User charges

In a payment mechanism based on user charges, the private-sector party gets revenues directly through charges on private end users of the infrastructure facility. By this payment method, the public-sector party fully transfers the demand risk to the private-sector party. To the extent that users pay the corresponding fees, there is no cross-subsidy from taxpayers to users that might compromise public finances. Bearing the demand risk, the private-sector party has direct incentives to improve performance in order to encourage service usage and thus increase revenues. Moreover, it is possible to manage demand by setting a pricing rule that charges users according to usage, e.g. in the transport sector, tolls can vary by vehicle type and time of day.

If the private-sector party is able to control demand risk, it is efficient to fully transfer this risk to the private-sector party by implementing a user charge-based payment mechanism. With risk transfer, the uncertainty surrounding revenue streams and forecasts on service demand influences the cost of capital facing the project, with more uncertainty leading to a higher cost of capital. When user charges are the only source of revenue for the private-sector party, higher cost of capital calls for a higher user charge level to reimburse investments. Also, contract length may have to be increased. As explained above, risk transfer can help incentives but it comes at a cost. Therefore, demand risk plays a crucial role in determining the bankability of the project by affecting the project's cost of capital.

The link between demand risk and tariff level affects the public sector's choice regarding the payment mechanism to implement. It may happen that an excessive demand risk wipes out the project's benefits because the resulting cost-covering user charges are so large that users prefer to seek for alternative services, thus making the project unbankable. Under these circumstances, the public-sector party could modify the user charge-based payment mechanism in such a way that demand risk is not fully but partially transferred to the private-sector party. A possible modification is a payment scheme where the public sector sets tariffs and pays a revenue subvention to complement the fees collected by the private-sector party from the service users. By this mechanism, the public sector can set the service tariff at a level that maximizes social benefits of the project. In addition, the private partner and its providers of capital reduce their exposure to demand and collection risks. Hence, the cost of capital should be lower, and also the amount of support needed from the public sector.

Criteria to set tariffs

When the private partner's revenues in a PPP project are based on user chargers, tariff setting criteria become a relevant issue. Tariff levels should follow three main criteria:

(i) allocative efficiency

(ii) bankability of the project

(iii) distribution considerations

(iv) other factors

(i) Allocative efficiency calls for a pricing rule which sets tariffs according to marginal costs. From the public sector perspective, the tariff setting should take into account the social costs and benefits associated with the project. Service provision involves not only the private production costs facing the private-sector party but also any cost imposed on other activities, e.g. externalities like pollution. Hence, a cost-covering tariff based on both private and social costs and benefits may be higher or lower than the tariff level that maximizes the net sum of private benefit and cost.

(ii) When user charges are the only source of revenue for the private-sector party, the level of user charges should be also consistent with recouping initial investments and sunk costs.46 The tariff level should be such that revenues cover operation costs and investments in the service provision, allowing a commercial rate of return. The effect on revenues of changing user charges depends on the price-elasticity of demand for the service.47 In turn, the volume of demand affects the operation costs of providing the service.

(iii) To the extent that the public sector is concerned with the project's social benefits, e.g. improvement of health from installing proper sewerage systems, pricing service below marginal costs might be the preferred pricing structure. But to ensure bankability and incentives to invest in service expansion and quality improvements for the private partner, the public sector must subsidize the project where it is at a loss.48 Distributional issues arise also within actual users as long as they differ in terms of income and service usage. Seeking equity of treatment regarding user charges, differentiated tariffs can be set according to types of services, categories of consumers, etc. It is a common practice to establish systems of cross-subsidies where some groups pay tariffs below costs and others pay tariffs above costs to compensate. But from the perspective of efficiency, these systems have negative consequences to the extent that consumption patterns are distorted for users enjoying subsidies, and for users contributing to finance them (Kerf, 1998).

(iv) Tariff setting should cope also with other factors such as the collection risk, i.e. the risk that users of the service try to avoid paying the user charge. Since the users' incentive not to pay increases along with the tariff level, a too high user charge may lead to the private-sector party taking excessive collection risk.

A number of subvention schemes may be offered to the private-sector party when the expected revenues are not sufficient to ensure project bankability.

First, capital expenditures contributions (capex) may be offered by the public-sector party taking the form of: (i) capital grants; (ii) loans; (iii) equity. In order to avoid public sector exposure to construction risk, the construction phase should be funded by the private-sector party, and capex contributions should be injected only after project completion. Capital grants minimize conflicts of interest, but the public-sector party should take into account that a capital grant is a sunk cost which is not refunded in the event of contract termination. Moreover, as long as senior debt will be repaid first in case of private-sector party default, the use of capex contributions may not be appropriate.

Second, revenue support to improve the private partner overall cash flow may be structured as depending on the number of users, thus being equivalent to user charges in terms of incentives and risk transfer. Alternatively, it could be set in such a way that payments decrease over time, thus giving incentives for the private-sector party to encourage usage; or that payments decrease as usage level increases, thus avoiding windfall earnings under unexpected increase in demand. Revenue support can also take the form of revenue guarantees payable only in years where revenues from user charges fall short of a specified level.

Third, debt guarantees could be provided by the public-sector party, thus having no effects on the fiscal budget as long as it is not called upon.

Case Study: M1-M15 motorway (Hungary)

The concession to design, finance, build, operate, and transfer a 43-km motorway implemented a user charges payment mechanism that fully transferred traffic (demand) risk to the concessionaire, without any support from the public sector other than the initial planning and site acquisition. The award criterion was the lowest tariff (toll) requested by the competing bidders. The concessionaire was entitled to set initial tariffs at the revenue-maximizing level, and to adjust them subsequently according to indexation provisions.

Although there was a parallel un-tolled road that remained unimproved, the economic rationale for the project was largely based on time savings to be realized by users (estimated at 20 minutes per full journey).

As many commercial vehicles kept using the alternative, un-tolled road, traffic volumes and total revenues were half of the originally forecasted values for the first year of the concession. This led to litigation on tolls, suspension of investments and loan disbursements, and a debt default by the private partner. Both the concession and debt obligations were taken over by the public-sector party.

This case highlights the difficulties in applying user charges and forecasting demand, especially when the project involves a greenfield investment, there are alternative free- available services, and no revenue subventions are offered to the private-sector party.

Source: European Commission (2004)

Case Study: TransMilenio Bus Rapid Transit System in Bogota (Colombia) (Part II)

The TM project specified in detail the technical requirements for the buses: operators of main routes should have afforded modern buses, and operators of feeder routes could use standard buses. To reduce journey times, both regular and express bus services were to be provided with predetermined schedules and making information available for users through an electronic system. A pre-paid ticket with a unified fare scheme was to be implemented to simplify the service charging and revenue collection.

It was apparent that the TM project would dramatically change the workings of the bus transport system and damage the interests of the existing bus service providers. In this context, a number of measures were taken to attenuate resistance to and build support around the project. For instance, the bus companies, who had legal rights over the bus routes, were invited to participate as bus operators in the main routes. The small private bus operators would be allowed to serve in parallel routes, thus competing for passengers with the TM bus services. To cope with the users' reaction to the introduction of the new system, a 3-week free trial period was offered at that time.

Payment mechanism

The payment system implemented in the TM project implied that the demand risk was jointly borne by the bus operators since all the revenues collected were distributed among them. However, the revenue distribution was based on the weekly route distance that each bus operator served regardless of the number of passengers transported. Since TransMilenio SA could penalize a bus operator failing to comply with its contractual obligations by reducing its assigned weekly route distance (and so increasing that assigned to the other operators), it turned out that the bus operator's performance affected its share in the revenue distribution (and implicitly the share of demand risk borne individually). In fact, TransMilenio SA was able to reduce up to 10% of the operator's income, thus imposing a significant monetary loss for quality service failure.

In determining the fare level, both the bankability and affordability of the TM project were taken into account. In the project planning, a fare level around 0.40 cents had been estimated as consistent with the project's bankability. In fact, one year before the new system was introduced, the fares charged by the existing bus service providers were increased from 0.30 to 0.40 cents. Hence, at the time the new system commenced, there was no price difference between the TM bus services and those provided by the small private bus operators. Since the TM bus services were much faster and of a higher quality, the small private bus operators found it hard to compete for passengers in the parallel routes they were allowed to serve.

After the initial fare was set, the contracts envisaged a mechanism to adjust the service charge periodically. Price variation provisions aimed at protecting the bus operators from unexpected changes in operation costs they could not control. Besides, it was established that the public-sector party must compensate the operating companies if it intervenes to reduce bus fares, thus preventing the public sector from manipulating the project's (and operator's) main source of funds with political objectives.

The implementation of a pre-paid ticket system played an important role in the TM project as it allowed for separating the operation of buses and the management of revenues. Moreover, the ticketing and payments systems greatly contributed to improving safety and service quality by eliminating the 'war of the cents'. In addition, the systems were instrumental to ensure transparency and to avoid conflicts of interests: while an independent company collected the fees (thus avoiding potential disputes among bus operators), another company managed the trust fund (thus increasing controls over the revenue collection).

Outcomes

By all accounts, the inherited bus transport system exhibited low service quality and high levels of congestion and pollution. But soon after the TM project was launched, significant improvements were achieved in terms of the efficiency, safety, and environmental impact of the system.

One year after the TM project was launched, an evaluation reported encouraging results: journey times were reduced 32%, implying an equivalent to a one hour/day saving for the average passenger; average speed in the main routes were much higher than before; pollution levels in Bogotá resulting from the bus transport system dropped; and the number of accident fatalities decreased.

In 2004, another report reviewed the performance of the project and reported further improvements in safety and traffic managements. It was a remarkable achievement that improvements were observed in such a short period of time. Thus, the TM was considered an overall successful PPP experience.

Sources:
Fernholz and Morales Fernholz (2005)
TransMilenio SA web page

Case Study: Southern Railway in Sydney (Australia)

The New Southern Railway (NSR) project involved an underground line with 10-km, a two-track railway, and four stations. The Airport Link Company (ALC) was awarded a 30-year concession to design, build, operate, and finance the NSR. Around one quarter of the project budget was privately financed by debt and equity. The ownership of the land in which stations were built remained under the State Rail Authority (SRA), and the ALC had to pay a lease for using it.

In the pre-design stage of the project, the statutory risk (i.e. approval risk) was borne by the SRA as five local governments had to approve the line passing through their territory. The design risk of the tracks, tunnels, and station infrastructure was transferred to the ALC through a lump-sum payment. Construction risk was also transferred to the ALC since it received an inflation-adjusted, lump-sum payment in exchange for delivering the infrastructure on time and with the quality level agreed in the contract. The contract fully allocated operation risk to the concessionaire, making it responsible for the operation and maintenance costs associated with the infrastructure management. While most revenues were collected in local currency, some of the major construction inputs were imported and paid in foreign currency, so the ALC bore exchange rate risk. By government subventions, the ALC shareholders were granted tax concessions to limit tax liability after debt servicing.

The contract set out a payment mechanism based on user fees, thus transferring demand risk to the concessionaire. In addition, the ALC was allowed to charge a station fee on the passenger tickets so as to recover its initial capital costs, and to earn secondary revenues from retail activities at the stations. Some important government guarantees were set in place: the SRA agreed to compensate the ALC if usage fell short of the expected level, and to purchase the four stations if usage was so low that the concessionaire defaulted on its loans. As the SRA expected usage to increase significantly over time due to population growth and urban development, it considered these guarantees to be a relatively low risk.

Eventually, a quite poor risk management led to a remarkable project failure. Usage level turned out to be only a quarter of the expected level, partly due to an excessive user charge (including the station fee) that could hardly compete against the prices offered by alternative transport means such as buses and taxis. These problems caused a default on the ALC debt just six months after the line started to operate. The government attempted to bail out the project by subsidizing fares to increase service demand (e.g. granting concession fares to groups and offering airline-train ticket packages). A large fiscal burden transpired from both subsidizing the final users and compensating the ALC through the SRA.

Despite the remarkable failure, the government chose not to resume control of the project and thus kept it in private hands. Up to the present, the concessionaire has been heavily compensated, the service demand is still far from the initially expected level, and fares are still uncompetitive.

Source: Loosemore (2007)

Case Study: Chiloe Bridge (Chile)

The concession contract combined the application of user charges (bridge tolls) with a minimum income guarantee (MIG) provided by the government. For each year of the concession, the concessionaire was entitled to receive the difference between the annual revenue and the MIG specified in the contract.

In order to avoid excessive profit-making by the private partner, the contract also included a profit-sharing mechanism: if annual revenues were higher than an upper income band, the private-sector party would pay 50% of the excess amount to the public-sector party.

The project was however cancelled in the construction phase because the costs exceeded the maximum level predetermined in the contract.

Source: Ministerio de Obras Publicas de Chile (Tendering Document)

Usage payments

A payment mechanism based on usage can be seen as a variant of user charges, but where it is the public-sector party that pays the private-sector party instead of service users. In this scheme, the public-sector party sets tariffs to be charged on users according to its objectives. After receiving the associated revenues, the public-sector party makes unitary payments to the private partner depending on the actual usage level.

In most cases, there are bands for usage levels determining the payments, and thus setting limits to the demand risk transferred to the private partner. Usage payments imply less risk for the private-sector party as final users do not pay for the service, so in principle demand levels are not affected by income shock. As it was mentioned above, a lower exposure to demand risk leads to a lower cost of capital for the project. Using bands at low usage levels bounds the risk to the private-sector party that service demand is lower than expected. In practice, lower bands provide a certain minimum usage payment to cover debt service, but not to ensure a positive return on equity. On the other hand, using bands at high usage levels caps the number of users for which the public-sector party should make payments, thus bounding the public-sector party's financial liability.

A usage payment has advantages in terms of incentive design since the private partner's actions regarding service availability and quality affect the usage level on which the payment depends. Besides, the scheme is easy to implement because it is quite consistent with the traditional practices of financing infrastructure projects out of public funds. However, the scheme involves financial risks for the public-sector party because payments are uncertain ex ante, and this can cause difficulties in budget planning. Usage payment also involves distributional issues: service users may pay a relatively low fee while taxpayers end up subsidizing them.

Case Study: Randstad Wijkertunnel (Netherlands)

In a tender to build the Randstad Wijkertunnel, the BOT contract partially transferred design and construction risk to the private partner. The payment mechanism relied on a shadow toll setting minimum revenue but letting the maximum revenue uncapped. During the operation phase, the service demand was larger than expected, so the costs for the public sector rose dramatically.

This case illustrates how demand risk allocated to the public-sector party may increase its financial burden when usage payments are uncapped.

Source: European Commission (2004)

Case Study: Beiras Litoral and Alta Shadow Toll Road (Portugal)

The concession contract required the private sector to widen and upgrade a 167-km road in the border between Portugal and Spain. Since no alternative un-tolled road was available for the heavy traffic using the road in concession, the government chose to implement a shadow toll regime making usage payments to the concessionaire.

Usage payments were based on a four-band system: the first band was intended to cover fixed costs and senior debt service; the second, variable costs and subordinated debt services; the third, dividends. Overall, there was little demand risk in the project because traffic volumes were already quite large; in addition, the usage payment mechanism implied risk-sharing between the contracting parties. Fixed availability payments were to be made mainly during the construction phase, introducing the shadow toll in the operation phase.

With this project, the public sector sought to enhance the availability of road infrastructure minimizing its financial contribution as hard constraints limited the public budget. But a number of factors eventually raised the fiscal burden associated with the project. Soon after the award, an environmental appraisal concluded that changes had to be made in the initial construction plan; since these changes would have led to large compensations to the private sector that the public sector was unwilling to pay, the construction works were delayed for years. In addition, the already high traffic volumes increased even more, thus raising the usage payments due to the private-sector party.

Source: European Commission (2004)

Case Study: A55 Llandegai to Holyhead Trunk Road in Wales (UK)

In 1998, the 30-year PFI contract to design, build, finance, and operate the A55 Llandegai to Holyhead trunk road (the final link in the improvement of the rout from Chester to Holyhead-linking Dublin and Ireland with Wales and England) was awarded by UK Highways A55 consortium.

The size of the project represented a big impact on the people living in the area. Public exhibitions and consultation with residents took place to keep people informed. The design of the new highway was sensitive to the environment, integrating the road into the landscape, thus reducing its visual impact.

Despite the complexity of the project design, the 22-mile dual carriageway final stage from Llandegai to Holyhead was successfully built six months earlier than the scheduled: it took 27 months to be built, including the design stage.

Once the construction phase ended, the consortium revenues were based on usage payments (e.g. shadow tolls), combined with availability payments and safety record of the road. A mechanism to cap the maximum amount of payment was also specified.

Sources:
PPP Forum, June 2006
Private Finance Information Service

Availability payments

In a payment mechanism based on availability, the public-sector party rewards the private-sector party for making the service available regardless of the actual service usage. The payment scheme typically involves also deductions if the private partner fails to comply with availability targets. In any case, objective measures defining service availability should be established in the contract, e.g. lanes ready-to-use in roads and capacity to undertake water treatment works. In addition, deductions should depend on whether the private-sector party can or cannot control the events causing unavailability, the private partner's effort to provide alternative services, the spread and recurrence of unavailability episodes, and the rectification period needed. The weightings of deductions are important: if deductions are too low, it may be convenient for the private-sector party to under-perform; if they are too high, risks increase and the contract may require a higher pricing (HM Treasury, 2007).

In practice, availability payments are used in projects related to infrastructure construction and management. There is no demand risk for the private-sector party, so the cost of capital is likely to be lower. Moreover, since the construction phase should be completed before services can be made available, the invested funds represent a fixed cost at the outset. In terms of incentives, an availability payment encourages efforts to ensure potential service provision. It could be coupled with user charges or usage payments to the extent that it is efficient to allocate some demand risk to the private-sector party to promote quality- enhancing efforts.

Case Study: Dublin Bay Wastewater project (Ireland)

The PPP contract to design, build, and operate the wastewater treatment plant was part of the Water Services Investment Program launched by the Irish public sector. The primary goal of the Program was to improve the quality and efficiency of wastewater treatment by attracting the best technology and expertise available on the market.

The contract was awarded to an international consortium for 20 years for the operational phase.

The public sector retained asset ownership and provided no guarantee for the private-sector party since the overall investment was financed by the Irish public sector along with a grant by the EU Cohesion Fund.

The private-sector party bore the operation risk and was expected to cover maintenance and operation costs from the service charge paid by the public sector. Thus, it had incentives to undertake cost-reducing efforts in order to increase profits.

The public sector collected revenues charging commercial consumers only because the Irish law exempts domestic consumers from paying for water treatment. In determining the tariff level, the amount of un-treated discharges and the capital and operation costs were taken into account.

The use of modern technologies and a sophisticated combination of treatments turned the wastewater treatment plant in a unique facility of its type.

Source: European Commission (2004)

Performance payments

A payment mechanism based on performance rewards the private-sector party for meeting certain standards of the service provision. In practice, performance payments complement other payment method such as usage or availability. The scheme sets charges for performance failures which are deducted from unitary payments. Alternatively, as discussed earlier, the contract could establish 'bonuses' to be awarded if and only if certain target performance levels are reached.

Several issues must be taken into account when the public-sector party uses performance payments. In order to stimulate quality innovations, the contract should specified objective measures defining service performance, e.g. quality of water in terms of pH levels, on-time delivery of the service, and adequate road signs. In particular, the standards of performance must be monitored at a low cost.

The payment structure must define the consequences of a failure to meet the required quality level of the service. The simplest approach is to categorize various types of performance shortcomings and use a grid of monetary deductions. An alternative, two-stage approach is to assign penalty points to the private-sector party any time a performance failure occurs, eventually attaching more points to a serious and recurrent failure, and to set a rule that translates points into monetary deductions. Generally, deductions are made when a certain number of points have been assigned to the private-sector party within a defined time period. To provide incentives to perform, there should be an adequate calibration between the seriousness and frequency of a failure, the number of penalty points assigned where applicable, and the financial impact of deductions on the private partner (HM Treasury, 2007).

When the private partner's performance is continuously poor and early failures are not rectified within a certain period, the public sector may include a 'ratchet mechanism' in payment deductions. For example, a simple ratchet mechanism increases the number of penalty points incurred for any given failure that is repeatedly observed over a time period. The ratchet mechanism informs other parties involved in the contract, e.g. lenders of capital, the private-sector party fails to perform. Thus, it encourages the private partner to take early remedy actions to avoid reputation losses.

Case Study: Moray Coast Wastewater project in Scotland (UK)

In 2001, the Catchment consortium was awarded a 30-year contract to design, build, finance, and operate three sewage treatment plants, a sludge dryer, twenty pumping stations, two new long sea outfalls and a 47-km pipeline network.

In designing the project, environmental issues had to be considered because of the natural beauty and fauna of the Moray coast. Thus, the public-sector party (the North of Scotland Water Authority) retained the statutory/planning risk. Instead, construction and operation risks related to the variability of wastewater flows were borne by the private-sector party.

The payment for wastewater and sludge treatment received by the private partner was based on daily samples of treated effluent. No payment was to be made unless the private partner complies with the sampling regime and the wastewater treatment standards required.

The contract also envisaged an arrangement to share revenues and refinancing gains between the public and private parties.

Before being awarded with the Moray project, the Catchement consortium had been selected for two PFI projects, the Highland and the Tay wastewater projects. The previous contractual relationship between the consortium and the North of Scotland Water Authority certainly facilitated the contract drafting and the project operation. The Moray project was completed on schedule and satisfactory results were obtained in the first performance tests.

Source: International Financial Services, London (2003-2004)

Case Study: The London Underground (UK) (Part III)

The payment mechanism specified in the PPP contract consisted in a basic infrastructure service charge (ISC) combined with bonuses and deductions. To the extent the Infracos met performance, availability, and ambience targets, they were entitled to bonuses that increased their revenue. On the other hand, failure to meet these targets triggered deductions that reduced their revenue.

The Infracos' performance in rehabilitating and upgrading the tube was to be measured by the journey time capability (JTC), i.e. the time needed for a train to complete a journey. To achieve the performance targets and reduce the JTC, the private partners had to improve track, signaling, and trains. Availability was to be measured by the number of lost customer hours, with penalties varying with the severity of a failure, e.g. breakdowns, signaling and other failures were penalized more heavily at peak times. Ambience and general conditions of the trains and stations were to be measured by customer surveys.

As it was mentioned in Part I of this case, the PPP contract also included debt guarantees allowing lenders to recoup their investments in case the contract terms were substantially modified.

Poor performance and penalties

Soon after the contracts began, the Infracos were subject to criticism because of their poor performance. The criticism on safety issues became stronger when two derailments occurred in the tube lines assigned to each of the consortiums.

Moreover, the performance targets based on JTC were hardly attained as the rehabilitation works delayed significantly, suggesting the works schedule proposed by the companies were unrealistic. To defend themselves against the mounting criticism on their poor performance or overambitious bids, the Infracos argued that the assets they inherited were in physical conditions much worse than they had anticipated.

The Infracos' poor performance led LUL to apply penalties and to threaten to take over the contracts if the situation were to persist. In the first year of the contracts, the companies were fined £32 million by deductions for failing to meet some of the targets, and earned just £12 million in bonuses for achieving other targets.

Despite the large (net) deductions applied to the basic ISC, the consortiums made huge profits. According to the NAO report (2004a), the Infracos shareholders earned a rate of return around 20%, a third higher than the normal rate of return in private finance deals.

Therefore, the impact of payment deductions on profitability must have been small (at least relative to gains from keeping low the quality of supply). Indeed, several observers argued that the deductions were too small considering both the payments made to the Infracos to undertake the pledged works and the inconvenience suffered by final users due to service disruptions. The too low deductions for poor performance appear to have distorted the incentive scheme sufficiently to generate the widespread poor performance of the Infracos together with their high profitability.

Sources: see London Underground (Part VII).