Provisions could also allow for a periodic price review taking place once during a certain specified period of time, say every three or five years.60 These reviews are useful to adequate tariffs or unitary payments to long-run changes in the private partner's uncontrolled costs, e.g. technological progress modifying the cost structure, introduction of new inputs whose prices are not tracked closely by the available indexes, etc.
The 'value testing' provision, for instance, establishes how to adjust prices periodically according to the evolution of the costs of service provision. In 'value testing' procedures, information on costs is collected directly, so implementing the procedures involves higher transaction costs compared to a simple, mechanic inflation indexation. But there is an important advantage: an adjustment of service charges based on accurate, specific information on costs closely tracks the private partner's uncontrolled costs, and thus provides incentives to control costs and properly select suppliers.
In practice, the main procedures conducted to test value are 'market testing' and 'benchmarking'. The 'market testing' aims at ascertaining the market value of the main inputs involved in providing the service through a re-tendering among potential suppliers of these inputs. The information collected is used in the price review for tariffs or unitary payments. In the 'benchmarking', information on market prices of inputs is gathered to compare the private partner's costs and adjust prices.
'Market testing' and 'benchmarking' are useful procedures for soft services when there are competitive markets providing comparable data. In contrast, to the extent that markets are concentrated, the current supplier is unlikely to be undercut by other competitors. Furthermore, these procedures are vulnerable to collusion between the private-sector party and the supplier, where the supplier could choose not to participate (or make a good offer) in the tendering process in exchange for a monetary reward from the private-sector party. Thus, the price review may simply update tariffs or unitary payments according to the current suppliers' prices (HM Treasury, 2007).61 When value testing procedures were implemented in the UK, they proved to be a lengthy process taking around 2 years to be completed, and some difficulties arose in finding suitable benchmark data to compare with.
In implementing these procedures, a choice should be made on when price reviews and testing will take place. In fact, a trade off exists regarding the length of the regulatory lag. If the first review is planned to occur in an early phase of the project, a potential operator could bid aggressively, offering a low tariff and expecting the review to increase it soon after the contract is awarded (this kind of incentive distortion arising from expected contract revisions will be discussed in detail in section 5). On the other hand, if there is a lengthy period before the first review, the private-sector party is largely exposed to the risk of misalignments between the initial fixed price and the operation costs, and thus it may require a higher service charge level (HM Treasury, 2007).
Along with mechanic indexation clauses, the contract may include value testing procedures, i.e. market value and/or benchmarking, since without a periodic testing the private sector may want to ensure itself against unexpected cost variations by increasing the bid price. Allowing the price of service to be reviewed according to market prices, value testing procedures limit the uncertainty faced by the private partner and give it an opportunity to raise prices when un-controlled costs increase. Besides, these procedures enable the public-sector party to benefit when market prices fall.
Even when market testing is included in the contract, the public sector should be able to undertake a benchmarking procedure. This is the case when, for example, the market testing procedure fails because of the lack of any bidder other than the incumbent. Similarly, provisions for market testing should be included even when the most appropriate test is thought to be benchmarking. This is the case when, for example, there is no available information or the price adjustment was not agreed.
The contract should specify the frequency of value testing exercises. Generally, value testing is conducted every five or seven years, but in some cases it may be appropriate to undertake the first testing exercise after a longer period of time. The longer initial period aims to ensure bidders do not deliberately set a low initial price which they could raise in the first price review. On the other hand, the public sector may be exposed to an excessive risk premium if the initial period is too long.
Value testing may be not appropriate for all types of service. Market testing and benchmarking are primarily aimed at 'soft services', i.e. facility management services such as catering and cleaning, where there is no significant capital outlay involved in providing them. Accordingly, these procedures are not suitable for 'hard services', i.e. services where the private-sector party is responsible for the maintenance of the facility and incurs in capital costs, since the price of the current private partner is hardly comparable to the price offered by a bidder that has not incurred in such capital costs.
Moreover, value testing may not be appropriate when the provided services are specialized and only one or two companies supply them. In particular, for the potential benefits of market testing to be realized, there should be strong competition between service providers, and the public-sector party should keep the market active and competitive, e.g. by informing suppliers about future bidding opportunities. Value testing procedures can be a lengthy process and difficulties may arise in finding suitable benchmark data for a comparison purpose.
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60 In LAC countries, the duration of regulatory lag is usually 5 years (Guasch, 2004).
61 To address the problem of concentrated markets, a 'benchmarking' procedure could be conducted using cost information of comparable firms in other regions or countries, or cost estimates resulting from a simulated model that formalizes the behaviour of a hypothetical efficient firm. In practice, a model of an efficient firm is used to regulate the electricity sector in Chile (Kerf, 1998; Di Tella and Dyck, 2002) and Peru (Guasch, 2004).