Several recent reports on PPP contracting highlight the need for enhanced contractual flexibility, in particular aimed at taking into account possible changes in user needs that - in the presence of rigid contracts - have sometimes triggered very costly contract renegotiation processes.64 Enhanced flexibility, in particular directed to accommodate changes in user needs, is important for the long-term projects typical of PPP, and may be achievable through well designed change-management contractual clauses necessary to limit potential abuses. However, enhanced flexibility will inevitably come at the cost of lower predictability and higher risk for the investing private-sector party, and of reduced effectiveness of the competitive selection process.
Below we briefly discuss the trade-offs between flexibility, investment protection and predictability, and contract renegotiation. We then discuss the risks that large post-award contractual changes and renegotiation in general pose on the effectiveness of the procurement, and the consequent need to limit and structure such processes as much as possible. We conclude discussing how contract design can help in minimizing the costs arising from contractual flexibility. This section will not focus on how contract duration can be limited in order to enhance flexibility (on this, see Section 6), nor on anticipated changes in payments such as tariff indexation (on this, see Section 4).
Contract design should build flexibility into the contract so as to limit as far as possible the need for contractual changes.
Flexibility/change needs are often classified as being anticipated or not at the contracting stage. Anticipated changes include, for example, potential changes in quantity/capacity of the output specified in the contract, for example, caused by an unexpected demand increase. In a road project, the amount of street lights required may change over the years with unanticipated changes in urban development of some areas.
At the contract drafting stage, a substantial investment in contract design should be undertaken to anticipate the possible changes that may be required with reasonable likelihood, and to describe and regulate all these changes in the original contract. This will create built-in contractual flexibility while reducing as far as possible the need for contract changes/renegotiation.
If the anticipated changes involve mainly changes in the amount of output, they can easily be pre-specified in the original contract and become integral part of the bids in the initial competitive selection process. Similarly, any other anticipated change that can be foreseen in its precise form, should be pre-specified as conditional output in the initial contract and be part of the initial bid, so that the potential changes are efficiently priced at the competitive stage (in the street light example, a unit price for additional lamp or kilometer of road enlightened could be in the contract). The weight to assign in the selection process to the terms relative to anticipated potential changes should then be proportional to the likelihood and the value of these changes.
In the some (rare) cases the need of potential change is anticipated but such that the exact form of the change is not clear, so that it is not possible to pre-specify the change in the original contract to have it priced at the competitive stage. If these anticipated changes are small in size and need to be operated swiftly, provisions could be inserted in the contract establishing that the private-sector party will have to implement the changes required by the public-sector party, within certain limits, and that compensation for the extra costs will be paid. Consideration should be given to the possibility to specify in the contract that the compensation will be on a cost reimbursement basis, with a contractual obligation to ensure value for money for the public sector. Compensation will also allow for a mark up on the costs that should not be subject of bidding in the contracting stage as competition on mark ups of cost-plus contracts tends to have counterproductive effects. The profit mark up on changes operated under cost-reimbursement compensation will be chosen ex ante, according to standards of profitability in the sector and with the advice of external experts, and will be pre-determined by the contract, hence remaining fixed whoever wins the competitive phase.
The obligation of ensuring value for money for the public sector must be backed by benchmarking on both the definition of the mark up and on the following cost assessment that the private-sector party provides after a change is required, before approval of the changes, to ensure that mark up and projected costs are at market level. In this cases a third party - like a panel of expert - should also be involved in the process of approval of the cost of changes before implementation, to prevent abuses of the flexibility created by cost-reimbursement scheme.
More flexibility may still be needed along the development of the project than what is achievable through anticipated change clauses, so that a limited number of exceptional contractual changes should be admitted. Contract design can limit the possibly large negative effects of post-award contractual changes aimed at facing unanticipated change needs - discussed in the accompanying paper - by inserting contractual clauses that limit and structure contract renegotiation.
In particular, to ensure maximal transparency, the contract should define a detailed change protocol, that should precisely structure the process through which any proposed change is requested, assessed and, if eventually approved, implemented.
Small changes, e.g. linked to adaptation to particular user needs, should not require changes in payments but be covered by the provision of original contract and they may follow a faster procedure. For large changes that require pricing, transparency and value for money for the public sector become essential.
Transparency of the contract change process must be guaranteed by contractual clauses requiring full and proactive disclosure of all acts at all stages of the change protocol.
Transparency and accountability of changes should be further stimulated by involving an independent third party, an arbitrator or, better, panel of technical experts, as supervisor of changes and responsible for the governance aspects of changes. Their approval could be asked also in terms of real needs for the changes and appropriateness of the decided changes and their pricing. In case of changes required by the private-sector party and implying revision of prices, the change protocol should require the third party and the public sector to ascertain and publicly explain that the shock motivating the request for change was not an event part of reasonable business risk that a competent private partner would have anticipated and priced in the initial bid. (The cost of forecasting/bidding mistakes should be born by who makes them as far as possible).
In particular, as suggested in the Section 4 of these best practices for other contractual issues, the motivation behind the initial choice of mark up, and that behind the decision to ask for a change and the decision to approve the binding cost assessment presented by the private partner for the change (including the benchmarking exercise and the opinion of the third party) should be made public, posting them uncensored on the homepage of the PPP, within a pre-specified and short term after the approval.
Value for money of approved changes in prices should be ensured by contractual clauses requiring any such price change to be subject to a market value test, in terms of benchmarking or full market testing (new competitive tendering).
The contract should also establish a freeze period, the longer the larger the relative weight of the construction phase in the PPP, and possibly longer for demands for contract changes coming from private partners. The rigidity induced by such contractual clauses will deter opportunistic renegotiation, which typically expects revisions of terms much earlier, stimulate investment in in-built contract flexibility, while leaving open the possibility to accommodate efficient changes later on, when it is more likely that substantial unanticipated changes in technology or demand took place that effectively require contractual changes.
Finally, the contract should establish substantial fees to accompany private partners' demand for contract changes; these should be withheld in case the demand for contract change is rejected as unfounded. This would deter frivolous demands while leaving open a channel for serious ones.
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64 See e.g. HM Treasury (2006, ch.5).