Guidance 1E. R. Yescombe (2007)
Public-Private Partnerships
Principles of Policy and Finance

A chapter of this book is devoted to discuss and describe payment mechanisms

Guidance 2Scottish Gov. (2007)
Briefing Note 1
Payment Mechanisms in Operational PPP Projects

Discussion of key issues in designing a payment mechanism

Guidance 3HM Treasury (UK), (Ver. 4,  2007)
Standardisation of PFI Contracts
Includes a thorough overview of the major principles and issues relating to the payment mechanism and gives some drafting suggestions

Payment mechanism

Guidance 1, 2, 3

The payment mechanism lies at the heart of the PPP contract. The primary purpose of the payment mechanism is to remunerate the PPP Company sufficiently for it to be willing to enter into the PPP contract and provide the service. The payment mechanism is the principal means for allocating risks and providing incentives in the PPP contract.

A useful way to approach the design of the payment mechanism is to start with a basic/ideal structure for the Authority. Ideally, the Authority will want to pay the PPP Company, in arrears, a fixed price for (and only for) each unit of service that has been provided and has met the service quality requirements. This would comply with the key PPP principles that payments should be made only if the service is available, at the agreed standard of service, and that payments should not be based on the PPP Company’s actual costs (a PPP contract is not a “cost-plus” contract). This basic/ideal mechanism would give the PPP Company strong incentives to perform but would require it to bear excessive risks. “Excessive” in this context could mean that the premium required by the PPP Company to bear the risks would not be worth the gain obtained from increased efficiencies. It could also mean that the PPP Company would be too likely to make excess profits or face large losses, which would threaten the viability of the PPP arrangement. The detailed design of the payment mechanism can then be derived by moving away from the basic/ideal mechanism and ensuring a balanced risk/reward scenario for the PPP Company. In particular, it is important to make sure that risks that are largely beyond the control of the PPP Company are not allocated to it.

Further adjustments to the basic/ideal mechanism should be considered:

  • The payments to the PPP Company usually need to be “indexed” to compensate for cost increases due to inflation (the indexation should be based on an agreed set of published indicators).

  • Cost items that are beyond the control of the PPP Company can be handled on a “pass-through” basis (i.e. the Authority reimburses the costs actually incurred by the PPP Company). Where this mechanism is contemplated, the Authority should ensure that the cost items subject to pass-through are limited and defined in detail.

  • The deductions applied to the service fee for poor performance should be linked to the degree of deficiency in the service quality. The service quality measurement needs to be verifiable and objective. Generally, the amounts deducted should be consistent with the losses that the Authority or users would incur as a result of the service shortfall.

  • Demand risk is often considered as at least partially beyond the control of the PPP Company. A variety of mechanisms are available to shift some or all of the demand risk away from the PPP Company. For example, the service fee / user charge can be gradually increased as demand falls. Also, a minimum payment guarantee (i.e. the PPP Company is paid a certain amount even if actual demand falls below an agreed minimum) can be implemented. 

When designing the payment mechanism, the Authority and its advisers should pay attention to features that could give the PPP Company perverse incentives or are complicated or ambiguous (as these may later give rise to disputes). The payment mechanisms of comparable projects / sectors (where available) may also be a useful benchmark.

The Authority’s advisers should use a model to test alternative payment mechanisms. A scenario analysis should be run to calibrate the parameters of the payment mechanism to ensure that it performs satisfactorily under a set of likely performance scenarios. Although poor performance should have a material impact on the equity return of the PPP Company, it would be counterproductive if it were to jeopardise debt service payments too easily (as this could result in the bankruptcy of the PPP Company or make the PPP contract difficult to finance).