Presentation Transcript

1. Renegotiation

   Olivia Jensen PhD
2. Long-term contracts PPPs as long-term contracts Similar to long-term contracts between private parties Example: car parts supplier Why do we have long-term contracts? Make it worthwhile for parties to engage in ‘relationship-specific investments’ Relationship-specific investments allow for greater efficiency …But create risks for the investor Long-term contracts as a solution Infrastructure is an extreme case of relationship-specific investment
3. Incomplete contracts Long-term contracts are necessarily incomplete Impossible to specify all possible future circumstances and write them down in a contract in a way that is enforceable Contracting parties unable to define their own future interests Necessary to have a mechanism to adjust the contract over time as circumstances evolve Informal discussions Periodic review Contractually specified mechanism for adjustment ‘Renegotiation’ refers to material changes in the contract
4. Causes of renegotiation External shocks Macroeconomic: inflation, exchange rates, affordability Political: change in government Technology Contract-specific shocks Demand higher or lower than expected Changes in related laws and regulations Opportunism Bargaining power of one or both parties changes Change the balance of benefits between the parties
5. ‘Hold-up’ Firm’s bargaining strength increases after the contract has been awarded because of the political and financial costs to the public authority of terminating and rebidding the contract Public authority’s bargaining power increases after the private party has made the bulk of sunk investments
6. Is opportunistic renegotiation a problem? Firm opportunism Undermines the efficiency-revealing properties of competitive bidding Weakens the efficiency incentives of the contractor over the life of the contract Reduces public confidence and support for the contract Government opportunism Private party reduces its risks by investing less Decreases transparency, fairness and creates opportunities for corruption
7. Renegotiation Common subjects of concession contract renegotiations: Tariff (end-user) or fee (paid by public authority) Investment requirements Firm-led Link tariff to inflation/ exchange rates Increase scope of cost pass-through Delay investment requirements Government-led Freeze tariffs Require competitive tendering for capital projects
8. Renegotiation Renegotiation of concession contracts is extremely common e.g. in the water sector, 75% of contracts were renegotiated (Guasch et al 2003) But terminations are rare Renegotiations take place 1-3 years into the contract
9. Which factors make renegotiation of concessions more likely? Political and institutional factors Absence of a regulatory agency when contract signed Low bureaucratic efficiency Corruption Elections Contract-specific factors Bidding procedure – competitive tendering ‘High-powered’ contracts – use of price-cap regulation Contract award based on tariffs Contracts specifying investment requirements
10. Concession Example: Argentina’s railroads Freight rail and urban commuter lines privatised by the Menem government in the early 1990s as concessions Main objectives: reduce the subsidy from the government, increase investment and improve service Competitive tenders contested by local companies Successful result: positive concession fees for freight rail and significantly reduced subsidies required for urban rail Demand increased in all the concessions
11. Argentina’s railroads cont. Demand for freight rail had been over-estimated 3 of the 5 concessionaires in financial trouble All companies cut investment and failed to pay concession fees Government did not enforce payment Demand for commuter lines had been under-estimated Lines were becoming congested and more investment was needed to solve over-crowding problems Government was not able to increase its subsidy to cover the investment required Government faced an impossible choice: Enforce the original contracts and accept service failure Renegotiate but undermine public confidence and the legal force of the contracts
12. Argentina’s railroads cont. Government decided to renegotiate Political pressure: Presidential elections + requirement that contracts be approved by a special commissions Macroeconomic situation: devaluation, recession Progress renegotiating was slow Commuter concessionaires proposed big new investments funded by doubling fares over 5 years New contracts challenged by the commission and by opposition groups Opposition candidate won the elections in 2000 Some of the new contracts were suspended by the new Government 2001 Crisis: Government defaulted on original commuter concessions
13. Delegated service contracts Administrative contracts between local governments and private companies Shared responsibility for investment Contract form allows the public party to make changes to the specifications Public party required to provide adequate compensation to the private party for changes made Specialised court system for disputes between the parties
14. PFI Example: La Trobe Hospital, Australia Project was completed on time and on budget After 6 months of operation, the operator approached the state government for an adjustment of the charge Government refused on grounds that the contractor could not demonstrate adequately that operating losses were occurring and did not want to set a precedent for renegotiating contracts After 1 year, government accepted that the contract would either need to be renegotiated or the project would fail
15. La Trobe cont. Why did the project incur operating losses? Flaws in the project’s financial model Fees based on Victoria’s universal payment mechanism for hospital services: for a given level of activity, government funding therefore falls each year. Failure to understand the tax regime Underestimation of staffing requirements and other costs Operator bid at a discount to average funding rates on the assumption that operating efficiencies could be achieved Casemix funding was inadequate for public hospitals and was supplemented by injections of ‘one-off’ government funds for which the private provider was not eligible
16. PFI in the UK Contract provisions Initial contracts were very incomplete e.g. process for benchmarking; procedures for handover on termination were not clear Payment mechanism: unitary charge + adjustment mechanism Investment requirements not specified in the contract Private party may face demand risk Contracts mostly signed by local authorities Award procedure Bidding followed by discussions with preferred bidder Parties’ bargaining power Pattern of capex and returns for the private party
17. PFI in the UK (Re)negotiation of the contract is standard practice once the preferred bidder has been selected Cost and time over-runs Cost over-runs as high as 600% 98% contracts overrun by 11-166% Bidding and advisory costs of £100,000-2mn Over-runs on advisory costs 25-500% Example: School-building programme
18. Changes in PFI contracts Changes are very common across contracts and frequent within contracts (NAO, Making Changes in Operational PFI Projects, 2008) £164mn of changes made to PFI contracts in 2006 (capital cost) Annual operating cost of changes in 2006 was £14mn
19. Changes in PFI contracts (2) Causes of change Change in national policy e.g. Agenda for Change and Payment by Results in the health care system or carbon emissions policies requiring insulation in social housing Change in local regulations or needs e.g. hospital staff or head teacher make a request for new electrical sockets or to install air conditioning Work requested had been considered for the original contract
20. Changes in PFI contracts (3) How are these changes made? Changes are managed by the SPV and implemented by FM providers Almost always initiated by the public authority Capital costs paid directly; operating costs covered by an adjustment to the unitary charge Adjustment to the unitary charge established through discussions between the parties Almost all the changes were made to assets Results Quality of changes generally good (less than 10% dissatisfied) Concerns over VFM
21. Adjusting the unitary cost SPV gives an estimate of costs Work carried out by sub-contractors Life-cycle costs SPV fee Requirement for competitive tendering (CT)? Major works/ minor works Changes to contract guidance for major works Benchmarking for minor works
22. Comparison of costs 59% of project managers say procurement costs are higher under PFI for equivalent small changes than with traditional procurement and take longer to deliver “Our contract says the SPV isn’t required to get competitive quotes in the first instance. So what happens is we write changes up into a contract variation, they come back with a price, we say “Ha-ha, now go off and get three quotes.” We can’t instruct them to get three quotes in the first place, which is really infuriating. It would be so much simpler if you could say to them, “Please just get three quotes.”” NAO focus group attendee
23. Comparison of costs (2) Room conversion in a court Larger changes compared well with traditional procurement both in costs and delivery times Urgent changes were delivered promptly
24. Factors making PFI contract renegotiation less likely Private sector Dedicated bid manager Nature and strength of the consortium Quality of the proposal Innovative proposals Willingness to take on risks Ability to obtain planning permission Tie in equity over a long timeframe? Experience? Public sector Dedicated project officer Establish the parameters of the project and prepare a clear output specification In-house expertise in evaluation and negotiation Coordination between different public parties Ability to effectively sensitise the public Willingness to take on risks Dedicated PPP unit?
25. Best practice Competitive tendering required for major works and cost validation/benchmarking for minor changes Local authorities should: Set up forums/databases on costs and share information; use central PPP support agencies (PUK Operational Task Force, 4ps) Appoint a dedicated project manager Take a strategic approach to changes – bundle/phase changes Understand the contract Keep good records of changes made Provide a clear briefing to SPV on changes required Communicate with frontline users and stakeholders on changes
26. Performance monitoring Unitary charge is adjusted according to service performance Adjustments based on service performance are not frequent and are generally a small proportion of the total charge Impact on incentives Performance monitoring on the basis of KPIs Often 200 of these; requires a weighting system Service providers self-monitor; reports are audited by the public authority Value testing is still very new – by 2007, only 11 contracts had enterered value-testing
27. Market-testing More than half currently operational PFI contracts have a regular benchmarking or market-testing (open competition) requirement for the ongoing services component (‘soft services’) For a substantial proportion of contracts, MT is not appropriate Early PFI contracts did not include this as a requirement Since 2006, contracts have usually included MT clauses Facilities management is an important component of overall contract costs (about 25%) Many early contracts did not specify the MT process or had vague clauses that were not implementable
28. Benchmarking study No contracts were awarded to external tenderers MT adjustments for telecoms projects led to significant reduction in prices Buildings projects resulted in increases above inflation Authorities made reductions in service requirements to limit cost increases Process took longer than expected (9-25 months on average, up to 37 months for 1 project) but comparable to rebidding a contract under traditional procurement
29. Experience of market-testing Adjustment to the UC established through negotiation Some PFIs worked out informal profit-sharing arrangements Market-testing more effective than benchmarking Difficult to find suitable benchmarks and sufficient data Many contract clauses still not expected to be effective Example: Sussex Partnership NHS Trust £22mn capital value, £900,000 annual cost of service MT for cleaning and catering Contract awarded to in-house supplier +5.7%; £156,000 less than the incumbent’s tender Other risks associated with using an in-house supplier
30. Best practice Lesson learnt from first round of MT Early engagement of the parties to establish the process for MT (up to 2 years before) Need for realistic timescales and process plan agreed by parties Need for adequate resourcing and intelligent management on the part of the public authority Availability of good quality benchmarking information Role of external advisors and within-government support (Ministry level PFI units, PUK etc) Encourage competition e.g. by informing potential bidders about forthcoming tenders New guidance issued 2006 Preference for MT over benchmarking
31. Changes in PFI contracts over time Refinancing Controversial topic Profits of first refinancings were not shared with the public sector Guidance introduced to require profits to be shared 50-50 (2002) In current economic conditions, adjusted to 70% for the public sector Decision to stop using PFI for certain project types IT
32. PFI in solid waste Main market driver is the 1999 EU Landfill Directive limiting the amount of biodegradable waste sent to landfill Targets for 2010, 2013 and 2020 UK will find it difficult to meet the 2013 target Possibility of EU fines + Central government will fine local government £150/tonne Role of PFI 18 LA have signed PFI contracts worth £1.6bn Local government eligible for central government grants £750mn made available in PFI credits, further £2bn allocated PFI used for larger projects, non-PFI usual for small projects
33. Challenges for using PFI Risks for contractors Demand risk is high compared to FM contracts Regulatory risks associated with securing planning permission Waste management is a complex process with several stages (collection, recycling, treatment, disposal) – more risk in the operating stage of the contract Treatment technologies are relatively new and untested in the UK Governance risk: coordination is needed between central and local government and sometimes between Local Authorities Markets for treated waste products are undeveloped Supply-side of the market is relatively undeveloped Similarities to concession contracts
34. Progress so far Market has developed slowly DEFRA established a special unit in 2006 which has accelerated the process Initially only a small number of bidders for projects but this has improved and international companies have started to participate in the market Risk margins are higher for waste than other PFI sectors reflecting extra risks and conditions in capital markets Larger PFI projects have encountered long delays – on average 19 months prior to contract award Need to improve the business case; changes in method; affordability concerns Market conditions for financing
35. Recommendations Local authority: Active role in project preparation (identifying suitable sites, securing planning permission, sensitising public opinion) Contracts should provide for sharing of demand risk Contracts need to strike a balance between encouraging innovation and using lower risk, tried-and-tested technologies Central government: Develop a benchmarking database Develop Key Performance Indicators to monitor project development Place experienced commercial staff in procurement teams (‘Transactors’) Support contract management
36. Lessons for PFI from other PPP types Contract drafting Contracts need to include provisions on adjustments, process for monitoring, rebidding and termination Information Establish an agency with a specific remit to collect information? Cross-border cooperation? Incentives SPV like a concessionaire under a cost-plus system of regulation does not have an incentive to minimise costs Need for a regulator?