the tender process for the original PPP contract. Usually, the best it can hope to achieve is competitively tendered prices for specific elements of the extension, such as the supply of extra trains. For the remaining elements of the extension, such as the operation and maintenance of the extra trains and the extended network, pricing can only be agreed or determined once the scope of the work is settled. For these elements, all government can do is seek:
• a commitment from the SPV to negotiate the price and other consequences when government has worked out what it wants; and
• a right to have the price and other consequences determined by an independent third party if the parties can't reach agreement.
Whilst the right to have the price and other consequences determined by an independent expert seems a reasonable solution, it would be high risk for government to order a significant variation before the price is agreed or determined, as the price determined by the expert could be many millions different to what government expected. Some PPPs allow government to obtain an independent expert's determination on the price before government must finally decide whether or not to proceed, but many don't. Even if government has this right, forcing this price on the private party it is rarely an attractive pathway.
One way of injecting competitive tension into the pricing of variations is to require the SPV to competitively tender the relevant work. This occurred for stage 2 of the Gold Coast light rail project, where the SPV ran a competitive tender process for the design and construction of the extension. However, as government wanted to avoid the need for customers to change vehicles at the point where the extension will join the existing network, and didn't want to incur the expense of breaking the PPP contract to enable the operation and maintenance of the extended network to be competitively tendered, it had to negotiate terms for the operation of the extension with the incumbent operator on a sole-source basis.
As previously mentioned, the main reason why changes are difficult to implement on PPPs is the large number of parties that need to agree to the change. Government should seek to contain the ability of the debt financiers to withhold consent to variations that don't materially affect their interests. But for extensions and other variations that will materially affect the debt financiers, consent rights are inevitable. What can government do if it can't obtain the agreement or consent of a party that will be affected by such changes?
One option is for government to give itself the right to terminate the PPP contract for convenience, so that it can call for tenders for a new contract which combines the operation of the original and extended networks. But this can be an expensive right to exercise, as it typically involves paying the SPV an early termination amount sufficient to enable it to repay its debt (including the cost of unwinding interest rate hedges and the like), payout its contractors (including an amount on account of profits foregone), and provide its equity investors with their forecast return.
Another option, is for government to try to include provisions in the PPP contract that give it the right to remove the non-consenting party from the transaction. For example, government could seek the right to:
• require the SPV to replace the O&M contractor;
• buy-out non-consenting debt financiers; and/or
• buy-out the equity investors.
But these rights are difficult to obtain, even if government offers to fully compensate the party being taken out, as the knock-on consequences for those remaining in the transaction could be significant.
A better option, for infrastructure assets that are likely to be subjected to material changes during the term of a PPP contract, may be to consider an alternative, more flexible, contracting strategy for the initial project.