In PPP/PFI contracts, contractors are paid to deliver particular levels of service which is set out in the contract, or service agreement. Client should not specify how the services will be delivered, but they do retain the right to incentivize contractors to ensure the services are up to their required standards. This right is usually exercised through a relatively elaborate payment mechanism that decides the amount of cash paid to the contractor on a month by month basis, known as the unitary charge.
This mechanism for determining the level of cash paid also has a big impact on the relationship between clients and their contractors. Therefore, for PPP/PFI contracts to work well, it is important the way cash payments are assessed and made by the client not only take account of the clients' expectations, but also the needs of contractors.
In addition, a prerequisite for successful PPPs is a credible legal and regulatory framework that protects private sector interests and property rights and enables commercial contracts to be legally enforced. It is also of vital importance that the government agencies have the necessary authority to grant concessions and licenses, and this is often made possible through specific concession laws. No contract can be totally complete, because not all the information regarding the PPP is available at the time of contracting. It is therefore important to have mechanisms in place that can solve disputes and potential conflicts of interests in a cost-efficient manner.
Financiers want to be paid for any borrowings on capital assets in which they have an interest. Payment mechanisms should be structured accordingly to meet these payment objectives over the life of the contract. This is can be achieved by having two kinds of deductions from the unitary charge:
• Availability deductions
• Service delivery deductions.
The primary purpose of separating these deductions is to ensure that any penalties for service failure are proportionate to the cost of providing those services. However, it also allows portions of the payments from the client to be ring-fenced by contractors so that finance payments can flow more directly to the financiers and the service payments can flow to the appropriate sub-contractor. Separating these cash flows also allows the performance of each sub-contractor to be monitored separately and more easily. It can also ease the process of replacing an under performing sub-contractor by the main contractor if this is the case (Arizu, Gencer and Mauer, 2006).
Some or all of the unitary charge is usually indexed through application of a relevant index, for example inflation or average wages. These indices must be chosen with care. While they may not be directly relevant to the underlying cost stream (and in the PFI contracts, it is usual for there to be no link between cost structure and the index used for risk transfer purposes), it is possible that unrelated indices could lead to cost and prices becoming misguided and perhaps unsustainable. In any event, the client should be aware that it will pay a premium at the start of the contract to cover any perceived inflation risk.
In practice it is unlikely that a PFI/PPP contract is likely to be fundable unless caps are placed on any performance deductions made from the contract over a period of time. The size of the cap is usually related to the proportion of the unitary charge which is paid to the contractor.