When the private-sector party fails to deliver the service on time or to meet the performance standards, the public-sector party may use contractual protections such as liquidated damages and performance bonds. Liquidated damages are rules that set in advance an amount to be paid by the private-sector party to compensate for the estimated economic losses incurred by the beneficiary in case of certain breaches of contract. Liquidated damages are often calculated as a percentage of the contract price that depends on the project complexity, e.g. it ranges from 10 to 15 percent in gas pipelines projects, and from 35 to 40 percent in coal-fired power generation (Kerf, 1998).
Facing liquidated damages, the private partner may increase the price required for the project to ensure itself ex ante against the risk of late service delivery. The private partner will increase its tendering price anticipating any contingency that makes liquidated damages payable, e.g. the private-sector party can raise the estimated construction cost or require a longer construction period. Therefore, using liquidated damages is likely to increase the unitary payments or user charges the private-sector party receives, and also to lengthen the time schedule of the project.
The HM Treasury (2007) suggests that since liquidated damages can compensate for the beneficiary's economic losses but at the same time they have a negative effect on pricing, the use of liquidated damages in addition to deductions or rewards for quality is cost-effective only as long as the expected losses suffered by the beneficiary are greater than the payment increase required by the private-sector party. However, this does not take into account the gain that liquidated damages may create in terms providing incentives to invest and perform when it is not possible to introduce sufficiently strong deductions or bonuses linked to quality. By increasing incentives, liquidated damages can be suitable also when the expected losses suffered by the beneficiary are lower than the payment increase required by the private-sector party.
Performance or 'surety' bonds are used as a guarantee of construction completion in case the private-sector party goes bankrupt and thus the project remains unfinished (Engel et al., 2006).49 The bond is issued by a bank, an insurance company or a specialized 'surety bonds' company in favor of the public-sector party and guarantees a payment (typically around 10 percent of the value of the construction contract) or even the private partner replacement and project completion (in the case of surety bond companies) in case of non performance by the original private partner. When the public-sector party requires a performance bond to the private-sector party, the risk of losing the bond encourages the private-sector party to comply (Gausch, 2004; Engel et al. 2006). In addition, it prevents the private-sector party from 'walking away' from the project if disputes arise.50 On the other hand, as with liquidated damages, a private partner asked to post a performance bond is likely to react by passing through the cost and time schedule the risk of loosing the bond in the future (HM Treasury, 2007).
Contractual protection payments are not recommended if the public sector does not suffer any significant loss as a consequence of the private partner's bad performance, e.g. because payment deductions for poor quality have been sufficiently strong. As it has been argued, both liquidated damages and performance bonds are likely to increase the price and lengthen the project schedule, so the public sector should consider their effects on the value for money (HM Treasury, 2007).
Liquidated damages and performance bonds should be used besides deductions as further contractual protections for the public-sector party in case the private sector fails to meet the service commencement day or (for bonds only) it goes bankrupt leaving the project unfinished. Although these protections may lead the private partner to require higher tariffs and/or a longer construction period, there are typically significant gains in terms of incentives to invest and perform, especially when the public sector is in a weak bargaining position, once the contract has started, because of the need to ensure service continuation.
The amount of liquidated damages should be specified in the bidding documents so bidders can price the risk of incurring in such charges. To assess the economic value of liquidated damages, the public-sector party could ask bidders to price also a project without liquidated damages; then, the difference in the bid price should reflect the risk premium attached by the private sector to the contract including liquidated damages.
To reinforce incentives to perform the contract should specify the circumstances under which the contract may be terminated on private sector default and performance bonds are payable (See Section 4 for issues related to early contract termination).
| Transparency of the payments to the private partner and gain sharing [Brazil: Lei 11.079, Art. 5] The clauses of public-private partnership contracts shall be in accordance with the provisions of art. 23 of Act 8987, dated February 13th, 1995, as applicable, and shall also state: IX - the sharing with the Public Administration of the economic gains of the private partner resulting from the reduction of credit risk related to the funding contracted by the private partner; [Mexico: Acuerdo Secretaria de Hacienda Diario Oficial 9 Abril 2004] 27. LA solicitud de autorización, las dependencias y entidades deberán anexar los siguientes documentos: I. El proyecto de contrato de servicios de largo plazo, que deberá contener, entre otros términos y condiciones, los establecidos en la fracción VI del numeral 21, así como los siguientes: c) La forma, términos y condiciones de pago |
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49 In the US in 1990-1997, more than 80,000 private partners went bankrupt leaving unfinished project with liabilities of USD 21 billion (Engel et al., 2006).
50 For example, in the Tucuman water project (Argentina), a conflict arose between the private partner and the authorities on matters of water quality and pricing. The performance bond posted by the private-sector party did have an impact in solving the conflict (Kerf, 1998). However, in the water sector, it is debatable whether performance bonds are an effective device to make private partners assume risk for poor performance (Lobina and Hall, 2003). When a public authority is relatively weak, e.g. a local authority dealing with a transnational firm, it may be reluctant to call in a performance bond. The public sector may fear retaliation from the private-sector party who could withhold payments of lease or concession fees, or threaten to discontinue the service provision.