Theme1: Making changes in the output specification

The topics to discuss by the moderator is:

1. How each country’s approach on the policy and process might differs from others.
2. Procedure for making changes to the output specification
3. Determining the price for the modification
4. Method of payment

[1] Author: Richard Foster, Moderator

Date:

2008/04/01

Organization:

Executive Manager,
Partnerships Victoria
Commercial Division
Department of Treasury and Finance

PPP contracts in Australia typically provide that government may initiate modifications to the facility and the service specifications at any time during the contract term. The cost of government-initiated modifications is borne by government, although it may be financed by the contractor and recovered through the service payments over the remaining life of the contract.

The following describes the Standard Commercial Principles that we apply to modifications (including changes to the output specification) in our Partnerships Victoria projects, and some of our experiences to date. Please consider how our approach might differ from your own, and use this as a starting point for discussion and comments on the policy and process issues associated with making changes to the output specification.

Under our principles, the contractual modifications process does not apply to:

1. Minor changes to the facility that do not exceed an agreed threshold,
2. Any refurbishment and maintenance works required during the operational phase, and
3. Any other changes or alterations required to ensure the facility is fit for its intended purpose (the contractor is obliged to maintain a "fit for intended purpose" facility, and bears all costs associated with this)

Any modifications proposed by the private party are implemented at the private party’s own cost following approval by the State.

Modifications due to a change in law are dealt with under the change in law provisions in the contract.

PROCEDURE FOR MAKING CHANGES TO THE OUTPUT SPECIFICATION

In Victoria there are no specific restrictions on negotiating with the existing contractor with regard to modifications, but the State would consider on a case-by-case basis whether any modification should be separately tendered in order to obtain the best value for money outcome. In almost all cases, interface risk is best managed by having the existing Contractor implement the modification. This is particularly the case where the focus of the modification is on changes to the output specification rather than changes to the physical facility.

It is important to note that major changes early in the project life could lead to legal challenges by losing bidders on the basis that they could have won the bid had the modified project been put to the market in the first place.

Government may at any time request a modification to the facility by serving a notice on the private party.

Within a defined period after government’s request, the private party must give government its proposal for carrying out the proposed modification, including details of any effect on the facility and delivery of the contracted services, necessary capital expenditure, any impact on recurrent costs (on a fully transparent basis) and, where necessary, how the private party will fund the costs.

As a practical matter, it is generally preferable for the State to discuss the proposed change informally with the Contractor prior to initiating the formal contractual change process. This ensures that the formal change request reflects a joint understanding of the potential risks and constraints of the change.

Where a project is undertaken in a new sector, for which there is little experience in developing output specifications, the parties may find after a year or two of operations that a small proportion of the performance requirements in the contract are not as easily measured as expected, or do not appropriately incentivise performance that best meets government’s needs. In these circumstances, the parties may seek to make changes in the specifications that produce a "win-win" outcome by providing greater clarity and more appropriate incentives.

DETERMINING THE PRICE FOR THE MODIFICATION

Our contracts include detailed modification compensation principles to ensure that the State receives value for money when it requests modifications.

The State will pay reasonable costs arising as a direct result of carrying out the modification works, including an allowance for profit, and incremental changes in overhead, management and administration costs at rates agreed in the contract (which may depend upon the total value of the modification).

An allowance may also be made for delay costs or prolongation costs arising directly from the modifications.

The private party must provide evidence that it has used reasonable endeavours to ensure that sub-contractors minimise costs and maximise any reduction in costs.

Where the parties cannot agree upon sub-contractor costs for a modification, the contract to implement the modification works may be awarded by competitive tender, and the private party must appoint the tenderer whom the parties agree offers the best value for money.

METHOD OF PAYMENT

Any payment made by the State to the private party for the modification will be made on a whole-of-life basis (that is, it will take into account both the positive and negative effect of the modification on recurrent expenditure, as well as the capital cost).

Significant modifications outside the scope of the original project that require extra funding have to go through the normal budgetary allocation process.

There are three mechanisms for compensating the Contractor for modification works:

1. up-front reimbursement of costs of capital works, or
2. by increasing the amounts of the service payments over the remaining contract term, or
3. by extending the contract term.

The mechanism used is determined by negotiation between the State and the Contractor. From the State’s perspective, a range of issues need to be taken into account when negotiating the form of payment. If the State makes an up-front payment, this will not be subject to abatement for sub-standard performance in future. Conversely, if the modification will be paid for by increasing the amounts of the service payments over the remaining contract term, the State must consider to total cost, which will include the contractor’s financing costs, in determining whether this option offers value for money.

Thank you to my colleague Tara Spivakovsky for her input to this discussion.
Kind regards,

[2] Author: Nicholas Jennett

Date:

2008/04/18

Organization:

Structured Finance & Advisory - AGI/EU
European Investment Bank

Dear Richard and Tara

Thank you for this extremely interesting contribution. I have a couple of questions that I would like to pose - these mostly concern financing aspects.

You indicate that the SPV must make reasonable endeavours to minimise sub contractor costs. What are its obligations in respect of securing funding where the authority is not paying the capital up front? Can it simply go to exsiting funders, or is there some form of benchmarking, or even competitive element? Where an incumbent funder is not chosen to fund the change, how will this work in respect of, for example, new inter creditor arrangements?

Related to this, what powers to funders have to prevent a change? In particular, if a change fundamentally altered the nature of a project, this could undermine the strength of the credit from the funders’ perspective.

Finally, how are equity returns potentially affected by a change? I assume that equity has the right to prevent any change that would undermine returns, but are equity returns capped out at the original base case as part of the negotiation of the cost of the change?

Do you, or other participants, have examples of projects where these issues have been worked through in practice?

Thank you

Nick

[3] Author: Susan Tinker

Date:

2008/04/20

Organization:

Assistant Vice-President,
Procurement Services
partnerships British Columbia

HI all.
I will be posting a response to Richard and Tara’s original post on Monday. I have an additional question though, which we are currently struggling with. For hospital projects, do your output specifications focus on performance during the operations period, and if so, what kind of performance measures are you using. For example, are you using efficiency measures for medical staff? If yes, I would like to learn more about the kinds of measures you use.

Thanks,

[4] Author: Richard Foster, Moderator

Date:

2008/04/28

Organization:

Executive Manager,
Partnerships Victoria
Commercial Division
Department of Treasury and Finance

Here are some thoughts on the comments from Nicholas Jennett and Susan Tinker. Thanks again to my colleague Tara Spivakovsky for her input.

A. The SPV’s obligations in respect of securing funding where the authority is not paying the capital up front.

Whether modifications are paid for up-front, by an extension of term of the contract or an increase in the service payment over the life of the contract is a matter for negotiation between the parties. Where the government initiates modifications, the Contractor must put forward a proposal on how it intends to achieve those modifications, including any necessary funding.

Government approval is required for the Contractor’s proposal, including the funding arrangements. The government can refuse to approve the funding proposal - however if government does this it must then be prepared to forgo the modifications or fund them up-front itself.

Where government does not elect to make a capital expenditure payment, the private party is required to use all reasonable endeavours to obtain additional or alternative funding to pay for any necessary capital works. New or additional funding is generally subject to various restrictions considered necessary by government under the circumstances, including:

• Where the new/additional funding is debt finance, any increase in the service charge should not me more than the amount required to amortise the loan amount (and interest) over the term of the loan; and
• Where the new/additional funding is in the form of equity, the increase in the service charge is not to be greater than the amount required to give the equity holders the prevailing market rate of return on the additional funding.

B. Issues arising where new funders are brought in to fund the change

The contractor’s obligation only extends to using "reasonable endeavours" to obtain funding for the change. Therefore, if existing funders are unwilling to fund modifications the Contractor must approach third parties, and the Contractor and both the new and existing funders will have to negotiate suitable inter-creditor arrangements. (The new funders will also have to agree to enter into a funder’s direct agreement with government.) If, despite using all reasonable endeavours, the Contractor cannot secure agreement of both the new and existing funders, the contractor will not be obliged to fund the change.

Should they chose not to fund the change, the existing funders do not have rights to prevent the change - the contractor will either obtain alternative funding, or government will have to pay the capital cost up front. From a policy perspective, it would not be acceptable to government (at least in social infrastructure projects) to have a contract under which the funders were entitled to veto a change.

C. Impact of changes on equity returns

During the bid phase for the project, the contractor is required to bid fixed or maximum margins and other on-costs that it may apply to the cost of modifications over the life of the project.

As noted above, where new/additional funding for a change is in the form of equity, the increase in the service charge is not to be greater than the amount required to give the equity holders the prevailing market rate of return on the additional funding.

D. Do you, or other participants, have examples of projects where these issues have been worked through in practice?

We have had a number of relatively small changes implemented on a number of projects. Some of these have been funded by the contractor, and for others the capital cost has been paid up front by government. However none of these changes have been large enough to significantly alter the risk profile or funding needs of the project.

E. Output specifications during the operations period for hospital projects

For all our hospital projects, all medical services are still provided by the government - only facility management and ancillary services, such as cleaning, are provided by the Contractor. A detailed list of KPIs with different consequences and cure periods is implemented to ensure performance and focus most attention on critical areas. For example, lack of availability of critical function such as an operating theatre has an immediate impact on the service payment whereas non-critical breaches have longer periods for rectification and a lesser effect if this deadline is not met. This is accomplished through a points system where Quality Failure points are awarded for each breach and its duration. Where fundamental breaches occur, such as the HelpDesk not operating, they are categorised as Failure Events. We have not included performance measures related to performance or efficiency of the public sector hospital operator, as the contractor’s ability to influence these aspects is limited in comparison to the impact that the operator will have. However, in some projects where specific efficiency gains for government form part of a winning bidder’s proposal, it may be possible to include performance measures related to the availability of these efficiency gains once the project is operational.

[5] Author: Hirohiko Machida

Date:

2008/07/02

Organization:

Director,
PFI promotion office
Cabinet office of Japan

1. How each country’s approach on the policy and process might differs from others.

We have no statute which regulates procedures for change in output specifications in PFI projects (though there are a few general rules applicable both to PFI and traditional procurements.) Our guidance for PFI contracts, which was published in 2003, also does not provide the process.

Thus, the change process differs by projects. Now, we are preparing new guidance for it as a part of standardization of Japanese PFI contracts. We plan to publish its exposure draft in summer.

The essence of our current draft guidance for change procedure is as follows:

1. Both parties should realize the importance of the flexibility. The government should not make de facto change or should not leave the necessity of the change.
2. On the other hand, initial output specifications should be clear even if there is possibility that they will be amended in near future. If they are unclear, in the cases of changes, it becomes difficult for parties to objectively calculate the amount of additional payment.
3. The cost for government-initiated change should be borne by the government. The price determination process should be fair and transparent. The government should not impose unreasonable burden on the contractor.
4. As for small changes, simplified procedure is necessary (discussed later).
5. Where it is expected that there will arise some gaps between output specifications and reality, the PFI contract may provide bedding-in-period and/or periodic review procedures.

2. Procedure for making changes to the output specification/ Determining the price for the modification

Until now, in many PFI contracts in Japan, change procedures are not so clear. It is said that, in some cases, governments forced contractors to make changes in service specifications without payment because of lack of clear procedures. Thus, for the purpose of fair risk allocation, we are preparing principles for clear change procedures as a part of standardization of PFI contracts.
In our draft, we proposed change procedures which are similar to those presented by Mr. Foster.
The price determination process depends on the size of the proposed change.
As for smaller changes, we are considering the catalogue method where all-included price for each change is listed, and a kind of open-book method where the price is calculated based on unit prices used for the bid for PFI contract and margin. However, we have no experience to use such methods in PFI projects, therefore we are not so confident whether these measures are applicable to Japanese situation or not.
As for larger changes, we have considered the three methods: bench marking, market testing, and independent expert appraisal, which are mentioned in Standardisation of PFI Contracts version 4 in UK. However we understand that it is very difficult to determine which method should be used as a default method.
Though we realized issues to be discussed, we have not reached conclusion.

If you have some tips for price determination, we would appreciate it if you would put your comments.

3. Method of payment

At first we believed that the public sector should make lump-sum payment in the case of capital expenditure. However some argued that the requirement will prevent some local governments from making major changes.

We have not reached conclusion on that point, and we would appreciate it if you could post comments on (1) pros and cons of reasonable endeavour approach, and (2) other approaches than reasonable endeavour approach.