Payment mechanism refers to the method of payment to the private party such as user fees and/or government payments based on usage or availability (or both), and how incentives and penalties are to calculated in the private party compensation account. Payment mechanism shall reflect risk allocation within the scope of obligations and terms of service.
The Entity shall consider the following options for the Payment Mechanism. The options chosen will to an extent, be driven by the nature of the project and the due diligence done with respect thereto:
a) User charges-payment collected by the private party directly from users of the service.
b) Government payment-payment by the Entity to the private party for services or assets provided. These payments could be:
1. Usage-based-for example, shadow tolls or output-based subsidies.
2. Based on availability-that is, conditional on the availability of an asset or service to the specified quality.
3. Upfront subsidies based on achieving certain milestones.
c) Bonuses and penalties, or fines-deductions on payments to the private party, or penalties or fines payable by the private party, due if certain specified outputs or standards are not reached; or conversely, bonus payments due to the private party if specified outputs are reached.
The Entity shall design a payment mechanism that includes one or more of these elements, which shall be fully defined in the contract-including specifying the timing and mechanism for making the payments in practice. The payment mechanism should reflect, to the extent applicable, the risk allocation that maximizes VFM.
The Entity shall address specifically the following risks in the payment mechanism:
a) Demand risk.
b) Performance risk.
c) Inflation risk.
d) Interest risk.
e) Exchange rate risk.
For example, inflation risk refers to the uncertainty on the level of inflation during the period of the Privatization arrangement. As inflation is primarily driven by economic conditions, the private sector party is not able to manage this risk. If this risk nevertheless would be transferred to the private sector party, the private sector party would have to make an assumption on the level of inflation. The private sector party would make a conservative assessment of the level of inflation as the private sector party would not want to be exposed to a situation where the actual costs in nominal terms i.e. costs adjusted for inflation could not be offset by revenues. Thus the private sector party would include a risk premium for this uncertainty in its financial proposal. It is more advantageous to retain the risk of inflation. This could be effectuated by including an adjustment factor to the payment mechanism. This could be applied to either a user charge Privatization or a government pay Privatization. Both parties agree on a rate to allow for recovery of the costs in real terms i.e. not adjusted for inflation. The rate will be adjusted annually based on the actual inflation. In case of user charges, the private sector party will be allowed to adjust the user charge annually based on the actual inflation. In case of government pay Privatization i.e. availability payment, the periodical payments will also be adjusted for the actual inflation.
Alternatively, performance risk is a typical risk that is to be transferred to the private sector party. It refers to the risk that the performance does not meet agreed upon service standards (e.g. availability of the facility for use). In case of availability payments, the payment will be adjusted according the extent the performance delivery is not compliant with the standard. If for example, the contract agreement stipulates a minimum availability of facility for use of 90% of the time, and the actual availability is only 85%, the payment will be reduced. The level of the deduction is to be defined based on the specifics of the project and the impact of non-availability.
Due care is to be given to the treatment of demand risk, which should be identified by Demand Studies and the due diligence carried out on the project. Although a transfer of the demand risk through a user charge Privatization may be appealing as it relieves the Entity of financial contributions, the private sector party will charge a premium for bearing this risk. If demand for the use of the facility is highly uncertain and impacted by factors which are largely outside the control of the private sector party, the premium will be substantial and value for money is questionable. If this is the case, consideration is to be given to capping the demand risk. This could be done by introducing a minimum revenue guarantee that states that, if demand is below a predefined level, the Entity will fund the revenue shortfall. This capping of downside risk is to be offset by a benefit sharing provision that states that, if demand is more than a predefined level, the excess revenues will be shared between the parties. If demand is too uncertain even for such a risk sharing, the Entity is to consider the use of an availability payment scheme and retain the demand risk.