for Central and Local Public Sector Bodies in Relation to the Procedures in the Agency for Public Private Partnership

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1 for Central and Local Public Sector Bodies in Relation to the Procedures in the Agency for Public Private Partnership

2 TWINNING LIGHT PROJECT HR/2007/IB/FI/03TL PPP Guide for Central and Local Public Sector Bodies in Relation to the Procedures in the Agency for Public Private Partnership Twinning Light Project: Strengthening of the Administrative Capacity of the Agency for Public-Private Partnership in the Republic of Croatia in Relation to the Implementation of the New Public-Private Partnership Legislation Partners: CROATIA: GREECE: Agency for Public Private Partnership Special Secretariat for Public Private Partnerships Centre of International European and Economic Law

3 Public-Private Partnership Guide Table of Contents Abbreviations General Issues PPP definitions Financing structures of PPP projects Public Private Partnership Flow Chart Assessing a PPP Project Submission of a project proposal The procedure Evaluation of a project proposal Preface Value for Money (VfM) Risk allocation Main risks in PPP projects Issues arising in risk allocation Affordability of a project Public Sector Comparator (PSC) Technical and legal issues (maturity) Planning a PPP project Funding of PPP projects Basic principles Funding of PPP projects Communicating with the market Market Sounding Output specifications Preface Purpose Basic principles and framework Approval of the tender documents by the Agency for PPPs Private Partner Selection Procedure Introduction Principles of Public Procurement Public Procurement Procedures PPP contract management Preface Ensuring continuity of the contract management function Contract Management Team Contractual issues Early Termination Services commencement and Certification of Availability Force majeure, Relief Events, Compensation events Changes management Direct Agreement Step-in Rights The role of the Agency for PPP TWL- HR/2007/IB/FI/03TL 2

4 Public-Private Partnership Guide Abbreviations APPP CA Agency for Public Private Partnership Contracting Authority DKOM Public partner Commission for the Supervision of the Public Procurement Procedure EC EEA EU EUCJ GPA ippps IRR IT MEAT MELE MoF NPV OJEU European Community European Economic Area European Union Court of Justice of the European Union The Agreement on Public sector Procurement Institutional Public Private Partnerships Internal Rate of Return Information Technology Most Economic Advantageous Tenderer Ministry of Economy, Labour and Entrepreneurship Ministry of Finance Net Present Value Official Journal of the European Union TWL- HR/2007/IB/FI/03TL 3

5 Public-Private Partnership Guide PFI PIN PPP PP PSC SPV VfM Private Finance Initiative Prior Information Notice Public Private Partnership Public Procurement Public Sector Comparator (The risk-adjusted, estimated full lifecycle cost of a project if it was done by conventional in-house means. It is expressed in terms of Net Present Value. Special Purpose Vehicle (A project company established by the bidders that has as its sole purpose the delivery of a specific project, often referred to as the consortium, project company or concession company. Value For Money TWL- HR/2007/IB/FI/03TL 4

6 General Issues 1 General Issues 1.1 PPP definitions Public Private Partnership (PPP) is a form of cooperation between public and private sector players working together in the implementation of investment projects and the provision of services to the general public. These may be infrastructure projects such as the construction of roads, bridges, tunnels, railway lines, the building of a hospital, etc. In PPP projects, public and private sector each retain their own identity and responsibilities. They collaborate on the basis of a clearly defined division of tasks and risks. The purpose of collaboration is to bring about added value and efficiency gains and to foster innovation. The private sector gains new opportunities in a growing market, while the public sector can deliver either a qualitatively better end product for the same money or the same quality at a saving. 1.2 Financing structures of PPP projects In the traditional forms of public procurement, the public sector possesses and maintains its infrastructure, while it finances their construction via taxes or loans. The private sector is responsible for the project only during the construction period and upon the completion of works. The public partner also undertakes possible budget overruns that can result from problems and delays during the construction phase, while after a period of time there is no guarantee for the good operation and the quality of the project. The nature and risk of financing are totally different in the case of PPP projects. The private sector is responsible for the initial financing of the project, its maintenance and the delivery of relevant services during the lifetime of the contract. Via PPP, the Public sector procures services or works without the obligation to finance them immediately, since their initial financing is undertaken by the private sector. The invested private funds are returned to the private sector through periodic payments, TWL- HR/2007/IB/FI/03TL 5

7 General Issues whereas the Public sector knows beforehand the precise payments that have to be made during the contractual period. These payments cannot be increased, if the private sector that has undertaken the project faces issues with risks undertaken by itself, since it is the private sector that assumes the construction risk, the financing risk and the availability / demand risk. Payments on behalf of the Public sector or the end-users can only be made once the project is operational, and are directly linked with the performance of the offered services, which the private sector must maintain up to certain quality standards, until the very last day of the contract. Low services result with lower payments. According to their financing scheme, PPP projects fall into the three following categories: Figure 1: PPP project categories Projects that are designed, built, financed and maintained/operated by the private sector and their cost is repaid directly by the public sector (e.g. hospitals, schools, and prisons). Projects where the cost of capital which is shared between the public sector and the private sector, while the private sector has the total responsibility for the project. Financially free-standing projects, financed by the private sector, the investment of which is repaid via revenues from the end-users of the project. TWL- HR/2007/IB/FI/03TL 6

8 General Issues Privately financed projects repaid by the Public sector (PFI- Private Financed Initiative) In the context of such partnerships, the private entity in most cases sets up a Special Purpose Vehicle (SPV), which may be composed of specialized Private partners, construction companies, operation and management companies, technical equipment suppliers and other institutions with proven previous experience in delivering services, as required by the output specifications of the project. Other entities that usually participate in the SPV are financial institutions (mainly banks that usually provide big long-term loans). Loans and equity of the SPV are used for the construction of infrastructure or the delivery of services related with the PPP project. No payments are made until the structures and the relative services are delivered for use to the contracting authority. During the operational period of the contract, the contracting authority makes annual payments (availability payments) based on a payment mechanism, which is linked to the quality specifications set. With these payments, the Special Purpose Vehicle repays its loans and ensures a legitimate profit. Figure 2: SPV scheme for PFI projects repaid by the Public partner TWL- HR/2007/IB/FI/03TL 7

9 General Issues Privately financed projects requiring public sector revenue support In the context of such partnerships, commercial or other uses stemming from the exploitation of infrastructure or services may arise (e.g. exploitation of commercial spaces in a building, in which availability is accommodated public). In the case of these projects, the public sector supplements with annual entity payments the income of the SPV from the exploitation of such uses. Basically, it is the same payment mechanism as in the first case, which is, because of the additional income from commercial exploitation, renders the payments that are finally paid by the Public sector smaller. Figure 3: SPV scheme for projects requiring Public partner revenue support TWL- HR/2007/IB/FI/03TL 8

10 General Issues Privately financed projects repaid by the end users The difference of retributive projects from the two previous forms is that in this case, the private entity, apart from the design, construction and financing of work or service, will also undertake the operation or exploitation of the underlying infrastructure. Via the operation or exploitation of infrastructure and the fees imposed to the final users, the SPV does not receive any payment from the Public sector. These projects, because of the higher risk undertaken by the private sector, need special preparation and regulation of a series of issues that are related with their bankability. Figure 4: SPV scheme for projects repaid by the users 1.3 Public Private Partnership Flow Chart In order to help capture the principal changes in the process of project development and implementation and to enhance understanding of the public private partnership approach a flow chart has been developed. The Public Private Partnership Flow Chart is set out in the diagram on the next page and it seeks to present in a clear manner the main stages in the development and implementation of a public private partnership project. TWL- HR/2007/IB/FI/03TL 9

11 General Issues Figure 5 : PPP Flow Chart TWL- HR/2007/IB/FI/03TL 10

12 PPP Project Assessment 2 Assessing a PPP Project 2.1 Submission of a project proposal The procedure According to the Act on Public Private Partnerships and the Regulation on the Criteria for Assessment and Approval of PPP Projects, any public body that wishes to implement a PPP project is supposed to submit to the Agency for Public Private Partnership (APPP) a project proposal and all supporting documentation. Public bodies, within the meaning of the Act on Public Private Partnerships, are all deemed to be bodies that can be contracting authorities within the meaning of the regulations in the area of public procurement. The APPP issues appropriate decisions about project proposals, in accordance with the provisions of the Act on Public Private Partnerships. According to Regulation on the Criteria for Assessment and Approval of PPP Projects, the minimum content of a PPP project proposal should include the following information: Minimum content of a project proposal Information on the public sector authority: name, registration number, Personal Identification Number (OIB), and the address of the public body, name of the person authorized for representation, proposal of the person who will be responsible for project preparation and implementation, a copy of the decision or other act proving that the implementation of the proposed project is within the legal competence of the public body TWL- HR/2007/IB/FI/03TL 11

13 PPP Project Assessment concerned. General information about the proposed PPP project: title of the project, purpose and goal of the project, description of the project. Feasibility study and analysis of PPP elements of the project: a descriptive presentation of the proposed model of public private partnership, a feasibility study for the project, including a comparison of the planned costs of the application of the public private partnership model versus the classic (budgetary) model of funding of all costs of the implementation of the project over the whole proposed term of the contract (i.e. Public Sector Comparator), a general distribution of risks between the public and the private partner, including a general quantification of the risks concerned, occurrence probability assessment and the costs arising there from, Justification of the affordability and the strategic scope of the project: proof that the project proposal is in conformity with strategic and/or development documents previously adopted by the public body concerned, and with the valid physical planning documents for the area where the project is to be implemented, other proof by which the public body presents evidence in relation to the specific project proposal of holding or becoming a holder in due time of rights essential for the implementation of the project, a decision on environmental impact assessment, if in view of the purpose TWL- HR/2007/IB/FI/03TL 12

14 PPP Project Assessment and goal of the project there is a legal obligation to obtain the decision concerned, where the public partner is a unit of local or regional self-public sector, an institution whose founder is the unit of local or regional self-public sector, a company in majority ownership of the unit of local or regional self-public sector, proof that the total annual amount of all consideration that the public partner concerned, on the basis of all public private partnership contracts, pays to the private partners does not exceed 25 percent of the budget revenues in the previous year reduced by the capital income, information about the existing public private partnership contracts and about the overall amount of consideration paid on that basis, the proposed procedure for the selection of the private partner. Table 1: Minimum content of a project proposal 2.2 Evaluation of a project proposal Preface According to the Regulation on the Criteria for Assessment and Approval of PPP Projects, the APPP assess a project proposal according to two discrete sets of criteria: justifiability of the project and justifiability of using the PPP model. Justifiability of the project This set of criteria focuses mainly on the necessity of the project, the competence of the public body to implement it, the alignment with the competent line ministry and the Ministry of Finance as far as the strategic scope and its viability are concerned and on the profitability of the project (IRR). TWL- HR/2007/IB/FI/03TL 13

15 PPP Project Assessment Justifiability of the PPP model The second set of criteria is directly related to the use of the PPP model for the implementation of the project under assessment. The criteria that are used have to do with the evaluation of the allocation of risks and responsibilities between the public body and the private partner, the duration of the partnership contract and the calculation of the value for money of the project, using the public sector comparator test, which is a common criterion used for the evaluation of PPP, and especially of PFI projects Value for Money (VfM) VfM is defined as the optimum combination of whole-life costs and quality of the good or service to meet the user s requirement. VfM is not the choice of goods and services based on the lowest cost bid. To undertake a wellmanaged procurement, it is necessary to consider upfront, and at the earliest stage of procurement, what the key drivers of VfM in the procurement process will be. Some key generic factors driving VfM are listed below: Factors driving Value for Money The optimum allocation of risks between the various parties requires that risks are allocated to the party, or parties, which are best placed to manage and minimize these risks over the relevant period; Focusing on the whole life costs of the asset rather than only the upfront costs involved; Integrated planning and design of the facilities-related services through an early assessment of whether the possible integration of asset and non-asset services (e.g. soft services) should deliver VfM benefits; The use of an outputs specification approach to describe the contracting authority s requirements which, amongst other things, allows potential bidders to TWL- HR/2007/IB/FI/03TL 14

16 PPP Project Assessment develop innovative approaches to satisfying the service needs of the contracting authorities; A rigorously executed transfer of risks to the parties which are responsible for them, ensuring that the allocation of risks can be enforced and that the costs associated with these risk are actually borne by the parties in the manner originally allocated and agreed; Sufficient flexibility to ensure that any changes to the original specification or requirements of the contracting authority and the effects of changing technology or delivery methods, can be accommodated during the life of the project at reasonable cost to ensure overall VfM; Ensuring sufficient incentives within the procurement structure and the project contracts to ensure that assets and services are developed and delivered in a timely, efficient and effective manner, including both rewards and deductions as may be appropriate; The term of the contract should be determined with reference to the period over which the contracting authority can reasonably predict the requirement of the services being procured. This will require careful considerations of factors including: potential changes in end-use requirements; policy changes; design life of the asset; the number of major asset upgrades or refurbishments during the period of the contract; potential changes in the way services could be delivered (e.g. technical advancements); and the arrangements for the asset at expiry of the contract; There are sufficient skills and expertise in both the public and private sectors, and these are utilized effectively during the procurement process and subsequent delivery of the project; Managing the scale and complexity of the procurement to ensure that procurement costs are not disproportionate to the underlying project(s). Table 2: Factors driving Value for Money TWL- HR/2007/IB/FI/03TL 15

17 PPP Project Assessment In order for the VfM drivers to be effective and for overall VfM to be achieved, the procurement process needs to be well planned, managed, executed and transparent, whichever procurement route is taken. This will reduce transaction costs, increase bidder involvement and ensure a more competitive procurement. To do this contracting authorities need to ensure, from the very earliest stages, that they have, and are able to apply, sufficient and capable resources to the procurement process itself. If they are unable to do so then it is unlikely that they will be able to realize VfM Risk allocation The main principle in risk allocation in PPP projects is to transfer each risk to the party that is most appropriate to manage it. In general the private sector is expected to undertake the risks associated to the construction, financing, operation, maintenance and technical management of a project. Risks that are not transferred and remain with the public sector are, for example, changes in law or in public sector policy. The main business risk in PPP projects is availability risk: the constant and uninterrupted provision for use of a facility and its related services. The funds that the private sector has at risk in a certain project will be repaid (along with the profit element) only if the project and the related services are meeting the quality requirements during the whole life of the project. This approach is fundamentally different from the conventional procurement approach where the public sector enters into a design and construction contract and finances the project periodically as works are progressing, without being able to foresee if the project will be operational. To the contrary in public private partnerships, the private sector is responsible for the operation during the whole life of the project. Risk transfer is a constitutive element of any PPP project. Since the appropriate set of risks has been transferred to the private sector and these risks are managed effectively, then the higher financing cost associated with PPPs can TWL- HR/2007/IB/FI/03TL 16

18 PPP Project Assessment be overcompensated. The optimal combination of risks can only be determined on a case by case basis having as a guide market practices and experience in each sector. All involved parties in PPP projects have to undertake their risk analysis. Typically three groups are participating in this process: public sector, private sector and financiers. Although the methodology used for the determination and valuation of risks is common each party will seek different objectives: The public sector will try to enforce best practices in risk allocation as described in official policy guidance documents The private sector will have to judge if (and how) it will be able to manage the transferred risk The banks and financiers will normally seek to secure the repayment of the debt and interest at the narrowest possible time interval. Apart from risk allocation, financiers are also thoroughly evaluating the project, the power and the ability of the contracting authority to support the implementation of the project as well as the economic and political environment. Risk allocation is directly linked with the economic efficiency, the terms and conditions of the project agreement and eventually the success of the project. Consequently, all involved parties have to consider and evaluate risk throughout the whole life of the project. TWL- HR/2007/IB/FI/03TL 17

19 PPP Project Assessment Figure 6: Risk allocation process, from identification to final allocation through negotiations Main risks in PPP projects Construction risk This risk mainly covers incidents related to cost and time overruns in construction, failure to adhere to the specifications determined by the contracting authority and defects in construction. Construction risk includes a series of other risks (such as faults during the design of the project or poor performance of sub-private partners). As a result, financing cost during construction can be higher compared to the one after the TWL- HR/2007/IB/FI/03TL 18

20 PPP Project Assessment calculation before the completion of the project. For this reason a refinancing with more advantageous terms usually takes place after completion of construction. Undertaking and management of construction risk is born by the private sector. Availability risk This risk is most commonly born by the private sector, which is responsible for the delivery of certain volume and quality of services to the end users of the project, in accordance with the specifications set out in the project agreement. Those two elements (construction and availability) are the main measures of the performance of the private partner in a PPP project. For example, the Private partner who undertakes the construction and maintenance of a PPP school is obliged to have the school available for use irrespective of whether there is enough number of students or not, as this is a risk undertaken by the public sector. Accordingly, in a road PPP with no demand risk (see next paragraph), the main obligation of the Private partner is that the road is always available for use irrespective of the number of cars which are passing through. Demand risk Demand risk occurs when the number of customers is not adequate to buy the services offered through a PPP project. This risk derives from imponderable factors which may rise during the operation of the project and are usually very difficult to be determined in advance. The swift in demand for the offered services and the degree of deviation from the initially expected demand (at the time of project agreement signing) are covered by the contracting authority only for factors such as change in market preferences, technological obsolescence or surplus demand relevant to the capacity of the project rather than deficiencies of the Private partner (e.g. low quality of services). The biggest portion of this risk is undertaken by the contracting authority. When a portion of demand risk is undertaken by the Private partner, TWL- HR/2007/IB/FI/03TL 19

21 PPP Project Assessment the contracting authority guarantees a minimum level of income for the SPV, irrespective of potential fluctuations in demand. The monitoring of demand risk from the financiers is crucial throughout the life of the project as it influences cash flows. It is possible that the project agreement anticipates the substitution of the Private partner or the financiers with a decision of the contracting authority ( step in rights), when inflows fall below a predetermined level. Financing risk The financing risk is undertaken by the financiers. Specifically: The banks are evaluating and covering this risk based on the agreements that have been made between the involved parties for the allocation of risk. The allocation is crucial for the banks as 80% to 90% of the cost is financed by senior debt (if there is no economic participation of the public sector) Availability of adequate financing must be secured by the tenderers who shall provide the contracting authority the necessary evidence. In addition, it is usually provided that the contracting authorities can enter into direct agreements with the financiers Issues arising in risk allocation Risk allocation is a key element to a successful PPP project as it is directly linked to economic efficiency (VfM) and viability as well as the financial balance of the project. A PPP project which brings the best VfM to the Contracting Authority is a project in which each risk is undertaken by the partner which can handle it best. This means that a best risk handling entity can minimize both its chances of occurrence and the cost of this occurrence. If the public sector can handle a risk better than the private sector, then it must retain that risk. Indeed, transferring it to the private sector would be more expensive for the latter to cover, and this greater cost would eventually be re-billed to the public TWL- HR/2007/IB/FI/03TL 20

22 PPP Project Assessment sector through the periodical payments. Ultimately, a risk must be transferred only if the comparison between the values of this risk when handled by the public sector and when handled by the private sector is in favor of the latter. After reaching an agreement on risk allocation, the corresponding responsibilities must be clearly reflected on the project agreement. The main objective of the project agreement is to determine the rights and obligations of each party and to allocate the relevant risks. Depending on who is the bearer, there are two types of risks: Disbursable risks These risks can be evaluated and covered with an insurance policy. Non-disbursable risks These risks are based on their probability of occurrence and the cost overrun which they generate if they do occur. Figure 7: Types of risks In a PPP scheme, risks transferred to the private partner can be undertaken on two different levels: risk is transferred to a sub-private partner of the SPV. In this case, this sub-private partner will integrate this risk as a component of its fixed price for the work it is set to do. For instance, if a sub-private partner in charge of construction bears the risk of a delay, it will charge a higher price for construction to the SPV in order to be covered if such a risk materializes risk is maintained by the SPV. This will affect the financial structure of the SPV, as a structure carrying more risk will need to have more equity injected by the shareholders in order to be bankable A summary approach in risk allocation is as follows: TWL- HR/2007/IB/FI/03TL 21

23 PPP Project Assessment TWL- HR/2007/IB/FI/03TL 22

24 PPP Project Assessment Affordability of a project As mentioned above, while PPP, or any other form of PPP, should only be pursued where it delivers VfM, affordability is also a vital consideration. It is essential for resource budgeting purposes and it may also influence option selection. For example, it may not be possible to pursue all the projects that offer VfM because they are not all affordable within current budgets. In any case, there should be a high degree of confidence that the PPP project is affordable, both before going out to market and during the procurement itself. It is crucial that cost assessments submitted with the project proposal are realistic. Any problem with affordability that arises late in the procurement process will increase transaction costs and undermine private sector confidence in the private partner and prejudice the private partner s ability to achieve VfM. Therefore, it is vital that in designing specifications the contracting authority is mindful of its affordability envelope. Fundamental to any procurement decision will be a realistic affordability calculation, which refers to what is affordable within the department/contracting authority s spending allocation or expected future settlements. Projects estimated unaffordable should not be pursued and must not be brought to market. It is vital that in drawing up specifications contracting authorities are mindful of their affordability envelope, and the future resource implications for a project. Contracting authorities need to prudently assess their ability to meet the payment commitments arising under the PPP contract to ensure upfront that is affordable. The affordability assessment for a PPP project is carried out through the development of a unitary charge financial model. It should be noted that the issue of affordability should be dealt with in the project proposal. This specific point should also be taken into consideration for any public body that implements PPPs, and not only for units of local or regional self-public sector. Furthermore, this point should be interpreted as TWL- HR/2007/IB/FI/03TL 23

25 PPP Project Assessment estimation on an annual basis of the total amount of the forecasted annual availability payments of the PFI projects that a public body implements against its annual budget for the construction of works and the provision of relevant services. During the evaluation process, the APPP, based on the contracting authority s PPP project proposal, should assess the affordability of the project using the following Pro-forma Standard Review. It should be noted that the affordability of a project should be tested during the whole process up to the financial close of the project. In that respect, the Pro-forma Standard Review below, should be reviewed and updated when the contracting authority submits the tender documents to the APPP for approval. Affordability testing - Projected PFI service payments identified Unitary charge calculated (annual availability payment) Justification of the affordability (contracting authority s annual budget for the construction of works and the provision of relevant services, the unitary charge as percentage on the annual budget, the total amount of annual availability payments of any other PPP projects against its annual budget, presentation regarding the position of the PPP project at-hand within the contracting authority s general strategic framework) Shadow bid model assumptions capital expenditure, operational expenditure, lifecycle, other cost, income etc Comment on the funding structure of the project and the financial assumptions e.g. gearing (debt-to-equity ratio), debt margins detail what advice the contracting authority received from the transaction advisors in this respect Comment on all budgeted sources of income including any risks associated with the income assumptions (give careful consideration to 3rd party income assumptions) Is any land sales anticipated? Are any capital contributions from the contracting authority planned? If TWL- HR/2007/IB/FI/03TL 24

26 PPP Project Assessment so, how much, payable when and on what basis, how are the payments likely to relate to draw down of senior debt. Detail why a capital contribution is deemed to be necessary Affordable in the first full year, and over the whole life of the contract, taking into account the unitary payment and all sources of income, projected additional revenue support and additional income from capital receipts or third party income Review consistency of indexation assumptions (fixed/variable elements correspond with split of fixed/variable costs within the financial model) Detail the sensitivities to affordability that have been performed. Have members been made aware of the key risks to the project s affordability On-going affordability risks what sensitivities have been performed? Has the authority got appropriate letters of comfort from their technical and financial advisers regarding the appropriateness of the cost/income assumptions reflecting current market conditions? (this can be answered or reviewed on a later stage when contracting the project) Key shadow bid financial data to be summarized on the following basis Capital cost of PPP solution Lifecycle cost ( m) Operating cost ( m) Other ( m) Income ( m) Price base for the above ( m) Funding terms (senior debt: equity) Euribor swap rate (%) Table 3: Affordability testing TWL- HR/2007/IB/FI/03TL 25

27 PPP Project Assessment Public Sector Comparator (PSC) A PSC is an estimated, risk-adjusted, cost of the public sector itself delivering the project output. The PSC is expressed in terms of the net present cost to the public sector of providing the output under a public procurement, using a discounted cash flow analysis that adjusts the future value of the expected cash flow to a common reference date. This enables comparison with PPP option. The PSC has three core components: Raw PSC: the base cost of delivering the specified services under the public procurement method where the underlying asset is owned by and the service delivered by the public sector. Competitive neutrality adjustment: this removes any net advantages or disadvantages that accrue to a public sector run service by virtue of its public ownership, e.g. the nonpayment of insurance premiums or taxes by a public sector run transport service. The value of transferable risks: risks which the public sector would bear under a public procurement but is likely to transfer to the private sector. A further component, the value of retained risks (risks that are likely to be retained by the public sector and are reflected in the Raw PSC) may be calculated and added to each private sector bid. This will be necessary if different bidders accept different levels of risk transfer. The PSC is usually compared with the cost of the PPP option to the public sector. This comparison would indicate which option provides better VfM. The cost of the PPP option to the Contracting Authority (NPV of the Unitary Charge paid) is calculated through the shadow bid model which is structured to assimilate a private sector s bid. The shadow bid model is a spreadsheet model which calculates the periodic unitary charge that the bidder would require in order to be able to cover all costs arising from implementation of the project TWL- HR/2007/IB/FI/03TL 26

28 PPP Project Assessment (bid costs, design, construction, facility management, maintenance, life cycle cost, financing costs etc.) and at the same time be able to achieve a target rate of return (IRR) on the invested capital. Risk adjusted cash flows under the public delivery approach, and unitary charge under the PPP approach, are discounted at the same discount rate to allow for a meaningful comparison. The appropriate discount rate is the one that reflects the financing cost of the public sector. Figure 8: Public Delivery and PPP project global cost calculation The most suitable scheme is the one for which the NPV of the payments made by the public authority is the lowest and the VfM achieved is the difference of the global cost of the two approaches, as illustrated in the scheme below. TWL- HR/2007/IB/FI/03TL 27

29 PPP Project Assessment Fig ure 9: The difference of the global cost of conventional public procurement and PPP Key steps in calculating a Public Sector Comparator Step 1 Formulate Output Specifications The output specifications set out the range of services which the contracting authority seeks to procure and the performance levels required for each of the services. Figure 10: Key steps in PSC calculation TWL- HR/2007/IB/FI/03TL 28

30 PPP Project Assessment Step 2 Define Reference Project The Reference Project should: Reflect the most efficient and achievable form of public sector delivery that can be employed to satisfy all elements of the output specifications, basing on current best practices Provide the same level and quality of services as expected to be provided by bidders to enable a like-with-like comparison Be framed to be a conforming bid as if it were part of the bidding process. Step 3 Identify All Raw PSC Components The Raw PSC represents the base cost to the Public Sector of producing and delivering the Reference Project. It comprises the following components: Direct costs, which are costs that can be traced or assigned to a particular service, which include: - Capital costs, e.g. costs for design and construction of a new facility, procurement of the required equipments and purchase/lease of land, other development costs, etc. - Capital receipts, e.g. as a result of upfront sale/lease/disposal of assets not involved in the provision of services (such receipts should be deducted from the cash flows of the Raw PSC, basing on their expected timing, if the same opportunity is also available to bidders) - Maintenance costs, e.g. costs of raw materials, tools/equipments, labour, etc. required for maintenance - Operating costs, e.g. costs of inputs and staff directly involved in the provision of services, insurance, etc. TWL- HR/2007/IB/FI/03TL 29

31 PPP Project Assessment Indirect costs, (costs incurred not directly related to the provision of services, i.e. costs that contribute to the provision of a service but are not incurred exclusively for that one service), include: - Capital costs, e.g. costs for partial commitment of plants/equipments, partial usage of administration buildings, etc. - Operating costs, including corporate overheads (e.g. ancillary running costs of power, cleansing, stationery, non-core IT and equipments for administration, etc.) and administrative overheads (e.g. costs for employees not directly involved in the service provision, facilities management and project management, etc.) Expected third-party revenue, which over the life of the Reference Project reduces the net cost to the public sector and should be deducted from the operating costs in the raw PSC. Third-party revenue may be generated where: - Third-party demand exists for the infrastructure or related services - Service capacity exists above the public sector requirements - The public sector allows third-party utilisation. - Step 4 Calculate Raw PSC The Raw PSC should be calculated using the following formula: Raw PSC = (Capital Costs - Capital Receipts) + Maintenance Costs + (Operating Costs Third Party Revenue) Expected cash flows of the components of the Raw PSC need to be forecast over the life of the Reference Project and should be expressed in terms of NPV using a discounted cash flow analysis that adjusts the future value of the TWL- HR/2007/IB/FI/03TL 30

32 PPP Project Assessment expected cash flows to a common reference date. A similar approach should be adopted in calculating other components of a PSC (i.e. Competitive Neutrality, Transferable Risk and Retained Risk) to facilitate comparison of the PSC and private bids, which may have different cash flow patterns, on a common basis. Step 5 Calculate Competitive Neutrality Adjustments Competitive Neutrality removes the net competitive advantages/disadvantages which accrue to a public sector business by virtue of its public sector ownership. By including equivalent costs which will be incurred by bidders, it allows a fair and equitable comparison between a PSC and other private bids. Competitive advantages from public sector ownership (amounts that should be added to a PSC) include exemption from rates, public sector rent, taxes, duties, fees and charges, accommodation costs, legislation/regulation, etc. which are only levied on or paid by private enterprises, while competitive disadvantages (amounts that should be deducted from a PSC) may also arise, e.g. heightened public scrutiny and reporting requirements which are not faced by private enterprises. Competitive neutrality costs should be identified and included as NPVs of the projected cash flows over the life of the Reference Project. Step 6 Identify All Material Risks In the context of a PSC, risks reflect the potential for additional costs above the base case assumed in the Raw PSC or for revenue below it. It is therefore necessary to include a comprehensive and realistic pricing of all quantifiable and material risks in the construction of a PSC. For valuation purpose, a PSC only includes quantifiable and material risks. However, efforts should be made to identify and document all risks associated with the project. It should be noted that a number of similar risks, which may be immaterial by themselves, TWL- HR/2007/IB/FI/03TL 31

33 PPP Project Assessment may become material when aggregated. The reasons for excluding unquantifiable risks from a PSC should also be properly recorded. Step 7 Quantify Consequences of Risks Once all material risks have been identified, it is necessary to assess and quantify the possible consequences, both direct and indirect, of each risk eventuating, including the effect of any timing issues as different risks typically have different cost/time profiles over the term of a project. A useful tool for identifying the consequences and financial impacts of risks is a risk matrix, which should indicate how each risk should be allocated (transferred, retained or shared), and identify the main consequences, financial impacts and potential mitigation strategies for each risk. Step 8 Estimate Probabilities of Risks Having identified the material risks and assessed the variety of potential consequences, it is then necessary to estimate the probability of each of the consequences occurring and to consider whether the probability is expected to change over time. There are various risk valuation techniques which can be used to provide probability estimates, ranging from simple techniques that provide a subjective estimate of probability to more advanced multivariable statistical techniques. The technique that is adopted for a particular project or a particular risk depends on the significance of the project and the complexity of the risks within it. Step 9 Calculate Value of Risks As there is often more than one possible consequence for a particular risk, the value of each risk is then the sum of all these probability weighted consequences. TWL- HR/2007/IB/FI/03TL 32

34 PPP Project Assessment In addition, although a particular risk may be identifiable, it may be much more difficult to readily assess all the financial impacts associated with that risk. A contingency factor should therefore be included in each major risk category to account for any unobservable costs which will otherwise lead to undervaluation of the risk. The value of each risk should be calculated individually using the following formula: Value of Risk = (Consequence x Occurrence Probability) + Contingency For example, when considering the construction risk of a new facility, the following consequences may arise: Increase in construction costs (cost overrun) Delay in construction schedule (time overrun) Additional costs for providing similar services during the delay period, generally from existing facilities (service maintenance). The value of construction risk can be calculated by working out the following tables (all figures are rounded to 2 decimal places): Consequence Scenario Additional Cost ( mil.) Cost Overrun (1) Probability Value ( mil.) Below base cost (10%) -10 5% -0,5 No deviation 0 15% 0 Likely 10% overrun Moderate 15% overrun Extreme 25% overrun 10 40% % 3, % 3,75 Sub Total 11,00 TWL- HR/2007/IB/FI/03TL 33

35 PPP Project Assessment Consequence Scenario Additional Cost ( mil.) Time Overrun (2) Service Maintenance (3) Probability Value ( mil.) On Time 0 15% 0 Likely 1year delay Moderate 1½ year delay Extreme 2 year delay 4 50% % 1,5 8 10% 0,8 Sub Total 4,3 On Time 0 15% 0 Likely 1year delay Moderate 1½ year delay Extreme 2 year delay 2 50% % 0, % 0,4 Sub Total 2,15 Contingency (4) ,00 Total 19,45 Table 4: Expected value of Consequences under scenario analysis (1) Assuming a total base cost of 100 million. (2) Assuming a cost of 4 million per year. (3) Assuming a cost of 2 million per year. (4) Assuming a factor of 2% of the total base cost. Consequence Year 1 Year 2 Year 3 Total Cost Overrun 70% 30% - 100% Time Overrun 80% 20% - 100% Service Maintenance - 80% 20% 100% Contingency 70% 30% - 100% Table 5: Timing Weightings of Consequences TWL- HR/2007/IB/FI/03TL 34

36 PPP Project Assessment Consequence Year 1 ( mil.) Cost Overrun 7.70 (11 x 70%) Time Overrun 3.44 (4.3 x 80%) Service Maintenance Contingency 1.40 (2 x 70%) Year 2 ( mil.) 3.30 (11 x 30%) 0.86 (4.3 x 20%) (2.15 x 80%) 0.60 (2 x 30%) Year 3 ( mil.) 0.43 (2.15 x 20%) Total ( mil.) 11,00 4,3 2,15 2,00 Total ,43 19,45 Table 6: Weighted Valuation of Consequences The calculated cash flows should then be expressed in NPV terms. The above process should be repeated for all the material risks which have been identified and the total value of risk is then calculated by aggregating the value of all these material risks. Step 10 Identify Desired Risk Allocation It will then be necessary to classify these values into Transferable Risks, which the Public sector will allocate to bidders and Retained Risks, which risks the Public sector will bear itself, basing on an optimal level of risk transfer. Step 11 Calculate Transferable Risk and Retained Risk The value of Transferable Risk measures the cost that Public sector is willing to pay for those risks which it proposes to transfer to bidders. The value of Retained Risk measures the cost of those risks which the Public sector proposes to bear itself. Including the cost of Retained Risk in a PSC provides a comprehensive measure of the full cost to the Public sector for the Reference Project, and its value can be added to each of the private bids to allow a TWL- HR/2007/IB/FI/03TL 35

37 PPP Project Assessment meaningful comparison, particularly when different bidders accept different levels of risk transfer. There may be situations where specific components of a particular risk are allocated between parties, or where an overall risk is shared. Under these circumstances, it is necessary to separate the risk into Transferable and Retained Risk components. Risk sharing may be dealt with according to an agreed formula contained in a negotiated contract. Once all the Transferable Risks and Retained Risks have been identified, the size and timing of the expected cash flows associated with each risk need to be expressed as a NPV over the life of the Reference Project. Each of the risks should be included as a separate cash flow item and then aggregated to form the Transferable and Retained Risk components of a PSC. This allows for a detailed analysis of the key risks and their sensitivity to the overall PSC. Step 12 Calculate PSC Finally, a PSC should be calculated as the sum of the four components, in terms of NPV, as follows: PSC = Raw PSC + Competitive Neutrality + Transferable Risk + Retained Risk In general, when calculating a PSC it is important that practicable and reasonable evidence and data has been gathered in order to allow for a meaningful quantitative analysis. Contracting authorities should be aware that: The evidence base will need to be continually refreshed by the incorporation of new information from projects at all stages of procurement and operation. The contracting authority should avoid relying on over-elaborate estimates and should conduct sensitivity analyses TWL- HR/2007/IB/FI/03TL 36

38 PPP Project Assessment If the current evidence base is inadequate, then other information should be sought to justify the inputs into the model and steps taken to remedy this gap for future procurement; and While at an initial level the assessment will inevitably be conducted using high-level estimates, the assessment will develop as more detailed information is known about the programme and individual projects. It must be noted that the PSC is an estimate based on an outline Reference Project. Experience indicates that the PSC cannot be calculated exactly. It might be preferable to be expressed as a range of values (reflecting the accuracy and reliability of the available information) and used as only one component of the overall value assessment, not as a pass/fail test Technical and legal issues (maturity) Of key importance during the evaluation of a PPP project is the technical maturity of the project. The most important issues that need a careful evaluation are: Have the needs and objectives of the PPP proposal been clearly determined? The main focus in a needs assessment is to define the service needs and to determine the objectives to be achieved through the PPP project. These objectives must be quantifiable, measurable and specific in order to assist in analysis and the future preparation of the procurement process. For this purpose and for future monitoring after the completion of the project, it is extremely important that the contracting authority s needs and objectives are clearly determined. Furthermore, these elements are of great significance in order to structure, as accurately as possible, an initial project s budget. In the same context an important aspect that the contracting authority should consider is the stability for future demand of the project. TWL- HR/2007/IB/FI/03TL 37

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