To the extent that the service price is fixed during long periods of time, there is the risk that unforeseen changes in costs of major inputs, service requirements, or the regulatory environment render that price insufficient to cover operation costs and financial obligations. This risk affects both tariffs paid by final users and unitary payments paid by the public-sector party as long as they remain unchanged over time, and it is apparent in long-term contracts such as a 30-year concession. Thus, it is convenient for both parties to introduce provisions in the contract design to adjust the price in certain specified circumstances.
By reducing the risk exposure of the private-sector party, the provisions are likely to increase the initial bid price paid by the private-sector party in a concession (or lower the initial price paid to the private-sector party in a procurement agreement) in the tendering process. Besides, the provisions help in reducing the cost-covering service charge, either the tariff or the unitary payments, that is needed to ensure bankability. This is so because, when projections on demand and/or costs are highly uncertain, the private-sector party may seek to negotiate a relatively high service charge, thus requesting a sort of premium to compensate it for the possibility that the price fixed in the contract will become insufficient in the future. Under these circumstances, allowing the service charge to adjust according to the (observable) costs outside the private partner's control, the price adjustment clauses help in increasing the initial bid price paid by the private-sector party in a concession.58
The price-change provisions should be carefully formulated taking risk allocation and transaction cost issues into account. As we have seen before, there is no gain from transferring risk to the private-sector party that it cannot control. Thus, the clauses should provide the private partner with a hedge against unforeseeable cost overruns outside its control, while maintaining the incentives to undertake cost-reducing efforts and to seek efficiency.59 Further, the price adjustment rule and procedures should try to economize on the costs of collecting and processing information, and to minimize the scope for future disputes on price changes.
The payment mechanism should always encourage the private partner to control the costs of the project, but it should not transfer to the private partner the risk of cost overruns resulting from events outside its control. In order to protect the private partner from such cost overruns, and thus to avoid excessive risk pricing, the contract should include provisions to vary the service charge (i.e. the tariffs paid by final users or the unitary payments made by the public sector) according to the evolution of certain costs. As long as price variation provisions keep the service charge in line with market prices, they also protect final users and the public sector from paying an amount in excess of what other potential service providers would charge.
Price variation provisions may take the form of indexation clauses and/or value testing procedures (i.e. market value and/or benchmarking). In some cases, it is convenient to combine different provisions to reduce risk pricing. For instance, a private partner may be more willing to bear the risk that the project's costs increase above the price index agreed in the contract if a subsequent value testing will correct the price of service so as to fully adjust the cost increase (i.e. any misalignment between the price of service and the actual costs is of a transitory character).
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58 In addition, as long as most of the cost variation experienced by the private-sector party is of an industry- wide nature, e.g. changes in prices of major inputs used in the sector, the price adjustment provisions may prevent the difference between the service charge and the market price of similar services from varying excessively over time (HM Treasury, 2007).
59 In terms of the formula for incentive payment mechanism, the service charge could be determined by P = F+bCc+Cn, where Cc are costs controlled by the private-sector party, and Cn are non-controlled costs. More generally, the provisions should not distort operating, investment, and financial decisions of the private-sector party.