PPP - Paper 5 - contractual matrix and the importance of the project agreement

INTRODUCTION:

In this paper, the contractual matrix and the importance of the project agreement is reviewed.

CONTRACTUAL MATRIX

In many jurisdictions, the relationship between contractual parties tends to be personal and, therefore, there is not a reliance upon the contractual terms as such but more the intention of the parties. In other jurisdictions, there will be a code regulating certain contractual relationships. In other jurisdictions, the courts may be allowed to intervene when there is a change of circumstance which alters the economic equilibrium between the contracting parties. In limited recourse finance projects there needs to be certainty which is why the documentation tends to be voluminous and precise.

Lenders to the project and shareholders in the project company need to have some certainty as to the return and the mere fact that the host country is in economic difficulties should not give rise to a reason for the public sector to renegotiate the rate of return. If the parties have agreed, for instance, what is the proper rate of return for a power plant project, then that should be encapsulated in the power purchase agreement and, if appropriate, the implementation agreement between the host Government and the special purpose company. Those agreements should also set out clearly what is to happen if certain eventualities occur. Once the private sector knows what risks it is being asked to bear and has agreed a price, it is extremely difficult for the private sector subsequently and after the contract has been signed, to be asked to bear even greater risk because of economic difficulties within the host country. Further, the risks and rates of return for the first project in time and the costs incurred in creating the first project in time in a host country are greater than subsequent schemes. It often gives rise to complaint that the earlier schemes are making a greater profit than the subsequent schemes.

If the market has been asked to fund a particular project on the basis of a certain set of returns and long term money has been committed on that basis then it is inappropriate to seek to change the commerciality of the underlying project. However, the underlying commercial transaction should be seen to be transparent which is why on most occasions single negotiations should be avoided. There are circumstances where the risks are so unusual or great that the concession could be granted on a negotiated basis but on the understanding that there is an open book approach to the underlying construction contracts (i.e. that the construction bids received are disclosed to the public sector as are the bidding procedures and evaluation criteria). In countries within the European Union, other than in narrow circumstances, such as defence contracts, all procurement will be through a competitive process.

KEY AGREEMENTS

Project Agreements

It is important that the public sector understands the complexity of the projects as otherwise they will totally fail to understand the processes through which the private sector will have to go before financial close can be achieved. It is also helpful if the public sector understands that from the revenues received by the project company monies will have to be applied to operations, debt service and maintenance before any shareholder dividends can be distributed. In addition the public sector should realise that once the facility has been completed then the project company will have expended most of its debt and equity and, therefore, will only have a small working capital reserve available. The project company is therefore not able to take substantial risk at that stage and risk includes any event which increases capital cost, increases the operating cost or decreases the income.

Most infrastructure for PPPs are used to deliver a public service obligation and cannot be used for any other purpose. Lenders look to the revenue of the project company, rather than the inherent disposal value of the physical asset. This is the concept behind limited recourse finance and, therefore, lenders will be concerned that there are few risks remaining with the project company that might either:

+ increase capital cost or annual costs

+ decrease revenue

As a consequence the project company will seek to off-lay its obligations under what are known as "supply chain contracts" or "step-down contracts", whereby the risks are passed down to contractors of the project company. For instance, a hospital project, in addition to the Constructor, there are hard services contractors (i.e. contractors supplying maintenance services) and soft services contractors (i.e. contractors supplying cleansing, laundry and catering services). Sometimes the contracts are known as the hard facilities management and soft facilities management contracts. More recently in the United Kingdom, there have been equipment supply and maintenance contracts and in Portugal, clinical services will also be supplied.

There needs to be a close co-operation between the contractor who constructs the facility and the contractors who are responsible during the operational phase. The allocation of risk between these contractors becomes an important issue as the lenders will not want residual risk remaining with the project company.

Desirability of Contract Documents

An important element to the success of PPP is to ensure that the parties fully understand their respective roles. If, therefore, an invitation to bid is issued which only deals with technical matters, such as construction and operation, it begs the issue as to the allocation of risk and, therefore, leaves the private sector guessing how these issues should be priced. Invitations to tender or requests for proposals should allow sufficient flexibility for the private sector to use their initiative to come up with solutions but should contain enough certainty to allow the public sector to make a value judgement as to which proposal offers the optimal economic solution. It is therefore suggested that, wherever feasible, the contract documents (giving effect to the public sector's preferred risk allocation) should be prepared and submitted with the request for proposals. The bidders should be given an opportunity to comment on the documents and an evaluation can then be carried out as to what elements of risk are sought to be left with the public sector and what the price or level of charges being sought are.

Tendering without Contract Documents

Where the documentation for an invitation to tender is issued without any form of contract or risk allocation (other than in relation to technical requirements) there is a risk that in order to ascertain a preferred bidder, a memorandum of understanding is reached which then has to be subsequently fleshed out with the preferred bidder to create a concession agreement.[1] The difficulty, so far as the public sector is concerned, is that once it has selected the preferred bidder, thereby losing the advantage of conducting competitive parallel negotiations and maintaining the discipline on bidders, the preferred bidder may seek to renegotiate during the development of the memorandum of understanding into the concession agreement and, as a result, be able to achieve a more favourable risk allocation than might have been possible if one or more other bidders were still to be in the picture during comments and negotiations on the documents.

Although not a recommended solution, on one gas fired power station project[2], a power purchase agreement was drafted and submitted to bidders during the tender period which meant, for the purposes of evaluation, that one was able to determine what changes bidders were seeking to the agreement at the time the bids were received. It is important, however, to make sure the bid process prevents what has become a standard response for certain bidders which is to the effect that the bidder has no major commercial points on the project contracts but there are minor drafting matters which it would like to discuss once it is the preferred bidder. This normally is an indication of a substantial re-negotiation, which will occur once the pressure of a competitive bid process has been removed.

Contracts at Request for Pre-Qualification

In another proposed project on the Mediterranean coast[3], there was included as part of the pre-qualification process a draft contract on which pre-qualifiers were asked to comment. The purpose behind this was not to identify demanding bidders who could be rejected before pre-qualification because they raised too many points but to try to identify, in advance, how many common concerns there were reflected in the various responses. This would enable the public sector to see whether an approach could be achieved which would foreshorten the negotiating period between receipt of the final tenders and the signing of the relevant project agreements.

[1] see reference to BNRR and the Second Severne Crossing above

[2] Tapada, Portugal

[3] Lavrion, Greece