A key element in every PPP contract is the payment mechanism. The structure of the payment mechanism is the principal means for the public-sector party to allocate risks and give incentives to the private-sector party. In order to provide appropriate incentives and encourage good performance, payments are generally contingent on the project's results, not on the inputs and processes needed to deliver the service. The project's results are to be defined as output specifications in the contract.
In specifying a payment mechanism, it is desirable to meet some basic criteria. There should be simple and transparent rules linking payments to the measurable project deliverables determined in the output specification. These rules should be carefully design to provide strong and appropriate incentives for the private-sector party to perform. As discussed below, the risk allocation resulting from them is a key element in this regard. The rules should specify clearly and in detail the payments to make when performance criteria are met, and charges to deduct when they are not. Since the payment mechanism heavily affects the financial structure of the project, the rules should ensure the private-sector party is able to finance the project given the risks allocated to it, and that the public-sector party can afford the pledged payments. Otherwise, financing the project may become difficult.
To the extent that there is consistency between output specification, payment mechanism, and risk allocation, the contract design increases the likelihood that the project delivers value for money. Decisions to be taken in formulating a payment mechanism will be informed by the output specification and the project's risk assessment; similarly, the payment mechanism may also lead to further refinement of the output specification and risk assessment. As an introductory example of the interactions between these three elements, consider a standard case in the transport sector. The output specification may target lighting, signage, and road maintenance that are closely related to the quality of the service. A payment mechanism could be based on tolls paid by users and set by the private-sector party. Thus, the demand risk is fully transferred to the private partner who has strong incentives to improve service quality and availability in order to raise revenues. An alternative mechanism could be based on tolls paid by users but set by the public-sector party, who makes unitary payments to the private-sector party. Thus, the demand risk is shared by both parties. Incentives for the private-sector party to perform are given if the unitary payments are based on usage, availability, and service performance.
Case Study: The London Underground (UK) (Part II) The PPP contracts specified the improvements to be made by the Infracos on the tube assets. The output specifications required them to deliver substantial improvements in the physical conditions of trains, stations, tunnels, embankments, escalators, etc. It had been estimated that the private investment involved in the pledged works would have been three times the capital expenditure observed in the past. Building, refurbishment, and maintenance works had to be undertaken meeting a precise time schedule agreed with the Infracos. The works schedule had strict deadlines; for instance, trains should be refurbished or replaced over 15 years, stations should be refurbished over the first seven-and-a-half years of the contract, etc. Consistently with the PPP principle of letting the private partners choose how to accomplish the output specifications on the basis of their know-how and expertise, the contracts did not specify the way in which the pledged works should be undertaken. To give flexibility to LUL, the contracts set out 'specified rights' allowing LUL to require the Infracos to carry out additional works in certain areas that could not be fully contracted upon in the original contract. These rights were exercised by LUL in many occasions; for instance, Tube Lines was required to deliver an extra trailer car for every train in the Jubilee line and to extend the Piccadilly line to Heathrow Airport Terminal 5; Metronet was required to increase the number of trailer cars in the Circle line and to install air conditioning equipments on the sub-surface lines. Sources: see London Underground (Part VII). |