IMPORTANT CONTRACTUAL CLAUSES FOR PUBLIC-PRIVATE PARTNERSHIPS – LESSONS FROM THE WATER SECTOR
An important issue in the preparation of Public-Private Partnership (PPP) arrangements is how to safeguard the public interest in PPP contracts in a balanced and effective manner. This is the essential focus of this article.
Any discussion of public-private partnerships must inevitably begin with a consideration of the concept of concessions, since many PPP projects are based on concessions. Concessions have been known and used as legal instruments for centuries in Europe. In fact, some of the earliest concessions were during the time of the Roman Empire, when concessions were used as a legal vehicle for the running of markets, public baths, building roads etc. In medieval Europe, a concession was granted by royal decision to specific enterprises and had the character of a privilege entirely subject to the discretion of the sovereign.
The concession, as a legal instrument, enabled the sovereign to have public facilities developed and maintained without cost to public or royal funds. In fact, many facilities such as roads and bridges in medieval Europe would not have been built without concessions. A concession essentially gave the operator the obligation to build and maintain the infrastructural facility as well as a parallel right to any income that he could obtain from it, such as by charging the users of the facility in question, e.g. by means of road taxes or rent of stall rents in the case of markets.
The difference between concessions and other contracts can be illustrated by an example concerning road construction. In the case of road construction, a normal public contract may include payment for the construction and a fixed regular fee for maintaining the road. Alternatively, and as part of a concession, the private party takes on the task of construction and maintenance in return for the right to charge motorists a fee (toll) for using the road and recover his costs and profit in this way.
In recent decades, concessions are playing an increasingly important role in large infrastructure projects in the public interest; especially in fields such as transport, energy supply and the operations of certain utilities. One of the reasons for this, and another key difference with traditional public contracting, is that concession contracts are seen as low-cost in public finance terms as they typically do not involve public expenditure when the cost of investment is taken on by the private party.
The introduction, especially since the 1980’s, of the concept of public private partnerships (PPP) has often been perceived as a new type of legal vehicle for such projects. However, a PPP, in legal terms, is quite often based on a concession relationship. In other cases, a PPP may be based a management/leasing contract, on for example, or a joint venture with the public party (creating what are generally known as Institutional Public-Private Partnerships).
Regardless of the structure chosen for the contract, in any PPP there is an inherent conflict of interest triggered by the overall public interests and the primarily commercial motivation of the private party. This is not strange and certainly not unexpected and such motivation is of course perfectly justifiable. Nonetheless, international best practice has developed contractual tools for mediating this basic conflict of interest.
Best practice contractual solutions to balance the interests of PPP parties
From this starting point, it is useful to examine the contractual means that are available to the public party for ensuring that the private party performs optimally.Relevant examples of contract provisions for this purpose are common in the water sector. This is a sector within which PPP/concession arrangement have been frequently used, especially in the new EU Member States. However, the approach of the best practices described can be applied to contracts in other sectors, including e.g. waste management and electricity supply.
The proper allocation of risk is the purpose of virtually any contract but this is particularly accentuated in the case of long-term contracts such as PPPs. The basis for risk allocation is that the risk should be placed on the party who is in the best position to assess and manage (and avoid) the risk. It is normal best practice, therefore, that the operator takes the risks in connection with the operation of the PPP. He will on the other hand wish to negotiate specific contract clauses to neutralise this risk in case of extraordinary events or other circumstances reasonably beyond his control, such as raw water quality, for example.
The situation will differ, of course, depending on the circumstances of the project and the negotiating positions of the parties. There have been many cases where the risk has been unduly tilted to the disadvantage of the public party. On the other hand, no private investors would be interested in bidding on a project where the draft contract of the tender dossier leads to an allocation of risks that is out of proportion to the uncertainties of the project. Even if the tender of PPPs will normally include rounds of negotiations with interested bidders, the project may look unattractive from the outset and therefore not attract sufficient interest in the market.
It is difficult – and could be misleading – to point to a specific, concrete model contract as representing best international practices One way of illustrating best international practices is to list the elements that should typically be included in such contracts to protect the public interest.
The following important contractual element that this article is especially focusing on must be seen in addition to the elements of any normal contract, such as the identity of the parties, preamble, applicable law and jurisdiction etc. There are also very PPP specific items such as the specific hand-back procedures for assets at the end of the PPP project, the requirements as regards the investments normally to be provided by the operator, performance bonds and limitations as regards sub-contracting and assignment of rights. These aspects are beyond the purpose of this article which is to provide an overview of the tools normally used to ensure public interests in PPP projects.
(1) Performance Indicators
Over many years, there has been a development internationally towards setting increasingly detailed requirements in PPP contracts with water operators. This essentially involves the inclusion of clauses covering performance indicators. This development accelerated significantly during the late 1980s and was very much driven by the water authorities in England and Wales, arising, in particular, from the growth in the involvement of private water operators in water supply. With the emergence of private water operators, the public partner in effect delegates the water operation to the private operator, but this does not affect the statutory and ultimately the political responsibility of the public sector for ensuring ample and quality water supply to the population.
For this reason, the public sector party must be in a permanent position to ensure that satisfactory operations are maintained and that remedial steps can be taken in the case of deficiencies. Recently, the development of performance indicators has been further strengthened by the development of international standards (ISOs) for asset management, including water infrastructures. Performance indicators also require suitable data collecting/monitoring and audit procedures to be developed.
Previously there had been many cases where, in contracts or licences, the private party’s commitment was defined in vague terms like “endeavour to ensure uninterrupted water supply” or “highest quality levels possible under the concrete circumstances”. While contracts might have set quantitative levels concerning matters such as time-limits for the notification of planned interruptions of supply, such clarity was often undermined, however, by the addition of a provision along the line that the time-limit only applied “under normal circumstances”.
Experience has shown that such vague contractual clauses are of no value; essentially because it is not possible to verify compliance. Without this possibility, it is not possible to monitor whether the operator performs satisfactorily or not; nor, indeed, to remedy bad performance by means of sanctions. In turn, even where the conditions for water operation are reinforced by monitoring/reporting procedures and draconian sanctions for breaches of the conditions, this is to no avail if the precise indicators for good performance are not defined.
Best international practices have resulted in particular formulations for the performance indicators concerning water supply. Thus, a requirement of uninterrupted water supply is often translated into quantitative and in a sense negative terms by setting limits at a maximum of X interruptions of a duration of maximum Y each within a period Z.. Only when the interruptions are kept within these limits is the operation seen to provide uninterrupted supply. This type of performance indicator can be monitored and sanctioning in the event of non-compliance can be reduced to a relatively unambiguous procedure.
In fact, as part of a substantial review some years ago of the conditions for various EU-funded infrastructure projects in several countries including the Czech Republic and Slovakia, a recurring criticism was the lack of precision in performance criteria. Vagueness seeps in when no specific time limits or percentages were used or when indicators were otherwise made conditional by the use of terms such as “under normal conditions”.
The effect of purely quantitative performance indicators is that the water operator, as a natural part of his general responsibility for operational matters, takes the risk of cases arising where circumstances are not in fact normal. Thus, it is a normal feature of the relation between the private operator and the public sector that it is the private operator that accepts the risks of operation; not least because he is closest to actually dealing with such risks.
When the requirements for the operator are not easily verifiable then it inevitably works to the disadvantage of the public party and customers in general and the risks for the operation are consequently shifted away from the operator. Especially in situations where a concession relationship obliges the private party to invest in return for the right to operate, any risk transfer back to the public authority means that the essential purpose of having the water operation in private hands is lost.
Performance indicators cover strictly technical/operational aspects of the water supply activities e.g. continuity of supply, water quality and water pressure, loss of water. In addition to the above indicator as regards continuity there are other types. Water loss indicators set a certain maximum percentage of acceptable loss in relation to the total input of water. The loss can be measured in relation to parts of the mains or in relation to certain urban areas etc. Due to the age of the water infrastructure in some countries, the setting and adjustment of water loss indicators can be a challenging task.
Beyond the aspect of water supply as such, performance indicators are also used to set minimum requirements for customer relations; including, for example, what customers should expect in terms of helpdesk and complaints facilities. Customer relations were previously not given much attention but it has now been realised that a high degree of service in communicating with and dealing with requests of customers is an integral part of water supply operations.
An obvious aspect of customer relations is the time it should take for the operator to inform customers about interruptions of water supply. On this, a distinction is typically made between planned and unplanned interruptions. The typical indicator consists of specific time limits to be set for notifications as regards water interruptions. The critical issue here is to set an objectively clear point in time for calculation of the time limit.
There are also examples of performance indicators for the time it must take for a caller to be connected to the operator by telephone. In a concrete case from Australian practice, the private water operator must monitor and report the average time it takes for a caller to be connected when using a fault complaint line. The time is measured from the point where the call is received at the operator’s switchboard or the automatic answering service until it is responded to.
Connection is, in other words, understood as the time it takes to get in touch with an actual staff member and this means that automated services have limited value in terms of service beyond that of sorting calls. In the Australian case, the indicators set a target response time of 30 seconds and reporting by the operator must identify the percentage of cases where this target has been reached. No specific maximum time limit is set; but the implication of the reporting system is obviously that the operator is motivated to improve the customer telephone service, perhaps especially in cases where monitoring results are published in a market with several operators.
Other examples of indicators concern the handling of complaints. The indicators typically focus on the time it takes for resolving such complaints. On its own, a single indicator on this would undoubtedly result in the quick, formally correct but not necessarily reasonable resolution of complaints. In many cases, a supplementary indicator for capturing the amount of unjustly rejected customer complaints provides the necessary counterbalance on behalf of the customer. This indicator is typically measured on the basis of the number of complaints going to the public monitoring authority in cases where a customer complaint is viewed as inadequately dealt with at the level of the water operator.
Another indicator concerning complaints relates to the total number of complaints received by the water operator or by the public monitoring authority. This indicator makes no distinction as to content of complaints but reflects the position that any increase in complaints is in itself a sign that customer relations need to be improved. The weakness of an indicator based on the overall volume of complaints is that it may only reveal a fraction of the problem. Concretely, customers may have become accustomed to poor service and not complain. In other instances it may be difficult for customers to report complaints.
A further indicator of satisfactory customer relations is the extent to which the water operator acts proactively invites feedback from customers. This can be done by means of questionnaires and surveys; e.g. in advance of changes in practices or in general to gauge customer attitudes and preferences. Quantitatively, this indicator can be elaborated and defined in terms of the number of events over a certain period of time.
The specific circumstances (including the physical condition of the water infrastructure and the positions of the parties involved) dictate, to a large degree, what indicators should be used and what should be laid down as specific time limits or percentages depending on type of indicator. No fixed practices obviously exist in this regard.
However, what matters is that certain precise figures are laid down in a first phase as a verifiable basis for performance monitoring. Future adjustments to higher levels of performance can be managed via revision procedures laid down contractually or otherwise.
To ensure that customer interests are being heard, some countries have in addition to performance indicators, required that the boards of water operators include representatives of consumer interests. Thus, in the case of countries with regional water operators, it is the local customers that elect the representatives.
In Denmark, for example, the consumer representatives have the same rights and obligations as the other board members. It can be argued that this is a double edged sword, as there is a risk that the customer representatives progressively may ultimately identify more with the interests of the board. This risk can be particularly high in larger operations. However, in combination with precise performance indicators defining satisfactory performance levels for operations and customer relations, such representation can contribute to ensuring that customer interests are kept in focus.
(2) Reporting and other Monitoring
Performance monitoring is a necessary complement to performance criteria and they rely on each other. Without monitoring it is not possible to ascertain whether the criteria are being met. Without verifiable performance criteria there is, in turn, no clarity as to what needs to be monitored.
The best practice contractual rules normally consist of reporting obligations for the operator and rights for the public party to obtain information from operator. There is a broad scope for designing such rules to suit specific circumstances. The reporting requirement should include at least an obligation for the operator to submit regular reports on performance, repairs and other operational aspects (e.g. on a quarterly basis) as well as special reports in the case of extraordinary events or at the request of the public party. In addition, there should be requirements as to the content of the reports. The reporting requirements will, of course, need to correspond to the types of performance criteria used in the contract.
The rights of the public party to information are normally ensured primarily by prescribed regular meetings, e.g. in connection with the submission of regular reports. There is often also a right for the public party to call meetings at its own discretion to clarify specific issues. An essential right for the public party is relatively unrestricted access to the various water facilities as well as access to documents and information at the premises of operator for the purpose of eventual verifying the content of reports.
In its role as monitor, the public party must remain at arms-length from detailed operational matters. If the public party is seen to instruct the operator in this respect, then the operator can rightly claim that the public party must share any relevant operational risk. This blurring of the risk allocation would undermine the entire idea of the PPP project.
It is generally important for most public parties (because of limited personnel resources) to be able to transfer inspection rights and access to the operators records to professional monitors (engineers, lawyers, financial experts etc.) acting on behalf of the public party or indeed to other entities that might be empowered to carry out monitoring.
(3) Tariff calculation
Tariffs should be designed to reasonably reflect costs; they should drive efficiencies and be affordable. The profits to be made from operating public assets should reflect the relatively low market risk associated with providing what are essential services in a monopoly market, at least in the water sector.
Most European utilities are subject to tariff setting regimes which meet the above criteria. They may be regulated by an independent regulator (as is the case in for example of the UK) or require local or central government approval for tariff increases. One of the main advantages of independent regulation is that it removes politics from tariff setting and allows Governments to distance themselves from tariff increases. Many utilities prefer this mechanism for tariff setting as Governments are often reluctant to sanction unpopular increases in tariffs for essential services. However, tariff review by government was very much the norm up until the 1980’s.
The important thing for all parties (consumers, asset owners, governments and service providers) is that tariffs are seen to be fair, equitable and affordable. Operators and asset owners should be able to recover their operating and reasonable investment costs and shareholders should be able to earn a reasonable reward for their investment (although this should not be guaranteed; profit being seen as the reward for risk and to be earned by good management). Tariffs may also be used to encourage efficiencies, especially in previously State-owned utilities where practices may be outdated and staff levels too high.
Different tariff models exist and are used in different utilities. The so-called “cost-plus model”effectively allows profits to increase in line with any rising costs. Obviously, such a model does not encourage efficiencies. According to the most common model, which has been adopted by many regulated utilities in Europe, tariffs are set to ensure that operating costs are reduced to an efficient level and that only approved capital expenditure is recovered.
(4) Relations with consumers
It is a central characteristic of PPP contracts based on a concession model that the operator is given the right to collect revenue directly from the customers, i.e. the population. In this situation, the public party must ensure that the treatment of customers is fair and transparent and that it is otherwise in accordance with prevailing public policy objectives. This must, of course, be balanced against the fact that operators in these contracts typically take on the risk of bad debts.
In addition to granting the metering, billing and collecting right to the operators, the contracts will normally oblige them to have guidelines on these issues approved by the public party. Moreover, it can be part of the performance criteria that the operator can guarantee a high degree of exactness in metering of water consumption in the case of individual households.
Obligations in this regard can include provision of sufficient information to enable households to check the correctness of water bills. This normally would include a fixed set of information that the water bill must contain, such as the amount due for payment, the due date, the next due date, details of the elements constituting the billing, the date of the meter reading, interest charges for delays in payment and resulting amounts, the amount of any tariff increase, adjustments, extra-ordinary charges, or penalties levied, the billing period and whether the volume indicated is metered or estimated.
Normally the contract also sets the conditions for disconnecting customers and the consequences of incorrect disconnection. Conditions for disconnecting can include non-payment despite several reminders and the issue of a written warning a certain number of days before disconnection takes place.
Getting the balance right
It is clear from the manner in which relatively standardised types of contractual clauses have developed for concession-based PPPs in the utilities sectors that the cost-saving benefit for the State must be flanked by a range of additional guarantees that can be adequately monitored and contractually enforced. Thus, the creation of PPPs (and the obvious advantages of divesting important utility operations from the State) does not relieve the State from a significant supervisory role in regard to the private operator. Practice indicates that “best endeavours” obligations have now been generally replaced by performance based contractual clauses and that well-crafted and well-monitored performance clauses help to correctly balance the PPP relationship in the public interest and contribute to the success of PPP projects.
Author: Steen Bruun-Nielsen, Senior Public Procurement Expert
The contents of this article are the sole responsibility of the Crown Agents and its Consortium partners and the opinions expressed in this article are not to be understood as in any way reflecting an official opinion of EUROPEAID, the European Union or any of its constituent or connected organisations.