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					                                            
Financial Partnerships Unit
Finance Directorate




Briefing Note 1: Payment Mechanisms In Operational PPP
Projects
November 2007
Briefing Note 1: Payment Mechanisms in Operational PPP Projects




Foreword

This Briefing Note has been produced as one of a series of briefing notes developed by the
Scottish Government to disseminate learning experiences from operational PPP projects.
During 2007, the Scottish Government undertook extensive consultation with the operational
managers responsible for managing accommodation PPP projects in Scotland. The results
of their experiences have been recorded within this briefing note in the form of
recommendations regarding the approaches and actions to take at different stages in a PPP
project. Although the research is based on accommodation projects, it is expected to be
applicable to projects in all sectors. It supports the calibration of the sector specific payment
mechanisms included within the standard contracts. Where appropriate its recommendations
will be incorporated into the Key Stage Review and Gateway processes which are
implemented at various stages within capital procurement processes in Scotland.




Acknowledgements

The Scottish Government would like to thank all Procuring Authorities and private sector
partners who gave their time to participate in the research and provided supporting
information and analysis to help develop this note.




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Briefing Note 1: Payment Mechanisms in Operational PPP Projects




Contents


1.    Introduction ......................................................................................................... 4

2.    Procurement Phase: Development of the Payment Mechanism ......................... 6

3.    Pre-Services Commencement: Implementing the Payment Mechanism ........... 19

4     Operational Period ............................................................................................ 26

5     Unitary Charge .................................................................................................. 29

Appendices .............................................................................................................. 33

Appendix A: Glossary ............................................................................................... 34




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1.       Introduction

1.1      This briefing note has been developed following recent research into the
effectiveness of payment mechanisms in PPP projects. It has been structured to ensure that
the learning points identified during the research are applied to current and future payment
mechanisms developed for capital projects. As such, the findings have been presented over
the different phases of the payment mechanism from its original development and
calibration, through to its implementation in the pre-services commencement phase and its
management and operation during the operational period. The specific points covered at
each of these stages include:


      Section 2: Procurement Phase - Development of the Payment Mechanism
         o      the objective of the payment mechanism
         o      the calibration of the payment mechanism
         o      the negotiation of the payment mechanism
         o      indexation and sculpting of the unitary charge
         o      the key stage review process and approval of the payment mechanism


      Section 3: Pre-services Commencement - Implementing the Payment Mechanism
         o      implementing the payment mechanism – procedures manuals and user
                guides
         o      monitoring the payment mechanism
         o      reporting processes supporting the payment mechanism
         o      shadow running of the payment mechanism


      Section 4: Operational Phase - Managing the Payment Mechanism
         o      grace periods and snagging issues
         o      enforcing deductions
         o      incorporating project changes into the payment mechanism


1.2      In addition to this, Section 5 of this guidance summarises areas of the contract which
may result in changes to the unitary charge over the course of the contract. The research
highlighted the importance of Procuring Authorities being aware of these potential changes
in order to effectively manage affordability over the life of the contract. Procuring Authorities




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Briefing Note 1: Payment Mechanisms in Operational PPP Projects




also need to ensure that project changes are incorporated into the payment mechanism and
that deduction amounts reflect such changes to the unitary charge.




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2.     Procurement Phase: Development of the Payment
Mechanism

2.1    This section of the guidance covers issues which need to be addressed during the
period from approval of the OBC through the procurement of the project to commercial and
financial close. It highlights the key aspects of the payment mechanism which need to be
considered by a Procuring Authority and its advisers during the project development and
negotiation phases. The specific areas covered in this section are:


       o      the objective of the payment mechanism
       o      the calibration of the payment mechanism
       o      the negotiation of the payment mechanism
       o      indexation and sculpting of the unitary charge including phased availability of
              services


2.2    It provides guidance on how the sector specific payment mechanisms, included
within standard contracts, should be developed by Procuring Authorities to ensure they
capture the specifics of their project. The use of the Standard Contract and associated
payment mechanism is a requirement of Scottish Government funding. Certain sectors will
also have standard specifications and accommodation schedules which should be used.


Objective of the Payment Mechanism


2.3    The objective of the payment mechanism is to incentivise the PPP Contractor to
provide the PPP services to the required standards. If these standards are not met the PPP
Contractor will incur financial deductions, if they are met the PPP Contractor receives full
payment.


2.4    The payment mechanism involves the Procuring Authority paying the PPP Contractor
a known sum of money for the required level of service with the ability to vary the sum of
money to take account of:
       o      performance and availability risk which is borne by the PPP Contractor
              usually through financial deductions;
       o      risks retained by the public sector (for example inflation, costs of retained
              staff); but


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Briefing Note 1: Payment Mechanisms in Operational PPP Projects




        o      does not allow for a price change for risks transferred to the PPP Contractor
               (for example, construction cost overruns or increased maintenance
               requirements)


2.5     Sector standard documentation captures these principles as they apply to that sector.


2.6     The PPP services will be specified within a services specification. The services
specification will classify services as either availability standards or performance standards.
An example of an availability standard, within an accommodation PPP project, would be that
a minimum temperature must be met before a space could be classified as available. An
example of a performance failure would be that cleaning services had not been provided and
that areas, such as toilets, did not meet the required standards of cleanliness. Services
classified as performance will be prioritised, with health and safety issues usually being high
priority whereas the need for PPP contractor staff to wear regulation uniform will be a lower
priority.


2.7     If the total deductions reach certain pre-defined levels and/or performance standards
are consistently below the requirement, the Procuring Authority will be able to issue warning
notices and ultimately terminate a project for poor performance (classified within the Project
Agreement as Termination for Contractor Default.) These pre-defined levels are specified
within the Project Agreement.


2.8     The effectiveness of the payment mechanism is therefore determined by its linkage
into both the services specification which results in the deductions which can be incurred
and the warning notices and termination triggers included within the Project Agreement. The
research into operational projects indicated that where these linkages had not been fully
developed and considered, Authorities could not always enforce the service standards as
the PPP contractor refused to address failures in the specification - for example, where
temperatures did not meet pre-agreed thresholds.


2.9     The experience of operational PPP projects highlighted that it was essential that
professional advice was obtained from suitably experienced technical, financial and legal
advisers when developing a payment mechanism for a project. Additional guidance on the
principles underpinning the development of a payment mechanism is included within SoPC4
which can be obtained at www.hm-treasury.gov.uk/documents/public_private_partnerships.
The following sections provide an overview of the process a Procuring Authority should


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follow to develop a project specific payment mechanism and some of the issues it will need
to address during this development.


Development of A Project Specific Payment Mechanism


2.10   The calibration of the payment mechanism is critical to ensuring that a PPP
contractor provides facilities and services to the required standards and that a Procuring
Authority can enforce these standards. It is therefore, a key aspect of transferring the risk of
operating the PPP facilities and services which underpin the value for money of the PPP
contract.


2.11   The payment mechanism therefore needs to be considered within the context of:


       o       the services specification – this defines the services to be provided, the
               priority attached to these services and the rectification time available to a PPP
               Contractor to resolve a service failure. During the rectification period a PPP
               Contractor will not incur deductions – these will only be levied if a service
               failure is not addressed by the expiry of a rectification period. The services
               specification may include both temporary rectification periods and permanent
               rectification periods.


       o       the accommodation schedules and the weightings or priorities given too
               different areas. For example, if a hospital project has a difficult to mend light
               broken in an operating theatre and an easy to mend light broken in a store
               room.    The payment mechanism should apply a greater deduction for
               unavailability of the operating theatre to incentivise the provider to prioritise
               resources to rectifying the more difficult but critical failure in that area.


       o       the termination triggers to be included within the project agreement – these
               will include triggers related to the level of deductions which trigger a
               termination event.


2.12   The research indicated that the calibration exercise undertaken by a Procuring
Authority needs to consider these aspects of the calibration very carefully. For example, a
payment mechanism can appear very robust or even penal but if the rectification times are
overly generous, or the services are not specifically defined, it will be difficult to enforce.


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Briefing Note 1: Payment Mechanisms in Operational PPP Projects




Similarly, if the termination triggers are set at too high a level it is unlikely that a contract
would be terminated for poor performance. Both these aspects would undermine the
payment mechanism. In contrast a “draconian” approach may put off bidders and act as a
disincentive to contractors.


2.13    A practical example of the difficulties of comparing calibration exercises would be two
schools project teams comparing their deductions for the unavailability of a toilet. If they are
materially different, one team may try to re-calibrate its model.         However, on further
investigation the difference may be the definition of a toilet – one team defining this as a
toilet block and the other as a toilet cubicle.


2.14    Advisers will assist Procuring Authorities to ensure the right balance is achieved.


2.15    Payment mechanism principles are established in most sectors through the standard
PPP contracts. In some sectors, generic service standards and payment mechanism models
are available. At a project level, these need to be reviewed in detail to ensure they reflect the
scope and objectives of the individual scheme. The approach which should be adopted in
this process is outlined below.


Payment Mechanism Calibration


2.16    The appropriate calibration of the payment mechanism (i.e. the assignment of
numbers and related formula to contractual requirements) is key to achieving value for
money, risk transfer, workability and success of the commercial aspects of the project. Good
calibration leads directly to a good operational client/contractor relationship and is a key
legacy of a good procurement team.


2.17    There are a range of payment mechanism models across different PPP sectors.
Summaries of some of the common models can be found in SoPC4 which can be accessed
at           www.hm-treasury.gov.uk/documents/public_private_partnerships/ppp_index.cfm.
Research has indicated that across all of these models, there is a need to test the payment
mechanism in advance of actual service delivery and understand exactly (relative to the
economics of the project):


        o       what the financial impact of various levels of non-performance or
                unavailability will be. These must be sufficient to incentivise good


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Briefing Note 1: Payment Mechanisms in Operational PPP Projects




               performance but not so high that they encourage “risk pricing” by contractors
               or affect the bankability of the project. They need to be well balanced across
               all areas of performance so as not to introduce perverse incentives or
               unintended consequences. For example, that the failure to clean a store
               cupboard results in whole service unavailability; and


       o       how these impact contractually, generally through the accumulation of some
               form of failure or penalty points. In practice, it is sub-contractors partnering
               with the SPV who are responsible for the service provision and therefore for
               service failures and deductions. Therefore, significant deductions or penalty
               points can lead to for example, replacement of a sub-contractor and warning
               notice/default provisions. These should be realistic in relation to anticipated
               performance levels and not introduce any “hair triggers” which would make it
               impossible for a contractor, or their funders, to step in and improve
               performance prior to their contract being terminated.


2.18   Research indicates that the most effective way to understand these areas is to
develop a fully calibrated working model of the payment mechanism which reflects the
project being delivered. This will have to incorporate both accommodation and service areas
for modelling availability and performance requirements and where applicable, include
weighting and allocating financial values or percentages to these.


2.19   The majority of PPP sectors already have a standardised payment mechanism,
within their standard contracts, reflecting the specific objectives of the payment mechanism
within that particular sector. During the preparation of the Invitation to Participate in Dialogue
and in the dialogue period, the payment mechanism and related drafting should be
considered carefully including the calibration aspects. There is typically a direct nexus to the
work that public sector client teams do in analysing and configuring, then pricing
accommodation/facility and service requirements. The importance of certain areas of the
facilities, and/or services to be delivered and their financial values ultimately drive how they
are treated in calibration modelling.


2.20   Whilst standardised calibration models are required within sectors, population of
these models and assignment of values and weightings must always be project specific.




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Briefing Note 1: Payment Mechanisms in Operational PPP Projects




2.21     Best practice is to complete a draft calibration exercise based on the public sector
designs and release these to Bidders, potentially along with the associated calibration
models, as part of the ITPD and tender documentation. This will allow bidders to tender on a
common basis. Under the competitive dialogue process, the calibration model should be
refined with the bidders during the dialogue process and finalised prior to the appointment of
a Preferred Bidder.


2.22     The key parties and their roles in developing the payment mechanism are noted
below:


         o       The Procuring Authority – development of the payment mechanism in
         conjunction with their sector specific payment mechanism model and advice from
         their advisers. They are responsible for authorising the output and services
         specifications which define accommodation requirements, layouts and required
         service standards and response periods. They will identify the prioritised areas and
         services and ensure that their importance is highlighted to bidders and recognised
         within the payment mechanism.


         o       The Advisers –


                       Technical Advisers – will assist the Procuring Authority in the
             production of the sample project layout and the weighting of the relative
             importance of services and areas. The adviser must be able to impart knowledge
             of operational payment mechanisms and how the Authority’s requirements can be
             reflected within the model with appropriate weightings or values assigned.
             Technical advisers will also provide guidance on contractor performance across a
             range of likely performance/availability levels which can then be analysed against
             resulting financial implications. In turn these levels of performance (e.g. excellent,
             good, mediocre, poor) will be able to inform the level at which warning notices
             and termination triggers should be set. The performance data, ideally drawn from
             comparable operational projects in the form of “number of failures per month” for
             different levels of performance, is critical to the calibration process. (Access to
             such information should be an evaluation point when appointing technical
             advisers.) They will also advise on the appropriate rectification periods to be
             included within the services specification




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Briefing Note 1: Payment Mechanisms in Operational PPP Projects




                       Financial advisers - will typically model the payment calibration model
            on an interactive spreadsheet. This will reflect the areas of layout of the proposed
            project. The outputs of this model will be used to assess the level of deductions
            attributable to each service failure and the commercial implications of these. This
            will initially be based upon the forecast unitary charge for the project. The model
            should be developed at an early stage and shared with the private sector at
            appropriate phases of the procurement process in order that all parties
            understand the implication of the payment mechanism model. The calibration
            model will be updated to reflect the facilities to be provided by the Preferred
            Bidder and will play a key role in finalisation of the payment mechanism.


                       Legal Advisers – will liaise with other advisers to ensure the financial
            elements of the standard contract drafting reflect the results of the calibration
            work and will populate the payment mechanism schedules and contract
            accordingly. It is recommended that, in conjunction with other advisers, they
            provide a range of worked examples of deductions linking the legal drafting to the
            financial impact resulting from the model.


2.23    The purpose of developing a calibration model in support of a payment mechanism is
to ensure that the resulting financial and contractual incentives/deductions are appropriate,
fair and enforceable. Whilst ensuring that the contractor is strongly enough incentivised to
perform, it will also provide assurance to both public and private sector interests that the risk
profile to payments is ultimately bankable. There needs to be suitable protections against
hair trigger scenarios and rapid loss payment.


2.24    The bespoke nature of projects needs to be reflected in calibration development. It is
important to Bidders to understand which services an individual Procuring Authority
prioritises and why. In this way they can ensure that their service proposals can be tailored
for that individual project.


2.25    Specific areas of the calibration which have caused problems in the past, and should
be considered during the procurement process, include:


        o       the need for clarity regarding the rectification periods and penalties attaching
                to temporary and permanent rectification to ensure that service failures are
                fully addressed on a permanent basis. For example, if deductions only apply


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Briefing Note 1: Payment Mechanisms in Operational PPP Projects




               to temporary rectification periods – there is no incentive to implement a
               permanent resolution of a problem.      If they can only be applied once a
               permanent rectification is achieved, there is no incentive for the temporary
               rectification to be completed.


       o       the extent of variable and volume related payments (for example, energy)
               requires careful consideration when developing calibration i.e. how are they
               weighted across the project and do they form part of the unitary charge upon
               which the initial calibration elements are based?


       o       Energy – the link between the technical requirement for energy efficiency and
               the payments to be made for use of energy should be clearly understood with
               both parties.


       o       Interim services – these need to be clearly defined. A separate services
               specification and rectification period may be applied, especially in
               refurbishment projects.


2.26   It is expected that the payment mechanism calibration model will be maintained over
the operational stage of the contract. It can be used to test the results of the performance
reports. It is recommended that contracts contain provisions that allow parties to review and
undertake minor recalibration of output specifications on an annual basis. The calibration
model will be used to assess the impact of such changes.


Negotiation of the Payment Mechanism


2.27   The payment mechanism will be subject to detailed review and negotiation during the
dialogue period by both the short-listed bidders and their funders. Experience indicates that
the areas they are likely to focus upon are:


       o       Services specification: the service standards included within the project
               documentation and the associated rectification periods. This affects the
               Bidders’ assessment of the likelihood of deductions.


       o       Payment Mechanism: the amount of the actual deductions. How are these
               calculated? Are there any elements which may influence the level of


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Briefing Note 1: Payment Mechanisms in Operational PPP Projects




               deductions to be incurred? Areas under detailed review and scrutiny will
               include the use of minimum deductions; reliefs available for availability and
               performance deductions; any provisions which may trigger whole service
               unavailability; caps on potential deductions limiting them to the maximum of
               the monthly unitary charge and the interaction of availability/performance
               deductions.


       o       Warning Notices and Termination Triggers, Project Agreement: the
               Procuring Authority needs to consider the triggers they include within the
               project agreement. They need to be able to demonstrate to Bidders why
               these are appropriate and reasonable for the specifics of their project and to
               resist erosion of these triggers during the bid negotiation process.


2.28   Within the private sector consortium, the SPV will seek to step-down the payment
mechanism, triggers for warning notices and termination triggers to its sub-contractors. The
sub-contracts will therefore include similar provisions to the Project Agreement although, the
triggers attached to the warning notices and termination events will be tighter to enable the
SPV to terminate a sub-contract and address any performance issues before the main
project agreement attracts warning notices and/or termination notices.


2.29   The service delivered will in part depend upon the ability and skill of the SPV to
enforce its sub-contracts. There is evidence that a few SPVs have been unable to enforce
some sub-contractor obligations especially in relation to snagging items and performance
issues. This has adversely affected the services received by the Procuring Authority. It is
therefore recommended that Procuring Authorities consider including SPV performance
measures within their services specification which they can use to ensure that the SPV
enforces the sub-contractor obligations.


2.30   During the bid negotiation and dialogue phase, it is important to ensure that all the
Procuring Authority’s requirements are captured within the services specification. For
example, there have been examples in early PPPs where a bidder’s approach to service
delivery, which was clearly outlined within their bid, was not fully captured within the bid
documentation and therefore, not enforceable in practice. The recommended approach
ensures all parties have a clear understanding of the service obligations included within the
contract.   In some sectors, standard service specifications should help to achieve this




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Briefing Note 1: Payment Mechanisms in Operational PPP Projects




however, care will need to be taken if standard specifications are not available for example,
for Managed Equipment in health schemes.


Indexation of the Unitary Charge


2.31    The level of indexation of the unitary charge is a commercial decision for the
Procuring Authority. Indexation relates to the level of the unitary charge which inflates over
time. This is usually related to the movements in the Retail Price Index or Consumer Price
Index. The research indicated that the level of indexation applying to the unitary charge
varied significantly across Authorities reflecting their individual views on affordability and
their willingness to accept inflation risk.


2.32    The Procuring Authority needs to understand how the proposed level of indexation:


        o          Impacts not just upon the first full year’s unitary charge but the profile of the
                   unitary charge throughout the concession.


        o          Exposes the Procuring Authority to inflation risk.


2.33    It is essential that detailed sensitivity analysis is undertaken prior to determining the
most appropriate indexation level to be included within the tender documentation. Where
projects receive Scottish Government funding support, the Procuring Authority will be
required to confirm that the proposed project remains value for money and affordable under
a range of inflation sensitivities.


2.34    The Bidder’s financial model will include both fixed and variable costs. If the level at
which the unitary charge inflates matches the split of inflating and non-inflating costs within
the financial model, the model is protected against a mismatch of inflationary impacts. In this
case, the financial model is referred to as being perfectly hedged (from the perspective of
inflation risk.)


2.35    If the level of indexation of the unitary charge does not match the ratio of variable to
fixed costs within the bidders’ financial model, the bidder may propose a RPI swap. A RPI
swap is where a future income stream inflating by RPI is swapped for a future income
stream inflating by a fixed amount. RPI swaps are entered into at financial close and
therefore the rate applicable to the RPI swap may rise or fall compared to earlier estimates.


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Briefing Note 1: Payment Mechanisms in Operational PPP Projects




This is a Procuring Authority risk. It is therefore expected that the full benefit of the RPI swap
should be included within the financial model.


2.36   Where RPI swaps are proposed the Procuring Authority should:


       o       undertake sensitivity analysis of the impact of the inclusion of the RPI swap at
               both the rate included within the Invitation to Participate in Dialogue and at
               the prevailing market rate. They should ascertain the rate of the RPI swap at
               which a net cost is incurred by the Procuring Authority as opposed to there
               being a net benefit that can be used to decrease the unitary charge.
       o       ensure that the financial advantage of including a RPI swap is passed in full
               to the Procuring Authority.
       o       be able to demonstrate that a project is still value for money and affordable,
               over its contract life, under a range of inflation and interest rate scenarios.
       o       consider, and take professional advice, on whether better value for money
               may be achieved by developing alternative unitary charge indexation
               mechanisms. For example, by linking a percentage of the increase in the
               unitary charge to inflation and a percentage of the increase to a fixed rise. For
               example, 10% of the unitary charge could increase by 2.5% per annum and
               50% by the movement in inflation (which can be by reference to RPI, RPIx or
               CPI).


2.37   Procuring Authorities should include worked examples of the unitary charge
indexation workings within the project documentation to ensure a common understanding
and to avoid confusion during the operational stage.


Sculpting of the Unitary Charge


2.38   Sculpting of the unitary charge is defined as the specific tailoring of the unitary
charge level to reflect increases in lifecycle maintenance or specific costs to be incurred by
the PPP Contractor, at various discrete times throughout the concession. It will therefore
result in a unitary charge profile with peaks and troughs. The research indicated that in
practice this is not a common approach. If a Procuring Authority wishes to adopt this
approach, they must carefully consider the value for money and cash flow implications of it
and be able to demonstrate value for money and affordability within the Full Business Case.




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Specific advice should be provided by the Procuring Authority’s advisers regarding the
merits of any such sculpting.


2.39   Authorities should ensure that any sculpting of the unitary charge will not contravene
the requirements of the Scottish Government’s Capital Contribution Guidance. This can be
found at www.scotland.gov.uk/Topics/Government/Finance.


2.40   A Procuring Authority may require that services are introduced on a phased basis.
The implications of this must be carefully considered. It is likely that the approaches adopted
in these circumstances will either be to:
       o        phase in the unitary charge on the basis of the capital value of the services
                being delivered; or
       o        phase in the unitary charge based on the weighting of the services to be
                provided. This may be appropriate where the deductions are calculated on
                the basis of the weighted areas.


2.41   Specific advice should be sought from the Procuring Authority’s advisers as to which
option provides the most appropriate approach for a specific project. As a minimum an
Authority must ensure that it is not prepaying for other non-available services through the
mechanism adopted for phasing in the unitary charge.


The Key Stage Review Process


2.42   The payment mechanism is critical to ensuring appropriate risk transfer and
incentivising the PPP Contractor to meet the Authority’s objectives. The results of the
research indicated the importance of a fully calibrated payment mechanism and as such the
following steps will be included within the Key Stage Review process:


   o       Pre-ITPD KSR – this will review a range of payment mechanism scenarios. The
           scenarios     are     on     the        Scottish   Government’s      website      at
           www.scotland.gov.uk/Topics/Government/Finance/18232/12271 and are tailored to
           individual sectors. Procuring Authorities will be required to demonstrate that they
           have undertaken a thorough calibration exercise to ensure that the performance
           deductions, warning notice and termination thresholds are appropriately set within
           the ITPD documentation. Procuring Authorities should be willing to share the




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        results of the calibration exercise with Bidders to ensure all Bidders have a
        common understanding of how the payment mechanism is intended to work.


   o    FBC/Pre-Financial Close KSR –             at this stage of the procurement process,
        Procuring Authorities should:
                Specify and justify any departures from the standard form payment
                 mechanism.
                Demonstrate the calibration of the financial model and how this ties into
                 the agreed warning notice and termination thresholds. For example, that
                 unavailability of 5% of teaching or clinical space, for a day, results in a
                 significant deduction. Alternatively, understanding the proportion of the
                 teaching or clinical spaces which need to be unavailable, and for how
                 long, to trigger a warning notice.
                Indicate how they propose to manage the payment mechanism as part of
                 their ongoing contract management arrangements.
                Provide details of how the retained risk elements for example, inflation,
                 staff costs, energy unit costs will be managed.




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3.     Pre-Services            Commencement:                 Implementing              the
Payment Mechanism

3.1    This section of the guidance covers the period from commercial and financial close to
the PPP services and facilities becoming operational. It highlights the key aspects of the
payment mechanism which research indicates need to be considered by a Procuring
Authority and its advisers during the project’s pre-services commencement or construction
phase. This should facilitate a smooth implementation of the payment mechanism. These
areas of contract management should have been considered prior to commercial close and
this period allows for further development and refinement.


3.2    The specific areas covered in this section are:


           o Contract monitoring arrangements including contract management structures,
           reporting procedures and user guides.


           o Payment mechanism – planning for the operational period - confirming how it
           works; inter-relationship with services specification and termination events;
           shadow running of the payment mechanism.


           o Confirming and agreeing monthly reporting arrangements/procedures and
           report layouts.


           o User guides and training.


           o Budget Review.


Contract Monitoring Arrangements


3.3    Prior to services becoming operational a Procuring Authority should consider the
contract monitoring arrangements it plans to implement for the contract. This will have been
considered during the project negotiation phases and reviewed prior to financial close as
part of the Key Stage Review/Gateway processes.




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3.4      The Contract Monitoring and Management arrangements need to be considered on a
number of levels including:


             o The roles and responsibilities of the Procuring Authority’s Project Board,
             Project Manager, Monitoring Team and support services to be provided by
             different service areas within the Procuring Authority.


             o The interface with the PPP Contractor – who are the day to day contacts,
             what is the escalation process in the event of problems developing with the
             services to be provided?


             o The development of procedures relating to the day to day operation of the
             PPP facilities and services and the respective roles and responsibilities of the
             Procuring Authority, the Facility Users and the PPP Contractor.


             o The development of procedures to manage the payment mechanism and to
             verify payment details.


3.5      Further guidance on these areas can be found:


      1. in the Scottish Government Briefing Note: Managing PPP Projects - From Financial
         Close   to   Operations   which    is   on   the   Scottish   Government   website   at
         www.scotland.gov.uk/Topics/Government/Finance/18232/12271; and
      2. the Operational Taskforce No. 2: Project Transition Guidance which can be accessed
         at www.partnershipsuk.org.uk.


3.6      It is recommended that a contract administration manual is produced which collates
information on the processes and procedures for managing the operation of the contract
including responsibilities and timescales. This should, at a minimum, cover the issues noted
above.


3.7      During this phase the Procuring Authority will need to work closely with the PPP
Contractor. There are areas of operational procedures and contract management
procedures which will need to tie into the PPP Contractor’s proposed procedures.




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Briefing Note 1: Payment Mechanisms in Operational PPP Projects




3.8    In determining the contract management structures to be put in place Procuring
Authorities should ensure consistency between the team who negotiated and managed the
procurement and the team who will be involved in managing and operating the PPP
services. Authorities who have achieved this have noted the benefits to enhancing the
smooth transition to the operational phases due to their detailed understanding of the
services to be provided. This can be particularly important if the PPP Contractor’s staff who
operate the contract are different to those who negotiated it.


Payment Mechanism


3.9    Section 3 of this guidance outlines the approach which should be adopted by
Procuring Authorities during the implementation of the payment mechanism. This should
include the development of a financial model which records the calibration of the payment
mechanism and is shared between both parties.


3.10   On projects where this has been completed, the following steps should be confirmed
during the pre-services commencement phase:


             o   Updating the payment mechanism calibration model for changes in the
                 project since financial/commercial close. For example, if there have been
                 changes to the design of the project facilities these will need to be updated
                 to ensure that the weighted areas in the model reflect the built facility.


             o   Details of the unitary charge will need to be updated for example, to reflect
                 the actual indexation applicable and any changes relating to staff transfers.


3.11   There should also be a period of shadow running or at a minimum testing of the
payment mechanism model to ensure that all parties have a common understanding of how
it will work in practice. This will be particularly important where there have been significant
changes in personnel since the procurement and negotiation phase.


3.12   This should include testing of the payment mechanism for a range of service failure
scenarios. The following should be covered during this period to ensure that the payment
mechanism provisions within the contract are fully understood:


             o   Specific calculation of deductions


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Briefing Note 1: Payment Mechanisms in Operational PPP Projects




             o   Specific calculation of any multipliers or repeat failure deductions
             o   Common agreement on how rectification periods are calculated and when
                 deductions are applicable
             o   The format of the performance reporting
             o   How any help desk facility will be used for reporting faults and recording
                 events/rectifications.


3.13   It is important that the Procuring Authority understands when formal notices require
to be issued to a Contractor and in what format. Within the payment mechanism, this may
relate to instances such as “Unavailable but Used” – in this case a protocol should be
developed to ensure that the helpdesk inform the Procuring Authority that a space is
unavailable so that, when applicable, the Procuring Authority can serve a notice that this
space is Unavailable but Used. Research indicated that the deductions could be difficult to
implement especially where users, who are aware that a space is being used, do not inform
the individual within the Procuring Authority who is responsible for issuing notices.


3.14   The Procuring Authority should confirm with the Contractor their understanding of
how the Helpdesk will operate and the performance reports originating from there. Both
parties should ensure that they understand how performance failures are recorded; how their
progress is monitored and approved and how performance failure episodes are closed out
on the helpdesk record – for example, confirming that a performance or availability failure
cannot be closed off when the helpdesk refer it to a specialist sub-contractor.


3.15   From the perspective of the payment mechanism, the Procuring Authority will need to
consider who will be responsible for the following roles:


             o   who is responsible for overseeing the implementation of the payment
                 mechanism? This will include reviewing and agreeing the reported
                 deductions; and agreeing the level of backup to be provided for other
                 adjustments being processed as part of the unitary charge for example,
                 utilities costs.


             o   how will the Procuring Authority ensure that the performance report
                 provided by the PPP Contractor accurately records all performance and
                 availability failures, rectification times and resulting deductions? For
                 example, in schools projects Business Managers at the Schools may be


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Briefing Note 1: Payment Mechanisms in Operational PPP Projects




                 responsible for monitoring the performance of the Contractor at an
                 individual school level. Other Councils have employed compliance officers.


3.16    During this period the PPP Contractor will be finalising the operational arrangements
and both parties will require to work closely together.


Monthly Reporting Procedures and Invoicing


3.17    During the pre-services commencement period the exact format of monthly reports
should be agreed between the Procuring Authority and Contractor, and a detailed timetable
for the issue of these reports and the invoicing arrangements confirmed. These areas will
have been covered by the Project Agreement and should be reconfirmed at this stage. In
some projects it has been useful to agree the agenda for the [monthly] management
meetings at this stage.


3.18    The format and supporting documentation required for the monthly invoice should be
agreed with the PPP Contractor. This is particularly important for costs such as utilities costs
where Procuring Authorities should be able to clearly identify the utilities costs on the
facilities and services and that element for which they are responsible.


3.19    Procuring Authorities should also agree with the PPP Contractor the proformas which
will be adopted for issuing notices and the procedures to be put in place to issue those
notices. Within the payment mechanism, the timely issuing of notices regarding situations
such as Unavailable but Used should be clearly documented to ensure that these can be
issued in accordance with the Project Agreement to enable deductions to be made.


User Guides and Training


3.20    Critical to ensuring a smooth transition to the operational phases will be the
development of User Guides and Training. In some instances, these will be developed jointly
with the PPP Contractor. The guides are likely to cover the following areas for each category
of staff:


             o   Users of the Facilities - should be trained on the specific services to be
                 delivered by the PPP Contractor. This should detail the services to be
                 provided and the standards they are to be provided to; how they will report


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Briefing Note 1: Payment Mechanisms in Operational PPP Projects




                service failures; how the Procuring Authority will monitor the service and
                ultimately how the Authority can adjust the payment made for service
                failures. This training may be provided by way of user workshops and the
                development of user manuals. It is essential that a Procuring Authority
                involves the PPP Contractor in aspects of this training – for example,
                outlining to users how the facility/service will work and what happens when
                they report failures.


            o   Compliance/Monitoring Teams – should be trained in the detailed
                payment mechanism provisions and in particular, the service standards to
                be applied. A Procuring Authority should consider how they wish to monitor
                the performance of the contract and develop appropriate procedures for
                doing so. This may include the following options, which are not exhaustive:


                 i.Having a delegated facilities representative, for example, the local
                business manager, who monitors the performance of the facility and
                services on site. They would then review monthly performance reports to
                flag up any issues with the completeness or accuracy of the reporting. They
                would report into the contract manager.


                ii.Employing specific compliance teams to spot check facilities to ensure
                that the required performance standards are being met and that the
                performance reports received from the PPP contract are complete and
                accurate.


3.21   Guides relating to the payment mechanism should be developed which cover areas
such as:
            o   Overview of the payment mechanism – its objectives and broad principles
            o   The use of zones or areas as a basis for deductions
            o   Rectification periods
            o   Deductions including multipliers and repeat failures
            o   Deadlines relating to the payment mechanism


3.22   Guides relating to the negotiated position on areas such as malicious damage should
also be developed. These should clearly indicate:
            o   Who is responsible for what damage when


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Briefing Note 1: Payment Mechanisms in Operational PPP Projects




             o   The reporting procedures for malicious damage so that both parties can
                 verify that (1) malicious damage has occurred; and (2) when it occurred.
             o   The evidence required to demonstrate that damage is malicious rather than
                 wear and tear which will be resolved through the payment mechanism.
             o   The timetable for reporting malicious damage so claims can be verified on a
                 timely basis.


       Budget Review
3.23   Procuring Authorities should review their payment mechanism on at least an annual
basis in the pre-operational phase as part of their budgeting processes to understand any
fluctuations to the forecast unitary charge since financial close. For example:
             o   Changes in requirements (capital or operational) as discussed in 3.9
             o   Inflation
             o   Staff cost changes if retained staff salaries are a retained risk
             o   Pass through costs such as rates
             o   Energy – unit costs may be retained


3.24   Procuring Authority finance departments will want to ensure a “no surprises”
approach to the Unitary Charge when operations commence.




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Briefing Note 1: Payment Mechanisms in Operational PPP Projects




4      Operational Period

4.1    This section of the guidance covers the period from services commencement (i.e.
when the unitary charge commences) to contract end. It highlights the key aspects of the
management of the payment mechanism which need to be considered by a Procuring
Authority in order to ensure the project operates as smoothly as possible. The specific areas
covered in this section are:


            o Operation of the Payment Mechanism – Grace Periods
            o Deduction Enforcement
            o Snagging Items
            o Contract Changes


Operation of the Payment Mechanism – Grace Periods/Bedding In Periods


4.2    A grace period/bedding in period is the period at the beginning of the contract where
a Procuring Authority may agree to a relaxation of aspects of the performance regime in the
initial period when the PPP facilities and services become operational.


4.3    A PPP Contractor’s entitlement to a grace period will be outlined within the Project
Agreement. A grace period is not appropriate for availability failures – if a facility or service is
not available a Procuring Authority should not be paying for it through the unitary charge.


4.4    Grace periods for performance failures need to be justified on value for money
grounds prior to commercial/financial close. They may allow for lower deductions to be
applied during the first month of operation or for slightly longer rectification periods. An
Authority must be very clear on the benefits they seek to achieve through granting a grace
period and should monitor the contract to ensure that these are delivered.




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Briefing Note 1: Payment Mechanisms in Operational PPP Projects




Deduction Enforcement


4.5    The PPP Contract details the deductions which should be applied to various
availability and performance failures. These deductions are integral to the value for money
for the public sector and must be enforced in accordance with the terms of the contract. It is
sometimes suggested that making deductions erodes the working relationship between the
Authority and Provider. This need not be the case. Inconsistent application of the payment
mechanism, or more particularly sudden application of deductions after a period of non-
application, may cause short term relationship issues.       However, consistent and proper
application of the payment mechanism as contracted from the outset should be a contributor
to good relations.


4.6    The PPP Contractor is usually responsible for reporting any availability and
performance failures. The Procuring Authority needs to have mechanisms in place to be able
to verify the completeness and the accuracy of the reporting failures recorded within the
monthly performance reports.


4.7    In some circumstances, Procuring Authorities may decide not to enforce the
deductions in full. In these situations, Procuring Authorities must still record all performance
and availability deductions. If deductions are to be waived this must be clearly highlighted
with the reason for the waiver clearly documented – for example, the PPP Contractor was
unable to access an area to rectify a service failure. These should be recorded by the
Procuring Authority’s Contract Manager and the approach and records approved on a
regular basis by the Procuring Authority’s Project Board or Project Director. The exact
procedures will be covered in the Authority’s Contract Management Manual.


4.8    Deductions should always be enforced for priority services such as availability, health
and safety and security. Deductions should also be enforced in relation to the helpdesk
operation and management and reporting of deductions. This ensures that the performance
reporting is complete and accurate and is a robust basis upon which to assess the
performance of the contract.


4.9    Where deductions are not enforced, the PPP Contractor should be notified as to the
specific deductions which are not being enforced and the reasons why. These should be
clearly recorded.




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Briefing Note 1: Payment Mechanisms in Operational PPP Projects




4.10   Deductions should be made from the monthly invoice as they occur. They should not
be carried over and applied once the performance or availability failure has been rectified.
This may result in the deduction being processed over two monthly periods if they occur over
a month end. In these circumstances care should be taken to ensure that repeated failure
deductions are correctly applied – for example, that they are not triggered by the same
performance failure straddling a month end.


Snagging Items


4.11   In a number of PPP projects the continuation of snagging items into the operational
period has been an issue. The specific measures available to the Procuring Authority to
resolve these will be detailed within the Project Agreement. Some Authorities have included
these within their services specification with the failure to resolve snagging becoming a
performance failure.


4.12   It is recommended that a Procuring Authority discusses with their advisers, prior to
ITPD, the most appropriate options available to them to resolve snagging items. As outlined
above, this may include amending the service specification to include snagging items
following the 20 day resolution period or the retention of a proportion of the unitary charge
until such time as the snagging items are resolved.


Contract Changes


4.13   Procuring Authorities should be aware that any changes to services or project
facilities should be captured by the payment mechanism. For example, an extension to
project facilities should be covered by the payment mechanism where the PPP Contractor is
to provide FM and lifecycle services even if the Authority paid directly for the extended
facilities. Local agreements and non-documented changes should be avoided. For example,
unofficially agreeing to different rectification periods. This approach can provide the
foundation for future disputes.




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Briefing Note 1: Payment Mechanisms in Operational PPP Projects




5      Unitary Charge

5.1    The payment mechanism is the mechanism by which Procuring Authorities ensure
that they receive value for money from their PPP projects over the length of the contract. It is
the vehicle by which availability and performance risk is transferred to the private sector.


5.2    At various points during a PPP project, the unitary charge will vary from the amounts
included within the Financial Model agreed at Financial Close. This could be due to changes
within the facilities and services to be provided or due to changes arising from indexation or
benchmarking/market testing. It is important that any such changes are reflected in an
adjustment to the unitary charge and that Procuring Authorities can make availability and
performance deductions based on the increased value of the unitary charge. Separate
operational guidance is available covering areas such as market testing and benchmarking.


5.3    Within this section, we provide an overview of some of the factors which may result in
a change to the unitary charge. We would recommend that Procuring Authorities include in
their guidance and contract manuals a summary of which events may result in changes to
the unitary charge, which areas of the Project Agreement will cover these and at which times
during the contract these may occur. The guidance manual should be reviewed in
conjunction with the Procuring Authority’s advisers to ensure that it reflects the actual
contractual position for that project.


5.4    The points highlighted below will also be important in assisting a Procuring Authority
to manage the affordability implications of a project by highlighting those times in the
contract life when costs may increase.




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Briefing Note 1: Payment Mechanisms in Operational PPP Projects




Reasons for Unitary Charge Changes


5.5    The following bullet points summarise some of the reasons why the unitary charge
payable by an Authority may vary over the duration of a PPP project. These are generic in
nature and Authorities are recommended to confirm with their own project documentation
and project advisers, the specific provisions relative to their project:


            o   Inflation - the Project Agreement will indicate within the payment mechanism
           schedules by how much the unitary charge should inflate each year. This is
           usually a fixed percentage of the movement in the retail price index or consumer
           price index. The Project Agreement will also specify the date that the inflation
           should be applied – often the 1 April in any one year.


            o Insurance Benchmarking – current SOPC guidance requires regular
           benchmarking of insurance costs. The guide should outline how insurance cost
           movements will be shared; when the insurance costs are due to be benchmarked
           and the approach to be adopted.


            o Utilities Costs – the Project Agreement will outline how utilities costs are to be
           shared between a PPP Contractor and the Procuring Authority. These should be
           based on a sharing mechanism that incentivises both parties to be energy
           efficient. The Project Agreement should also indicate the level of supporting
           documentation a Contractor should provide to a Procuring Authority to enable
           monitoring and approval of utility consumption and consequent payment.


            o Soft FM Benchmarking/Market Testing – the Project Agreement is likely to
           include provision for certain soft FM services to be benchmarked at certain times
           during the contract life. The Procuring Authority will need to manage these
           aspects of the contract carefully. Separate guidance has been developed by the
           Scottish Government regarding the management of benchmarking and market
           testing exercises. This is available on the Scottish Government website at
           www.scotland.gov.uk/ppp.


            o Staffing Protocol – the Project Agreement will include provisions for the cost
           of transferring staff to be confirmed and updated within the financial model at the
           point of staff transfer. The guide should refer to the clauses within the Project


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Briefing Note 1: Payment Mechanisms in Operational PPP Projects




          Agreement which outline how such adjustments should be calculated and the
          process to be followed to update the unitary charge payable.


          o Consumables – Procuring Authorities should be aware of the PPP
          Contractors responsibilities for the provision of consumables under the Project
          Agreement. This area can give rise to additional costs being incurred for areas
          such as hand towels, key fobs etc.. Authorities should be aware of their
          contractual position in relation to consumables. This will have been agreed within
          the specification.


          o Malicious Damage – Vandalism – the Project Agreement will detail who is
          responsible for malicious damage risk and at which times. It is important that all
          parties have a clear understanding of who is responsible for this risk at any given
          time and how any rectification costs will be calculated. The guide should clearly
          detail the project requirements and who within the Procuring Authority team will
          be responsible for managing this.


          o Small Works – the Project Agreement allows for small works to be undertaken
          by the PPP contractor at pre-agreed rates.


          o Additional Hours – some projects include provisions for the Procuring
          Authority to purchase additional hours of use outwith the core hours.


          o Income from the use of facilities – Third Party Income/Community Use
          Income. This can be a complex area and the Project Agreement should define
          clearly how community use and third party income is to be managed; who is
          responsible for managing it and how any income and related costs are to be
          accounted for.       Some third party income – that which is underwritten in the
          financial model for example, catering or community facilities will not lead to
          change as this will be a Contractor risk.


          o Other Project Agreement Provisions - the Project Agreement will include a
          range of other provisions which may ultimately impact upon the costs paid by the
          Procuring Authority. Examples of these are noted below. It is recommended that
          a Procuring Authority obtains advice on these during the negotiation process.
              o      Authority step-in


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Briefing Note 1: Payment Mechanisms in Operational PPP Projects




              o      Variations –Authority Changes
              o      Emergencies
              o      Qualifying Change in Law
              o      Impact of works compensation event
              o      Impact of services compensation event
              o      Others
              o      Waste where payments are volume not availability related?
              o      Pass through costs will also need to be considered for example, rates
              o      Ad hoc services




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Briefing Note 1: Payment Mechanisms in Operational PPP Projects




Appendices




                                           33
Briefing Note 1: Payment Mechanisms in Operational PPP Projects




Appendix A: Glossary

Availability Deductions   Deductions applied by a Procuring Authority because an area or
                          service is unavailable. Services which are classified as availability
                          are indicated within the services specification.


Calibration               The process by which an Authority develops a payment
                          mechanism to incentivise a private sector provider to deliver
                          services to a pre-agreed standard. The required service standards
                          are recorded within a services specification detailing each service
                          to be provided and a priority level. The calibration exercise
                          determines the level of deductions which will be applied in the
                          event that services are not provided to the required standard.
                          Deductions can be made for poor performance (for example,
                          buildings are not clean) or unavailability (for example, space is
                          unavailable due to flooding).


Financial Model           This holds the financial data for the project over the construction
                          and operational period. It indicates the forecast unitary charge
                          based upon certain economic assumptions regarding forecast
                          inflation. The financial model is agreed at financial close.
Hair Trigger              A term referring to a payment mechanism which has not been fully
                          calibrated and includes a performance failure which can trigger
                          consequences far in excess of its significance. For example,
                          repeated unavailability of a store cupboard could trigger whole
                          service unavailability.


Indexation                The level at which the unitary charge inflates each year. This is
                          likely to be expressed as a percentage of the movement in either
                          the Retail Price Index or the Consumer Price Index.


PPP Contractor            The successful private sector consortia who are providing the PPP
                          facilities and services. A typical PPP contractor would include:


                             o   a SPV or ProjectCo who was responsible for managing and



                                               34
Briefing Note 1: Payment Mechanisms in Operational PPP Projects




                                administering the contract. The SPV would receive the
                                funding from the senior debt provider (either a bank
                                providing a senior term loan or a bond) and the
                                subordinated debt and equity from the project sponsors.


                            o   a building subcontractor who would be responsible for the
                                construction works and snagging.


                            o   a FM subcontractor who would be responsible for providing
                                the hard and soft FM services and may also be responsible
                                for    providing      the   lifecycle   maintenance.   Lifecycle
                                maintenance can also be provided by the SPV procuring
                                separate contracts for this.


Performance             Deductions applied by a Procuring Authority because a service was
Deductions              not delivered to the standard specified within the services
                        specification. The services specification indicates the priority level
                        associated with that particular service and the amount of the
                        performance deduction will reflect the service priority and the
                        number of service failures in a given period.


Rapid Loss Payments     An example of a hair trigger which can result in a significant penalty
                        deduction far in excess of the significance of that service failure.


Rectification Period    This is the period by which a reported fault has to be rectified.
                        Rectification Periods can be split into temporary and permanent
                        rectification periods.


                        A temporary rectification period means an initial solution needs to
                        be found to address a service failure within a specified period of
                        time. A permanent rectification period needs to be met to ensure
                        the service failure is rectified fully.


                        For example, a temporary rectification of some graffiti may be
                        covering the wall affected whilst the permanent rectification would




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Briefing Note 1: Payment Mechanisms in Operational PPP Projects




                         be making good the wall’s surface and presentation to the
                         standards specified within the services specification. A PPP
                         Contractor may be given a 3 hour temporary rectification period for
                         this and a week’s permanent rectification period.


Services Specification   This is a detailed document recording the service standards
                         required by a Procuring Authority. It details:
                            o    the services to be provided,
                            o    the standards at which those services should be provided,
                            o    the rectification periods available to the PPP contractor to
                                 rectify any failures in those service standards
                            o    whether service standards are considered to relate to
                                 availability or performance. It therefore indicates the
                                 applicable deduction in the event of poor performance.
                            o    For performance failures indicates the priority attached to
                                 that service. This in turn influences the level of deduction.


Sculpting     of   the This refers to the process where there are preagreed variations in
unitary charge           the profile of the unitary charge. These may reflect periods where
                         substantial lifecycle maintenance is expected and the unitary
                         charge is profiled so that the Procuring Authority pays more during
                         these periods in order to maintain the repayment provisions for the
                         bank.


SPV                      This is the Special Purpose Vehicle which is formed by the PPP
                         Contractor. It is the company which enters into the PPP contract
                         with the Authority; enters into sub-contracts which construction and
                         FM contractors and enters into the funding arrangements.




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