There are circumstances that may lead the public sector and/or the private partner to terminate the contractual relationship before the contract expires. Thus, the contracting parties could agree to specify clauses determining their rights to terminate the contract earlier.
According to HM Treasury (2007), the clauses should address two important interrelated issues: first, the reasons that may trigger a contract early termination, and second, the compensation each party is entitled to receive when the early termination occurs for one of these reasons.
Contract early termination may result from:
(i) default of either or both parties,
(ii) voluntary termination by the public sector,
(iii) force majeure events,
(iv) corrupt gifts and breach of refinancing provisions.
For each of the above cases, HM Treasury suggests the contract should specify the precise circumstances that can lead to termination of the contractual relationship and the criteria to establish the compensation of the parties and how the project's assets are transferred.
The compensation scheme suggested by the HM Treasury for cases (i) and (ii) is that the party in breach should fully compensate the other party in such a way that the latter bears no financial consequences from the breach (or voluntary termination). That is, the innocent party should be left in the same position it would have been in had the contract not be terminated. Instead, in case (iii), the mutual compensations should be based on the principle that force majeure events are the fault of neither party.
In practice, it may happen that some of the costs incurred by a party are non-contractible, and so under-compensation occurs despite the principle of full compensation. Anticipation of the possibility of contract termination can then discourage a party from incurring in non-contractible cost such as unverifiable investment. This is a key issue when the public sector voluntarily terminates the contract because, for example, the service is no longer needed, but the private-sector party has made non-contractible investments. Any under-compensation in the event of contract termination is then likely to damage the public sector reputation and to reduce incentives for non-contractible investments in future projects.
A key debated issue is the compensation payable on default by the private-sector party. Payments and asset transfers involved in this compensation should balance the protection of the public-sector party's interests and the convenience of not imposing unfair, excessive deductions on the private partner for its default. Excessive deductions would also create the negative effect of distorting the incentives of the public-sector party to call for contract termination. Consistently with such a balance, it may happen that the public-sector party is entitled to have the project's assets transferred to it (being compensated for the damages the private partner default imposes on it), but it is also obliged to make a payment to the private-sector party (avoiding a possibly disproportionate transfer of value from the private partner to the public sector), despite the private partner's default.
In the UK, for instance, three different approaches have been followed over time and across projects as regards to compensation in the event of private partner default: no compensation, stage-based compensation, and market-based compensation.