Standardisation of PF2 Contracts (5) Another new(ish) approach to public-private partnerships. January

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1 Contracts (5) Another new(ish) approach to public-private partnerships January 2013

2 Contracts January Contracts (5) Another new(ish) approach to public-private partnerships "Billy Beane, general manager of the Oakland A's baseball team and hero of the book and film Moneyball, told me in 2010 : When I think of Wenger, I think of Warren Buffet. Wenger runs his football club like he is going to own the club for 100 years. " Simon Kuper, Financial Times, 25 January 2013 One of the core requirements of a successful infrastructure programme, or indeed any investment programme, is a consistent approach over a number of years (in both measuring investment and its outcomes) as Warren Buffet has said: "investing is forgoing consumption now in order to have the ability to consume more at a later date" 1. In the sports world, the pressures to chop and change are as great, if not greater, but success is rarely achieved by throwing money at a problem and stability pays (absent a rich benefactor). By analogy, decisions by a Government in how to invest in infrastructure are not best made in response to criticisms on a weekly or monthly basis or for reasons of political expediency, but instead should be made dispassionately as if the Government were going to be in power for 100 years (that is, measuring what has been foregone by spending money on infrastructure now against value that will or will not occur in the future). In infrastructure a long term view delivers benefits for all involved. The major issue with PF2 is that it is being delivered at least in part because PFI became, for a short time, a political football in the UK (a condition viewed with bemusement by our international clients with PPP programmes) rather than following an evidence based assessment. The positive news, however, is that, overall, the changes brought about by PF2 are not significant and, should a deal pipeline to deliver new infrastructure appear, much of the previously developed expertise can still be adapted to ensure its delivery through PF2 2. The change from PFI to PF2 leaves untouched the core concept, of a contractual relationship between public and private sectors under which the ownership-like risks are taken by the private sector, and the public sector commits to buying a long term service. After two and a half years in power, and a review lasting over a year, the Government is to be applauded for this and restricting changes to a level of detail, although the challenge will now be to gain acceptance on what are, in places, very detailed changes to an already complicated structure. The key changes are said to have been introduced to address weaknesses and criticism of PFI. The following changes are of particular note: the creation of a centralised vehicle, the Central Government Unit, to invest in projects as a minority shareholder; a competition to identify equity co-investors in a PF2 project after the appointment of preferred bidder; introducing a process which incentivises the achievement of a competitive tendering process lasting no longer than 18 months, and limiting PF2 projects to those requiring capital investment of 50 million or more; a more comprehensive set of standard documentation (moving beyond the project agreement and direct agreement); removal of soft services from the scope of the contract, with a view to increasing flexibility; and reallocating risks to the public sector in respect of (i) incurring capital costs resulting from changes of law, (ii) utilities costs, (iii) contamination, and (iv) insurance. Overall, many of the changes are positive and reduce the overall risk transfer to the private sector 3, but it is difficult to escape the underlying theme of reducing the scope for innovation and incentives for investors and imposing greater costs through reporting obligations on the private sector. This will have an impact for a time. The principal concerns we have with the changes are twofold. Firstly, a contractually complex web of standard documentation has now been developed to support the pages of draft PF2 Guidance (to which will be added a pro-forma payment mechanism, a shareholders' agreement and a facilities management service output specification). Even well-advised newcomers to PF2 (those not disincentivised by the lack of a pipeline) may struggle with the additions to the already burdensome weight of documentation, the new approach to shareholding, and PF2's relationship with new sources of finance. Secondly, by removing soft services and reducing lifecycle incentives from the operating phase, there is a risk that the attractiveness of PF2 to facilities managers, who are essential to the efficient working of PF2, will have been significantly reduced. 1 The Berkshire Hathaway 2011 Letter 2 It will be interesting to see (in a decade or so) a comparative analysis of PFI/PPP against PF2 to assess which has delivered better value for money. 3 S&P's view (expressed in Infrastructure Journal on 16 January 2013) is that PF2 may result in more scope to raise ratings. 4 SoPC 4 was a mere 325 pages.

3 2 Contracts January 2013 Introduction On 5 December 2012, the Treasury released its review of PFI in the form of a policy document ("A New Approach to Public Private Partnerships" ("PF2 ")) 5 and a new draft form contractual standardisation guide (" Contracts, Draft form" ("PF2 Guidance")) 6. In the Foreword to the PF2 document, the Chief Secretary to the Treasury and Commercial Secretary to the Treasury express the view that PFI has become "tarnished by its waste, inflexibility and lack of transparency". Elsewhere 7, the document concedes, however, that PFI has offered benefits (including private sector management skills and innovation), which should be retained. The PF2 Guidance sets out the key new approaches to be taken in PF2, in comparison to the existing Standardisation of PFI Contracts Version 4 ("SoPC4"), published in March , comprising: public sector investment in the PFI; removing soft facilities management services from the scope of the PF2 contracts and focusing on hard facilities management services; transparency of operational and financial information on PF2 projects; appropriate risk allocation for the public sector; and delivering value for money. These are each addressed in turn in this note. It is worth noting that a number of key points are set out in PF2, in addition to the changes set out in PF2 Guidance. Three in particular need to be highlighted: Firstly, before diving into detail, to address the criticism that the PFI procurement process was too slow and expensive, the Government has decided that the competitive tendering of PF2 projects, from issuance of project tender to the appointment of a preferred bidder, will now not last longer than 18 months, unless an exemption from the Chief Secretary has been obtained. The sanction for failure to comply is withdrawal by HM Treasury of the budget for the project. Secondly, a set of new standard documentation has been promised by the Government, including new procurement and contract guidance, a standard shareholders' agreement, a standard facilities management service output specification and a pro-forma payment mechanism for accommodation projects. Finally, PF2 flags that the Government aims to structure PF2 projects to facilitate access to the capital markets, institutional investors and other sources of long-term debt finance other than bank debt. Part of this may involve using the new capacity Government has to guarantee obligations in connection with PPP projects 9. The tables that follow set out the changes made in the PF2 Guidance, grouped according to the key new approaches summarised above This document is currently in draft form. The PF2 document indicates at page 12 that the PF2 Guidance will be republished in final form following the consultation on the drafts of the standard form service output template, pro forma payment mechanism and shareholder arrangements, which will take place shortly. 7 The Executive Summary Under the Infrastructure (Financial Assistance) Act , which received Royal Assent on 31 October Allen & Overy 2013

4 Contracts January Key changes from SoPC4 The table below sets out the key changes introduced into PF2, by comparison with SoPC4. The first three columns are from PF2: A User Guide 10, but the fourth column (containing comments) is Allen & Overy's own. Not all changes made by PF2 have been referred to (as some are uncontroversial or clarifying well-established positions). Capitalised terms used in the table, if not otherwise defined, have the meaning given to them in PF2 or PF2 Guidance. 1. Public Sector Investment The PF2 Guidance provides for the Government to act as a minority equity co-investor. The equity investment will be managed by a centralised unit, based in HM Treasury. PF2 anticipates that these measures will address a number of criticisms directed at PFI procurement, including enabling greater synergy between the public and private sectors, greater transparency in relation to the project and improved value for money. This is because the public sector will share in ongoing investment returns. Chapter 5: Public Sector Equity Chapter 5 New Chapter providing guidance on public sector equity to be invested by a new central government unit (CGU) within HM Treasury, and provides for a Shareholders' Agreement (SHA) to be inserted in Schedule 4 following consultation. This is the most significant change in PF2. It is expected that CGU will invest 30-49% (i.e. a minority stake) of equity but CGU reserves the right not to invest at all. More detailed terms will be provided shortly when the SHA (in either full form or heads of terms) is issued for consultation, which we understand will be in the near future. All equity investors will be required to enter into a single SHA, which will contain provisions concerning initial subscriptions, further capital, transfer of shares, voting, tag along rights, and a lock up period. The Chapter also summarises management provisions, arrangements for dividends and provision of information, termination and shareholder events of default, the memorandum and articles of association, loan stock, and guidance where projects are transferring residual value. The Government subscribing for equity is likely to lead to some debate on the early transactions, until the Government attitude as a shareholder has become known 11. The most important issue here is not the issue of principle (i.e. it can be made to work), but to ensure that over complication is avoided (both in terms of process and drafting) and, on the smaller deals (where private sector risk capital is smaller than ever before), to simplify as far as possible the involvement of the public sector as a shareholder and any equity competition post-preferred bidder. A key point to be considered further is whether 30% should, in fact, be the minimum Government stake (as if that is matched in the equity competition by an incoming equity provider, the developer equity will always be less than 50%). 10 Published December 2012 and available on the HM Treasury website at 11 Although it might be the case that CGU will learn some of the lessons of BSFI, which acted as Government equity investor on the Building Schools for the Future transactions.

5 4 Contracts January 2013 Chapter 26: Funders' Direct Agreement Section 26.1 (Introduction) PF2 Guidance refers to the likelihood of there being a new class of subordinated debt providers investing in PF2 projects (rather than all subordinated debt being from developer equity). The funders' direct agreement will, PF2 Guidance states, therefore need to address intercreditor issues such as enabling sub-debt providers to step-in to the project if senior lenders/creditors do not. This is a point for future debate, and another source of complexity, if it ends up being needed at all. Chapter 28: Refinancing Chapter 28 /Market update This chapter incorporates the amalgam of the changes made to the SoPC4 Chapter 34 by Amended Refinancing Provisions issued by HM Treasury in October 2008, April 2009 and April 2012 and Note issued by IUK in June Included are changes to the definitions of Exempt Refinancing, Notifiable Financing, Limb (b) of "Qualifying Bank Transaction" and "Refinancing Gain" all of which have been used in the market in recent years. The last bullet to section requires authorities to agree with how to classify different categories of debt. The only noteworthy change is that a refinancing undertaken in respect of an aggregated funding vehicle established to raise finance and lend debt finance to a PF2 contractor is now included in the non-exclusive list of transactions which could be undertaken by the PF2 contractor following financial close and which could give rise to a "Refinancing Gain" 12. The PF2 Guidance recognises that, generally, the public sector will take equity in the PF2 contractor through the CGU. The CGU will then (in addition to the share received by the procuring authority through the sharing mechanism) take the benefit of any Refinancing Gain, like any other shareholder, but says that it will pass back this gain to the authority (minus its administrative costs). Under SoPC4, the authority was entitled to a 50% share of any Refinancing Gain arising from a Qualifying Refinancing. PF2 provides that the authority will receive more, being: a 90% share of the Margin Gain arising from the Qualifying Refinancing where there is a reduction in the margin from that shown in the Senior Financing Agreements as at financial close; and a share of any further Refinancing Gain (arising otherwise than from a reduction in margin) as follows: for a Refinancing Gain from 1 to 1 million, a 50% share; for a Refinancing Gain of 1 million up to 3 million, a 60% share; and for a Refinancing Gain in excess of 3 million, a 70% share. The PF2 Guidance gives the authority the right to request that the PF2 contractor request potential funders to provide terms for a potential refinancing. This sharing significantly reduces any incentive to refinance sets out a non-exclusive list of transactions which could be undertaken by the PF2 contractor and give rise to a "Refinancing Gain", including reduction in interest margins, reduction or release of reserve accounts, release of contingent junior capital, extension in maturity or increase in the amount of debt, refinancing undertaken without the direct involvement of the contractor, or now refinancings undertaken in respect of an aggregated funding vehicle established to raise finance and lend debt finance to the contractor. Allen & Overy 2013

6 Contracts January Removing Soft Services from the scope of the contract A key practical change in the PF2 Guidance is the exclusion of soft services from private sector delivered services under PF2 (other than those where exceptional integration benefits exist) and provision for periodic reviews of service provisions. The Government believes that this will give greater flexibility to the public sector to negotiate shorter term contracts and alter service specifications, or add or remove certain elective services (to the PF2 contract) during the life of that contract, and therefore give better value for money. Chapter 7: Services and Service Commencement Sections to (Introduction) This chapter is largely new. These sections recognise that soft services will now be excluded from most contracts and that the authority may retain (or appoint third parties to carry out) certain minor maintenance activities. Concepts are introduced of "Authority Services", minor maintenance services and "Elective Services". These sections recognise (a) that the authority may itself carry out or appoint a third party to carry out the soft and other services not included in the PF2 contract and (b) the need to address interface issues. As no soft services will now normally be contained in a PF2 contract, there are no major comments to make other than to note that different interface arrangement to those familiar under PFI will need to come into effect. The one exception to this is that a new concept of "Elective Services" is introduced to allow services to be "added back" into a PF2 contract. This requires a range of services to be priced at financial close by the PF2 contractor. These may relate to Hard FM or to IT services and must be offered at a fixed price. The procuring authority can then choose to deliver the services or require the PF2 contractor to deliver them at the price agreed at financial close. Detailed discussions are likely on how best to achieve a pricing solution which allows the PF2 contractor to put forward the certain pricing necessary to give such a level of authority optionality. Clause (Authority Services) Provides suitable drafting for authority services and interface measures, including the need for an interface protocol. Ensuring a workable interface (by which the authority takes the full risk of soft services and the impact of their non-delivery) will be important. Section 7.19 (Continuous Improvement and Efficiency Reviews) Provides for continuous improvement and efficiency reviews. This requires the PF2 contractor to procure and pay for a report that identifies potential efficiencies and savings in the services it is delivering. This report, if not done to the "standard acceptable", can be done by the authority appointing a technical adviser (at the cost of the PF2 contractor). One of the points to note is that if only Hard FM is being delivered this may make continuous monitoring difficult (as the PF2 contractor may not have a permanent presence on site e.g. in a school, because the caretaker will remain employed by the local authority).

7 6 Contracts January 2013 Chapter 8: Late Service Commencement Section (Introduction) This refers to the policy decision that authority services (i.e. soft services and a few minor maintenance services) should not ordinarily be provided by the contractor but by the authority or a third party contracted by the authority. Section (Introduction) This addresses the impact of delay by the contractor in achieving completion or handover dates and the need for the authority to deal with this in agreements for the provision of authority services. Chapter 9: Hard FM Maintenance Services Chapter 9 This chapter is largely new and builds on chapter 7 (Services and Service Commencement) by separating out the Hard FM services to be provided by the contractor from the authority services. Section (Accelerated or Deferred Maintenance) This is guidance and suitable drafting for accelerating or deferring programmed maintenance which allows the authority some flexibility around timing of maintenance. If savings result these would be shared on expiry as provided for in clause The interface protocol will need to include relevant measures to ensure the smooth operation of interfaces between the parties and that the date for service commencement is not delayed. Precedents already exist for such an approach in some sectors, which should be followed. PF2 guidance now recommends that (in the authority's arrangements with its counterparty) the authority service provider takes the risk of delay to the start date, although it is not clear if the PF2 contractor will have a direct claim in the event that the counterparty to the authority causes delay. Again, existing precedents should be followed, and the authority should bear this risk as against the PF2 contractor. Schedule 3 contains a template Hard FM maintenance services output specification which authorities are expected to adopt, with sector relevant amendments. The costs of acceleration or deferment of programmed maintenance are borne by the authority. Clearly, one of the benefits of PF2 will be the incentives created to manage the contract efficiently. Care should be taken not to use these provisions as an excuse for micro-management (which would destroy value for both sides). The new approach to lifecycle is that savings against budgeted costs are shared 50:50 between the public and private sector, reducing further any upside for an FM contractor. Chapter 11: Flexibility and Change Section 11.1 (Flexibility) New guidance on greater service flexibility, in particular pre-priced Elective Services which can be moved in or out of the contract easily without triggering a rerun of the financial model. It is clear from the PF2 Guidance that soft services should not generally be included in PF2 projects, but that authorities should still have discretion on the inclusion of minor maintenance activities through the Elective Services mechanism (see above). Allen & Overy 2013

8 Contracts January Transparency of operational and financial information During the consultation period, many stakeholders requested greater transparency in PFI arrangements. Chapter 31 introduces measures to improve transparency, both from the private sector and through public sector equity involvement. In addition, PF2 indicates that a "business case approval tracker" will be published on the HM Treasury website from Spring Chapter 31: Information and Transparency Chapter 31 Chapter 26 of SoPC4 has been enhanced to bring it in to line with best practice, clarifying what and how information should be requested and provided to the public sector together with new items of data (including information on IRRs and sale price of share sales) to be made available. Also clarifies the provision of information being part of the service required and consequences for failures. Also contains updated guidance on relevant legislation and recent changes to Government's transparency requirements. The Government will increase the amount of project information available to taxpayers. The aim is to give confidence that value for money is being achieved, and to improve the transparency of projects to procuring authorities. It will clearly cost more to produce this information. Within twenty business days of signature of the PF2 contract, the PF2 contractor must provide to the authority a summary of the contract written in plain English, containing specified items and other updates. The PF2 contractor also now has to provide to the authority and HM Treasury a calculation of the equity internal rate of return for the project as a whole and for each of the shareholders, to be provided on each 31 March and 30 September throughout the contract period. The PF2 contractor must also provide regular project reports, an indication form of which is set out in the PF2 Guidance. In the required drafting set out in the PF2 Guidance, the parties acknowledge that the internal rate of return information provided, and any information provided in respect of any change of ownership will not be treated as confidential information. It is probably unnecessary to do this as all such information that was not previously available will now be available through the CGU shareholding. It will, in any event, be interesting to see whether the availability of the "new" information in this format has any discernable effect on public comment on PF2.

9 8 Contracts January Appropriate risk allocation for the public sector The PF2 Guidance foresees more "appropriate" risk allocation for the public sector, including, following the example set by the Scottish Government with its "NPD Model", public sector retention and management of general change in law risk, and risk sharing for core required insurances in the operational phase of the project. The Government believes that this will improve value for money (and reduce costs) by reducing the PF2 contractor's requirement to build up reserves against risks. Chapter 13: Warranties and Undertakings Section (Due diligence) Section 13.3 (Benefit of Surveys and Reports) Authorities should ordinarily warrant title to land provided by them. Authorities should commission and assign to contractor the benefit of technical reports and surveys (e.g. ground contamination and asbestos) on land which they provide. Required drafting is set out, requiring the authority to warrant title. This applies unless there are particular reasons why the authority wishes to provide a certificate of title from its lawyers. If the authority does provide a certificate of title, the required drafting will need to be amended. PF2 Guidance also provides that the certificate of title should have a duty of care extended to the PF2 contractor and any replies to enquiries should be warranted by the authority. This is a reasonable amendment to what has historically proved an unnecessary expense for bidders. PF2 Guidance recommends that the authors of the technical reports extend a duty of care to bidders. The authority will not warrant the information contained in the reports (or which should have been so contained if the report was done properly) as the consultant will be liable to the PF2 contractor. This approach works provided the advisers concerned have an adequate scope and limit on liability. Chapter 14: Indemnities, Guarantees and Contractual Claims Clause 14.3 (Indemnity) Market up-date Some technical changes and changes in detail are made to this suitable drafting for a contractor indemnity, incorporating market update changes. "Authority Related Party" is defined. The definition of "Authority Related Party" replaces the authority's "employees, agents and contractors" and now comprises the "officer, agent contractor, employee or sub-contractor (of any tier) of the authority acting in the course of his office/employment/appointment, excluding the PF2 contractor and any Contractor Related Party". "Losses", or as relevant, "Direct" and "Indirect Losses" are yet to be defined. Section (Indemnities) Considers which party should bear vandalism risk. PF2 Guidance provides that the authority should decide how to allocate risk of vandalism. Where the PF2 contractor is not providing soft services such as security, PF2 Guidance correctly recognises that it may not be good value for the contractor to bear vandalism risk, which has been borne out in the first draft of the Project Agreement for the Priority Schools Building Programme. Chapter 16: Change in Law Chapter 16 Liability for costs of capital work required in the operational period (for a change in law which was not reasonably foreseeable) should now lie with the authority. Numerous responses in the PF2 consultation suggested that the previous approach to risk allocation, where the PF2 contractor would either bear or share the risk and had to set up a bank facility or cash reserve as security for this risk, did not offer value for money as the unitary charge was increased. This is a reasonable amendment to what has been historically proved to not represent best value for money for authorities. Allen & Overy 2013

10 Contracts January Section (Introduction) The general position is that where the change was foreseeable at the time the contract was signed the risk will lie with the contractor save that (a) during the construction phase, whether it was foreseeable or not, the contractor will bear the risk of a general change in law and (b) at all times the contractor will bear the risk of a general change in law which does not involve capital expenditure. Section (Exceptions) Some sectors have developed change in law provisions that are suited to their particular circumstances and these may need derogation from the approach adopted in this Chapter. Waste is an example. Chapter 17: Insurance Section (Introduction) Allows the possibility, in particular cases, for the authority itself to cover some risks by way of indemnity rather than require the contractor to insure them in the market. Section (Introduction) Notes that the usual required insurance should always be taken out in the construction phase, but allows for authority indemnity as an alternative for material damage and business interruption cover during the service phase, for projects with particular risk characteristics where it offers value for money. Any authority wishing to pursue this must prepare a business case and seek approval from HMT. The new position leaves the construction phase unchanged and requires the PF2 contractor only to bear the cost risk of changes in law that do not involve capital expenditure (and are not specific or discriminatory). The PF2 Guidance suggests derogations (e.g. in the waste sector) should apply if the Change in Law is foreseen, but the cost is not foreseeable at the time the contract is signed. The PF2 Guidance makes it clear that the cases where the authority should cover risks by way of indemnity instead of contractor insurance are those where it is better value for money to do this. This is a significant change and will have to be worked through on particular deals. PF2 provides that the projects for which the authority should consider providing indemnities to cover insurable risks itself (as opposed to the contractor taking insurance) are those with: a dispersed asset base; greater ability to recover losses from third parties; or a reduced risk of catastrophic loss. PF2 Guidance provides the following examples: a street lighting project, where the PF2 contractor will take the risk of replacing damaged street lights; local authority road projects, where the authority may find it better value for money to cover material damage etc. by way of indemnity; where there is an inefficient insurance market, the authority may consider retaining the risk; and where the project is part of an extensive programme procured by Central Government, the department should consider covering risk by way of an indemnity. The PF2 Guidance makes it clear that it would not be considered appropriate risk transfer for construction period risks, third party or other insurances (except for material damage and related business interruption) to be covered by the authority. It indicates that the scope of any authority indemnity must be carefully considered and any authority wishing to take this approach must prepare a business case and seek approval from HM Treasury. We would expect different approaches here from deal to deal as not all public bodies have the same attitude to insuring risks.

11 10 Contracts January 2013 Section (Introduction) During the service period the risk of insurance premiums change can, as under SoPC4, be shared but this Chapter now allows the authority to choose the amount of the "nil change" band (of contractor risk); the authority must specify the nil-change band (of increase and decrease of premium where the contractor takes the risk in full) in the tender documentation This band must be an amount equal to between 5% and 30% (previously it was 30% only) of the original insurance premium. As before, any increase above or reduction below the nil-change band is to be shared 15% by contractor and 85% by authority. See Section below. Section (Insurance See comment on Section above. Premium Risk Sharing Schedule) Section (Insurance premium Risk Sharing Schedule) Market up-date Definition of Insurance Cost Differential amended to remove the plus/minus sign before PIC as built into the definition of PIC. See amended definition of Project Insurance Change (PIC). This greater flexibility in the approach to insurance should reduce contingencies that PF2 contractors have to make for insurance premium increases (if authorities wish to bear such risks). The trigger level for premium risk-sharing arrangements to apply should be pre-set by the authority in its tender documents. The authority may choose a trigger figure between 5% and 30% (previously it was 30% only) of the original insurance premium for insurance premium price rises above or below. Project Insurance Change now expresses any net increase as a positive number and any net decrease as a negative number. This change reflects a common derogation request. Chapter 18: Authority Step-in Clause 18.2 (Authority Stepin) Clause 18.3 (Step-in without Contractor breach) Section 18.5 (Rights of Access) Clarification Clarification The circumstances where the authority is entitled to step in have been expanded to include "Emergencies". Also the need for the authority to use "Good Industry Practice" when it has stepped in (other than on contractor breach) is added as required drafting. Definitions are inserted of both Emergency and Good Industry Practice. Drafting to recognise that step-in where contractor is not at fault could occur while the building works are still in progress. Authority's rights of access (required drafting) are restated with explanation. It would be interesting to understand whether the change have been driven by any practical experience (e.g. an authority wanted to step-in but could not). It would be useful to know the practical reasons for this change. The authority will have a reasonable right of inspection of the Works and the Facilities and the Contactor must provide reasonable assistance for these purposes. Should the PF2 contractor breach its maintenance obligations, the authority may exercise its right to access and remedy such breach. The authority must comply with Health and Safety Requirements, and will be liable to the PF2 contractor for any material damages caused by the authority or an Authority Related Party (such damage to be deemed a Compensation Event). Allen & Overy 2013

12 Contracts January Delivering value for money. In addition to the provisions discussed above, PF2 Guidance introduces several additional measures in an attempt to increase value for money for the public sector and the taxpayer. The PF2 Guidance permits the Government to consider providing larger capital contributions with a view to making projects more affordable by lowering the debt finance required, reducing market capacity constraints and enabling more competitive pricing provisions. PF2 Guidance also amends the existing termination provisions to include a gain-share mechanism between the PF2 contractor and the authority for lifecycle surpluses. Chapter 4: Land, Equipment and Property Interest Section (Introduction) Specifies that authorities should ordinarily warrant title to land which they provide to the project. This is a positive change, and helps deal with one of the cost issues (effectively bidders each having to do their own individual title due diligence on each bid with most of the work therefore being wasted). See comment on Chapter 21: Capital Contributions Chapter 21 New Chapter on capital contributions (previously covered in Section 3.9 of SoPC 4 as, itself, updated) but incorporating policy changes to allow for some increased levels of capital contribution in the build phase (provided always that where the actual project time-line changes from the scheduled one, the ratio of capital contribution to private sector finance invested must not be adversely effected). The PF2 Guidance indicates that authority capital contributions must be considered at an early stage in the procurement to allow for competitive tension. PF2 states that capital contributions must be modest, and payments linked to the achievement of important milestones in the construction schedule, and directly attributable to the construction cost. The size of capital contributions should depend on the risk characteristics of the project. The PF2 Guidance states that including a capital contribution will lower the total unitary charge by reducing the amount required to service senior debt, but the unitary charge attributable to service providers will remain the same. Chapter 23: Early Termination Section (Events leading to Termination) Market up-date This is an additional contractor default where health and safety is a particular concern. Contains suitable drafting and definition of "Contractor Related Party". It would be helpful to understand if this arises due to a practical issue (termination was required, but the absence of a termination right prevented it). Section (Termination for Persistent Breach by the Contractor) A definition of "Information Breach" is needed and is provided. Information Breach is a breach of any of the provisions relating to contractor's records and provision of information or personal data, and can trigger termination. It would be useful to understand when this right would need to be exercised. Clause (Retendering Procedure) Lifecycle Surplus taken into account in determining what is paid on termination. The authority now has to pay to the PF2 contractor an amount equal to the Adjusted Highest Compliant Tender Price, less an amount equal to the Lifecycle Surplus 13. The effect of this is to impose an obligation on the PF2 contractor to pay any Lifecycle Surplus on termination. 13 Lifecycle costs profiled to be spent, less amounts actually spent by the PF2 contractor.

13 12 Contracts January 2013 Clause (No Retendering Procedure) Market up-date Several changes to give effect more clearly to the purpose of the Clause. New definitions, such as Handover Date, have been incorporated. The principles that the Parties should apply in agreeing the Estimated Fair Value of the contract have been updated: forecast amounts should be calculated as follows: for unitary charge payment, using the indexation formula in Clause (Indexation) and using the agreed assumed forecast rate of increase in the index; for third party income and costs, if indexation is appropriate and the appropriate index is the same as used for the unitary charge payment, the index and same assumed forecast rates of interest as above, and for third party income and costs, if indexation is appropriate and but the appropriate index is not the same as used for the unitary charge payment, the parties shall (subject to resolving any dispute pursuant to clause (d)) agree and index for any particular third party income and reasonable forecast rates of increase; any amount to be paid to the authority under Section 21 (Capital Contributions) should be calculated and discounted to the termination date at the termination date discount rate, in addition to the total future payments of the full unitary charge; and the total of all third party income to be received to the expiry date (less a reasonable amount to cover bad debts) should be discounted to the termination date at the termination date discount rate, and added to the payment calculated Clause (c)(iii) (No Retendering Procedure). An amount equal to the Lifecycle Surplus at the termination date should be deducted from the adjusted estimated fair value of the contract, which the authority pays to the PF2 contractor. Allen & Overy 2013

14 Contracts January Allen & Overy Contacts Any questions or queries in relation to this report or about PPP/PF2 projects more generally should be directed to any of the following Allen & Overy contacts: David Lee Co-Head of Global Infrastructure Group (London) Tel M david.lee@allenovery.com Conrad Andersen Partner, Infrastructure (London) Tel M conrad.andersen@allenovery.com Tamsyn McLean Senior Associate, Infrastructure (London) Tel M tamsyn.mclean@allenovery.com

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