Improving PPPs using payment mechanisms
What constitutes a payment mechanism, the benefits it brings and how it can be created is explained by GARY WATKINS, managing director at Service Works Group.
The routine use of public private partnerships (PPPs) to deliver new public infrastructure and improve the quality of service delivery is continuing to increase in Australia and across the globe. According to a report from Infrastructure Partnerships Australia, PPPs are the best method available to Australia’s governments to deliver large, complex and expensive projects, achieving significant savings in both time and cost. By the start of 2012, $64,663 million worth of projects had been procured through the PPP method, according to government statistics (www.infrastructureaustralia.gov.au/public_private).
Most of these projects are working effectively and delivering significant benefits for public authorities and service users. But, it is clear that the value created by PPP projects is maximised when public-private relations are underpinned by a properly designed contract management framework that outlines the service outputs that the authority requires, the methods for measuring and monitoring performance, and the regime under which the payment due to the private partner is determined. It is the contract management framework that puts into effect the transfer of risk and responsibility between the authority and the private sector, creating the incentives for the latter to deliver facilities and services on time and to budget – and to deliver public services at the level of performance and quality that the client requires for the full length of the contract.
INTERPRETING THE CONTRACT
Survey evidence from the UK shows that the most frequent reason for disputes between public sector clients and the private partner is over the interpretation of the contract (National Audit Office 2001). The key to successful partnering, therefore, is to ensure that the legal requirements of the contract are translated into a performance management software system that is clear, easily understandable and operationally relevant to all users. The benefits of this will be maximised if the provider of the performance management software is engaged during the preferred partner negotiations or, ideally, during the competitive bidding stage. Having an agreed and objective interpretation of the contract is important for all parties when dealing with complexities as they arise. The implementation of a well-designed performance management system can avoid problems of interpretation and communication, and the adversarial relationships that then result.
SPECIFYING OUTPUTS AND DETERMINING PAYMENT
For public sector authorities, a PPP project is considered successful if it delivers cost-effective, reliable services at the price and quality defined in the contract. Authorities also expect service outcomes to be auditable and transparent. Meeting these objectives requires effective interaction between the different components of the contract management regime.
The public sector authority’s requirements should be framed in terms of an output specification that the private partner must endeavour to meet through the delivery of construction and asset-related services (both ‘soft’ and ‘hard’ facilities management). The quality of service delivery is then measured and monitored through the performance management system, which determines the correct payments to a service provider from the authority. Where the quality of service delivery falls short of that outlined in the output specification, the payment mechanism determines the appropriate scale of the deduction.
The payment mechanism must clearly set out the time required for repair and rectifications of failures (depending on the salience of the affected area) before payment deductions are triggered. It must also include ‘ratchet’ mechanisms, whereby recurring or widespread failures across key services in a project lead automatically to correspondingly higher deductions.
Any deductions must be sufficient to incentivise good performance, but not so high that they encourage excessive pricing by private partners, or threaten the availability of debt finance. They need to be well-balanced across all areas of performance, so as not to introduce perverse incentives or unintended consequences. Unsuccessful partnerships are those that have been based on using the payment mechanism as a punitive, revenue-generating tool, rather than as a joint management tool to optimise performance, which is its intended purpose.
CALIBRATING THE PAYMENT MECHANISM
The economic characteristics and detailed design of the payment mechanism are central to the achievement of value for money, transparency and auditability. There are a number of points of detail involved in assigning numbers to the various parts of the payment mechanism – a process referred to as calibration. Ensuring the effective calibration of the payment mechanism is critical to ensuring that facilities and services are delivered to contract and that the client can enforce them.
Research from the Scottish Government indicates that the most effective way to design and calibrate the payment mechanism is to develop a full working model that reflects the project being delivered during procurement. Ideally, this should incorporate both accommodation and service areas for modelling availability and performance requirements, and, where applicable, include weighting and allocating financial values or percentages.
Best practice is to complete a draft calibration exercise based on the public sector designs and release these to bidders, along with the associated calibration models, as part of the tender documentation. This will allow bidders to tender on a common basis, while the model can be refined as the procurement process proceeds and finalised before contracts are agreed.
When designing the payment mechanism, the authority should ask itself some key questions:
- How demanding should we make the definitions of availability and service performance standards?
- How quickly, in terms of response and rectification periods, do problems have to be solved?
- What scope should the private partner have to provide alternative services/locations instead of having deductions applied, in order to give them greater flexibility to avoid deductions, or for allowing ‘unavailable’ facilities to be used?
- What are the right levels/weightings of deductions for unavailability or poor performance?
- What are the appropriate ratchet mechanisms for repeated or widespread failures?
- At what level should performance deductions be capped?
Calibration needs to be considered in the context of the services specification within the performance management system. This defines the services to be provided, the priority attached to these services and the rectification time that is available to the private partner to resolve a service failure (in which the private partner should not incur deductions, so that, instead, these are only levied if a service failure is not addressed by the end of the rectification period).
The services specification may include both temporary rectification periods and permanent rectification periods. In addition, the weightings or priorities given to different areas must be considered. For the public authority client, a broken light in a classroom or operating theatre is a more salient matter than the same problem in a storeroom. The mechanism needs to apply a greater deduction for the former than for the latter to incentivise the provider to allocate resources intelligently.
FIVE BASIC PRINCIPLES FOR ACHIEVING A WELL-DESIGNED PAYMENT MECHANISM
- No payments should be made until the specified facilities and services are available.
- The level of payment should be linked to the level of service. For a mechanism based on availability with an overlay of performance deductions, this means linking payment to both the availability of assets and the quality of the service.
- The unitary charge should never be paid in advance of the period to which it relates.
- The payment mechanism should adjust for sub-standard performance, and deductions should reflect the severity of any failure. Proportionality is key – minor failure leads to a minor deduction (except in the case of persistent or widespread failure), while major failures lead to a correspondingly substantial penalty.
- A balance should be struck among the variables in the payment mechanism, such as the initial weighting of deductions for failures, response periods and ratchets.
In conclusion, a good performance management system must provide a strong incentive for the partner to understand, control and minimise availability and performance risks, enhancing value for money for the public sector client. But, proportionality is essential.
When payment mechanisms are effectively calibrated, and service delivery is monitored and measured using integrated performance management software, PPP contracts can deliver long-term value for all stakeholders. The aim is to build and strengthen the operational partnership, giving an audit trail for compliance purposes while helping to manage a service provider’s risks by providing measurable cost savings, improvements in time control and higher productivity.
This article is based on the white paper PPP Performance Management through Payment Mechanisms. For a complimentary copy email email@example.com.