Treasury taskforce guidelines on the standardisation of PFI contracts

United Kingdom
Renee Kok and Peter Long discuss the principal areas of change in the long awaited TT guidance

Introduction

In July the Treasury Taskforce published the final version of its long awaited Guidance on the Standardisation of PFI Contracts. The Guidance has been produced following a lengthy and widespread consultation process based upon the publication of a draft at the end of January. The Guidance reports that a consensus existed with many issues but not with all. Where no consensus could be found, the Guidance says that it has taken “a middle route which contains the essential elements of a good commercial deal”, but the Guidance repeats the warning contained in its January draft against “cherry picking” the advice it contains.

The Guidance is given added weight in the foreword by Mr John Bourn, the Comptroller and Auditor General, where he says: “In looking at future deals the National Audit Office will take a close interest in the extent to which these standard terms have been followed and the reasons for any departure from them”.

Perhaps the most remarkable thing about the Guidance is that, despite the widespread consultation process, there are few significant differences between it and the January draft. In this article, we focus on three of the principal areas where changes have been made.

Contractor default

As Trevor Butcher mentioned in our Spring bulletin, payment of compensation to the contractor upon termination as a result of contractor default has always been a contentious topic. In particular, there has been continuing debate concerning the use of a market value based compensation scheme to calculate the compensation payable to the contractor.

Although, the July version continues with this approach, the relevant clauses have been redrafted to respond to some of the concerns of the private sector outlined in Trevor’s article. The concept of a “Liquid Market” is introduced. This is defined as a market for PFI or similar contracts in which there are sufficient willing bidders for a price to be achieved that will be a reliable indicator of fair value (fair value being an amount that would be paid in an arm’s length transaction between informed and willing parties).

Upon contractor default, the authority can still choose whether to retender the contract or not. However, it cannot elect to retender the service if:

  • the senior lenders have exercised their rights to step-in but cannot find a suitable substitute contractor because there is no Liquid Market; and

  • either the authority agrees, or it is determined by dispute resolution, that no Liquid Market exists.
    As with the January draft, if the authority has the right to elect to retender the service, it should put out to tender the unexpired term of the contract on its original terms and pay the proceeds of sale (net of the authority’s costs) to the outgoing contractor.

The July Guidance also now recognises that, during the period between the termination date and the date of the new contract, there will be no income for the outgoing contractor but its finance costs will increase. Accordingly, it suggests that the authority should pay a “post termination service amount” to the outgoing contractor. This amount is calculated by taking the unitary charge that was paid at the termination date and deducting from that both the costs of alternative provision of the service and any rectification costs. To the extent that the term of the new contract is the same as the unexpired term for the terminated contract, the post termination service amount should be deducted from the ultimate payment made.

Finally, the July guidance provides that if the authority elects not to retender the contract, or if a Liquid Market does not exist, the authority should pay to the contractor (from its own resources) an assessed value of the amount it would have received through an appropriate retender process as if a Liquid Market existed. The amount to be paid to the contractor is to be agreed between the parties but, failing agreement, it will be determined in accordance with the dispute resolution procedure.

Risks that become uninsurable

The January draft provided very limited circumstances in which a risk which became uninsurable during the life of the contract would revert to the authority. The draft confined these provisions to project specific risks. The July version amends these provisions and extends them to other risks normally insured against in long term contracts, eg material damage insurance.

However, “uninsurable” remains narrowly defined. The insurance must either not be available at all worldwide, or it must be so expensive that the risk is not generally being insured against in the worldwide market. Further, it is only in an extreme situation that risk reverts to the authority. If:

  • the risk being uninsurable is not caused by the actions of the contractor or a sub-contractor; and

  • the contractor has demonstrated to the authority that the contractor and third parties faced with the same uninsurable risk in the same or substantially similar businesses have ceased to operate such businesses as a result of that risk becoming uninsurable,

  • the parties must discuss how the risk will be managed. If the parties cannot agree on how to manage the risk then the contract continues but the unitary charge is adjusted by deducting an amount equal to the premium that was payable for insurance for such risk. If the risk occurs, the authority can choose either to pay the contractor an amount equal to the insurance proceeds that would have been payable had the relevant insurance been available or to terminate the contract and pay an amount equivalent to compensation payable on termination for force majeure.

Compensation events

The definition of “Compensation Events” has not changed in the two versions. What has changed is the method of calculating the compensation payable to the contractor for a Compensation Event. The July version continues to alert the parties to the dangers of using a financial model to calculate the compensation payable. It notes that the financial model may not result in one correct compensation amount, as there is more than one way of preserving the ratios and equity return in the financial model.

As in the January draft, the July version recommends that where the Compensation Event results in an increase in capital expenditure, the authority should deal with this by lump sum reimbursement or by stage payments. The Guidance acknowledges that the authority may wish to ask the contractor to finance the additional capital expenditure. However, the formula proposed in the January version for calculating the compensation payable in these circumstances does not appear in the July version. Instead, the Guidance suggests the following possibilities:

  • a lump sum payment paid immediately on service commencement;

  • an adjustment to the unitary charge to take account of the contractor’s additional funding; or

  • a supplemental unitary charge over a period of the authority’s choosing as an annuity equivalent of the capital expenditure,

If the Compensation Event results in a reduction in the capital expenditure, a reduction should be made in the unitary charge to reflect not only the capital savings but also savings on finance and operating costs. The Guidance recommends that the appropriate reduction be determined either using the financial model or by determining an annuity equivalent reduction.

Where the Compensation Event results in a change in operating costs, the appropriate change in the unitary charge should be by negotiation at the time of the Compensation Event taking into consideration the forecast operating cost changes both as to amount and timing.

Conclusion

As many have pointed out, very few of the PPP transactions which have closed to date follow the Treasury Taskforce Guidance in their entirety. The comments of the Comptroller and Auditor General will no doubt give considerable impetus in that direction. However, as he points out in his foreword, it will still be important to see how the terms work in practice, and he anticipates that the standard terms may develop further.