abridged version of research report on uk highway ppps

8/8/2019 Abridged version of research report on UK highway PPPs

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2010

RESEARCH REPORT

UNIVERSITY COLLEGE LONDON

DEVAYAN DEYUNIVERSITY COLLEGE LONDON

The Efficiency of Procurement in Transport Infrastructure PPPs The Case of UK Highways


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The Efficiency ofPPPs

Bartlett School of Con

Un

rocurement in Transport InfThe case of UK Highways

by

DEVAYAN DEY

truction Economics and Project

versity College London

September 2010

astructure

Management


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ABSTRACT

The aim of this report is to appraise the efficiency of procurement in Highway PPPs in the UK, understand thecausalities, and suggest possible improvements. This research uses an economics-based theoretical frameworkaided by current commercial issues to identify implementation gaps. This is followed by a statisticalinvestigation on operational efficiency to determine the significance of the identified gaps and to whatextent do they manifest into inefficiency. The focus of the research has been in investigating two very

vital areas in PPP Procurement: tendering process and payment mechanisms.

The research identified key areas of weaknesses and recommended possible solution to strengthen them.In the process, it has also put forward three introductory models:

Toll Price Regulation System A new form of Payment mechanism using concept of partial subsidy. Point Based System Proposal for relocating safety elements from payment mechanism to RFQ. Innovation Enhancement Proposal A regulatory approach to promote efficiency and innovation.

Key Words: Public Private Partnerships, Procurement Economics, Highways, Payment Mechanisms,Tendering, Project Development.


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CONTENTS

Abstract .................................................................................................................................................................. i

Contents ................................................................................................................................................................ ii

List of figures ....................................................................................................................................................... iv

List of tables......................................................................................................................................................... iv

List of boxes......................................................................................................................................................... ivDisambiguation ..................................................................................................................................................... v

List of abbreviations and acronyms ..................................................................................................................... vi

1. Introduction...................................................................................................................................................... 1

1.1. PPPs in Highways Emergence of DBFOs in the UK ......................................................................... 2

1.2. Research Rationale ................................................................................................................................ 2

1.3. Research Methodology .......................................................................................................................... 3

1.4. Research Outline ................................................................................................................................... 3

1.5. Value of Research.................................................................................................................................. 3

2. Procurement Economics A Literature Review of PPPs ................................................................................ 42.1. Economic Characterization of PPP........................................................................................................ 4

2.2. Theoretical Framework of PPPs ............................................................................................................ 4

2.2.1. Incomplete Contracts and Private Information ......................................................................... 4

2.2.2. Bundling and unbundling .......................................................................................................... 5

2.2.3. Transaction Cost Economics ..................................................................................................... 6

2.2.4. Principal Agent Problem ........................................................................................................... 6

2.2.5. Optimum Risk Sharing ............................................................................................................. 7

2.2.6. Whole Life Cycle Costing......................................................................................................... 8

2.3. Description of Highway PPPs ............................................................................................................... 8

2.3.1. Revenues in PPPs: ..................................................................................................................... 8

2.3.2. Costs in PPP .............................................................................................................................. 9

2.3.3. Public Benefits ........................................................................................................................ 11

2.3.4. Cost and Benefit Analysis & VFM Assessment ..................................................................... 11

2.4. Concluding Remarks ........................................................................................................................... 12

3. Procurement through Public Private Partnerships in Highways .................................................................... 14

3.1. Tendering in Highway PPPs ................................................................................................................ 14

3.1.1. Competitive Dialogue A Brief ............................................................................................. 14

3.1.2. UK Highway PPPs - Tendering Process ................................................................................. 14

3.1.3. Discussion ............................................................................................................................... 16

3.2. Payment Mechanisms .......................................................................................................................... 17

3.2.1. Congestion Mechanism (Performance Based) ........................................................................ 17

3.2.2. Lane Availability Mechanism (Performance Based) .............................................................. 21

3.2.3. Shadow Toll (Traffic Based) ................................................................................................... 25

3.2.4. Commentary ............................................................................................................................ 27

3.2.5. Real tolls and Least Present Value of Revenue ...................................................................... 28


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4. Operational Assessment ................................................................................................................................. 34

4.1. Safety Performance ............................................................................................................................. 34

4.2. Innovation and Externality .................................................................................................................. 42


5. Conclusions & Recommendations ................................................................................................................. 45

5.1. Research Overview .............................................................................................................................. 45

5.2. Research Findings ............................................................................................................................... 46

5.3. Recommendations ............................................................................................................................... 46

References ........................................................................................................................................................... 48

APPENDIX I: Forms of Public Private Partnerships (Source - Deloitte 2006) ................................................... A

APPENDIX II Safety Operational Performance Assessment Data Set ............................................................ B

APPENDIX III Structuring Safety Performance in PPPs: Points Based System ............................................. C

APPENDIX IV: Innovation Enhancement Proposal for PPPs Introductory Concept ...................................... G

APPENDIX V: Equivalent Traffic Flow .............................................................................................................. J


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LIST OF FIGURES

Figure 1 Transport Mode share - passenger transport (DfT 2010b) ___________________________________________ 1

Figure 2 Motor Vehicles licenced by Bodytype in the UK between 2000 and 2009 (DfT 2009) ______________________ 1

Figure 3: Monthly Payment (modified from Briggs & Drewett, Seminar at Warsaw, Poland, 2008) ________________ 21

Figure 4: Safety Adjustment (modified from Briggs & Drewett, Seminar at Warsaw, Poland, 2008) ________________ 21

Figure 5: Relation between the toll prices and K (the power of a) __________________________________________ 30

Figure 6: Box-plot for Cluster discriminating variable (Equivalent Traffic Fow) _______________________________ 35

Figure 7: Year-wise Weighted Accident Rate Comparison __________________________________________________ 36

Figure 8: Pre-transition Scatter based on year ___________________________________________________________ 36

Figure 9: Post-transition Scatter based on year __________________________________________________________ 36

Figure 10: Accident Vs Traffic Volume (Vehicle KM) _____________________________________________________ 36

Figure 11: Accident Vs Traffic Flow (Vehicle) ___________________________________________________________ 36

Figure 12: Cluster1- Pre and Post 1999 Accident Vs Traffic Volume (100 Million Vehicles KM per year) ___________ 38

Figure 13: Cluster1- Pre and Post 1999 Accident Vs Traffic Flow (Million Vehicles per year) ____________________ 38

Figure 14: Cluster 2- Pre and Post 1999 Accident Vs Traffic Volume (100 Million Vehicles KM per year) __________ 39

Figure 15: Cluster 2- Pre and Post 1999 Accident Vs Traffic Flow (Million Vehicles per year) ___________________ 40

Figure 16: Cluster 3- Pre and Post 1999 Accident Vs Traffic Volume (100 Million Vehicles KM per year) __________ 40

Figure 17: Cluster 3- Pre and Post 1999 Accident Vs Traffic Flow (Million Vehicles per year) ___________________ 41

LIST OF TABLES

Table 1 List of the DBFOs executed in England. (GB, 2010) ________________________________________________ 2

Table 2: Sensitivity Analysis (Simplistic) _________________________________________________________________ 9

Table 3 Probable cost segments in a Highway PPPs ______________________________________________________ 10

LIST OF BOXESBOX 1: The Framework _____________________________________________________________________________ 13

BOX 2: Competitive Dialogue Procedure _______________________________________________________________ 14

BOX 3: Most Recent Tendering Process in UK Highway DBFO _____________________________________________ 15

BOX 4: Congestion Management Payment (Congestion based Payment Mechanism) ____________________________ 17

BOX 5: Performance Bonus / Performance Adjustment Mechanism (Congestion Based) _________________________ 17

BOX 6: Construction Payment (Congestion based) _______________________________________________________ 19

BOX 7: Safety Adjustment (Congestion based) ___________________________________________________________ 20

BOX 8: Payment Structure (Lane Availability based)______________________________________________________ 22

BOX 9: Condition Adjustment (Lane Availability based) ___________________________________________________ 24


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DISAMBIGUATION

It is necessary to understand the differences between certain terms used in this report in order to beaccurate in interpretation. It is recommended that the reader understands them before proceeding withthe report.

Value for Money (VFM) and Efficiency:There is a relation, but also a distinct difference between efficiency and value for money. VFM improves

only if greater private sector efficiency results in lower costs to the department or higher benefits to thetaxpayers or both. That is, even if the contracts successfully incentivize greater efficiency in privatesector, it may not lead to value for money unless there is a positive benefit to the public sector or to thepublic.

Fundingand Financing:This report uses the words in two separate meanings. Funding refers to the source of revenue to theprivate sector (either user toll based or annuity based). Financing refers to the way the private sectorraises capital to execute the project.

ExternalitiesExternality relates to the spillover effect of an activity, action, investment, effort, innovation on the

subsequent one, and the cost and benefits. Externality is positive, when the spillover effect leads toimprovement in the cost or benefits, and negative when there is deterioration.

Quality of service can be specified, Quality of service can be monitored, Quality of service is contractible:Quality of service can be specifiedonly when the client knows what leads to a better service. For example, inan office building the client may know that a temperature of 23 degree centigrade will enhance theefficiency of executives. Here, the quality of service can be specified. On the contrary, monitoring thetemperature throughout the whole office may not be possible. It may be higher in certain corners andlower in some. Here, monitoring of the specified quality of service is difficult. Quality of service is contractibleonly

when the quality of service can be specified as well as monitored economically.

Proxy Elements:

Proxy elements are those parameters that can act as indication of quality of service. In the previousexample, temperature is used as a proxy element with a measure of 23 degrees.

Sharing of risk and allocation of risk:In this research, these phrases have been used carefully. While allocation refers to complete transfer of arisk out of many identified risks, sharing refers to distribution of a particular risk but with predeterminedaccountability.


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LIST OF ABBREVIATIONS AND ACRONYMS

CapEx : Capital Expenditure

COBA : Cost and Benefit Analysis

DBFO : Design Build Finance Operate

DfT : Department for Transport, United Kingdom

GMR : Guaranteed Minimum Revenue

HA : Highways Agency, United Kingdom

ISOP : Invitation to Submit Outline Proposals

ITT : Invitation to Tender

LPVR : Least Present Value of Revenue

OBS : Observation

OGC : Office of Government Commerce, United Kingdom

OpEx : Operating Expenditure

PBVI : Public Body Validating Innovation

PPB : Provisional Preferred Bidder

PPP : Public Private Partnerships

PQQ : Pre-Qualification Questionnaire

TUBA : Transport User Benefit Appraisal

VFM : Value for Money

WB : World Bank

WLCC : Whole Life Cycle Costing


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1. IntroductionIn transport infrastructure, the role of roads is dominant in most of the contemporary economies (WB,2007; Boarnet and Haughwout, 2000; Banister and Berechman, 2000; Carapetis et. al., 1984). In the UK,DfT (2010a) reports that road transport has been responsible for 84 percent of freight movements

within UK. In terms of passenger transport, 70 percent of the average number of trips and 83 percent ofthe average distance travelled in the UK were on roads (DfT, 2010b).

Figure 1 Transport Mode share - passenger transport (DfT 2010b)

In addition, there is a steady growth of 2 percent in the number of vehicles licensed each year (DfT2009), indicating growing traffic. High mode share along with growing traffic indicates that road andhighway infrastructure will remaina key investment area in UKs transport infrastructure.

Figure 2 Motor Vehicles licenced by Body type in the UK between 2000 and 2009 (DfT 2009)

In the past, investment in roads and highways was undermined quite heavily, especially when the needwas even more severe (Clark and Root, 1999). The poor condition of the infrastructure was blamed on

the decade long under-investment under the Conservative Government (Rintala, 2004). Added to that was the perception that the public sector had efficiency problems in delivery of the public services.Operation and delivery were plagued with time and cost overruns yielding sub-optimal value for money(VFM) (GB, 1998). Limitations on public expenditures imposed by the Maastricht Treaty and economicrecessions only worsened the investment situation (Allen, 2001; Hall, 2009).

The search of an integrated solution to these problems led to what we know as Public PrivatePartnerships (PPPs), more often accepted as Private Finance Initiative (PFI) in the UK. However, in therecent years, many have questioned the effectiveness of PPPs, especially in its capacity of deliveringsuperior VFM (Guardian, 2004; Building, 2008). This report acknowledges the importance of these


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questions and focuses on improving the procurement framework of UK highway PPPs in deliveringbetter VFM.

1.1.PPPs in Highways Emergence of DBFOs in the UK While the history of PPPs dates back to 17th century, it has gained popularity in major projects onlyduring the past two decades. Among the various forms of PPPs (see Appendix I), UK highway sector

took a form that is more commonly known as Design, Build, Finance & Operate (DBFO). DBFOstarted as a precursor and transition to motorway tolling, designed to create an operation industry takinga long-term commercial view (HA, 2008). The DBFO concept was included for consultation in Paying

for better Motorways: Issues for Discussion (May 1993). A preliminary note on the principles applying toDBFO was published in 1994.

Table 1 List of the DBFOs executed in England. (GB, 2010)

Till date, 12 major DBFO roads have reached financial close in the England (excluding those undertakenunder the Scottish Office, Welsh Office and Local Authority Schemes). Highways Agency manages 11 ofthem, while Transport for London (TfL) manages the A13 Thames Gateway DBFO.

1.2.Research RationaleSo far, there have been two separate forms of research in PPPs. While one generates numerous valuablemodels emerging from economic theories, the other emphasizes on pragmatic aspects like economic /

operational efficiencies, governance, financing, etc. Although both are aimed at improving VFM, there isa missing link between these two forms of research that suppresses full potential of PPPs. The vital areaof contracts and procurement that connects the two realms of theory and practice were left unattended.Contracts are vital, as they are a major route of channelizing the theoretical concepts into practice.Unless properly channelized, PPPs may not deliver the expected. To assess the efficiency of contractsand procurement in PPPs, we need to answer three basic questions: (i) what is theeconomic frameworkfor highway PPPs? (ii) to what extent do the existing PPPs conform to this framework? and (iii) underthe current level of conformance, how efficient are PPPs in delivering results? The answers to thesequestions will be instrumental in strengthening the procurement framework of PPPs.


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This led to the research aim, which is to appraise the efficiency of procurement of Highway PPPs in the UK,understand the causalities, and suggest possible improvements in the framework.

1.3.Research MethodologyIn UK Highway DBFOs, there has been a paradigm shift in the contractual framework. Over the years,the payment mechanisms have slowly shifted from demand to performance based i.e. from real and

shadow tolling towards mechanisms like congestion and lane availability. Similar magnitude of shift canbe noticed in the tendering process as well.

Answering the three questions as identified in section 1.2 will help to identify the implementation gapsin theframework in tandem with the shift.

The causalities of any identified gap will be used to structure the contract in a more effective way. Theresearch, within its capacity, has put forward solutions to bridge the implementation gap. It is worthmentioning that the solutions in this research have been designed keeping in mind the commercial issuesthat have surfaced in the recent past. This makes them practical, implementable and result oriented.

Thus, the primary methodology adopted in this research is to capture implementation gaps and bridge them by

designing solutions that can improve the VFM aspect in highway PPPs.

1.4.Research Outline This thesis is structured into five major sections: (1) Introduction (2) Procurement Economics (3)Procurement through PPPs in Highways (4) Operational Assessment (5) Conclusion andRecommendations.

Section 2 reviews the existing literature on the economic theories behind the concept of PPPs. Thepurpose of this section is to extract necessary theoretical guidelines to appraise the procurementframework. It also introduces the aspect of cost and benefits in PPPs, thereby exploring the commercialissues. Section 3 reviews the conformance of the tendering process in PPPs to the framework developedin Section 2. A similar methodology has been adopted for appraisal of the different payment mechanismsas well. Section 4 looks into the operational efficiency of the PPPs in areas of safety performances andinnovation. Section 5 summarizes the entire study and consolidates the findings and recommendations.

1.5.Value of Research This research will strengthen the understanding the procurement and development of highway PPPsusing a theoretical yet practical approach. It introduces a novel methodology for improving procurementin a way that can align both public and private sector motives. The framework developed in this researchidentifies the major considerations for structuring the tendering process and constructing paymentmechanisms. Most importantly, it uses performance evidences to triangulate our observations.

This research will be of interest to a wide range of individuals like central and local governments and

their agencies, consultants, financiers as well as academics.


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2. Procurement Economics A Literature Review of PPPsThere are various arguments as to why governments might undertake PPPs. There is a long history ofpublicly procured projects being delayed and turning out to be more expensive than budgeted (Flyvbjerget. al., 2003). Transferring these risks to the private sector under a PPP structure and having it to bear thecost of design and construction overruns is one way in which a PPP can potentially improve VFM in apublic project (Blanc-Brude et. al. 2006, NAO 2003; CIC, 2000; HA, 1997). De Palma (2009) points out

that on a broader perspective, PPP has the potential to induce private sector skills and efficiency indelivering public projects.

These arguments are derived from various theories and models that have been developed in the past 18years of PPP economics. The purpose of this section is (i) to understand the models and the underlyingprinciples of PPPs specific to tendering and payment mechanisms, (ii) to understand the commercialaspects and (iii) to use these understandings in generating a framework for our research. Throughout thissection, the guiding observations used in framework have been put up in box figures and are denoted bythe acronym OBS.

2.1.Economic Characterization of PPPThe role of the private sector in public projects is justified only when it adds value, i.e. for PPPs to beeconomically superior to the traditional public provision. It should not give rise to costs that exceed theassociated benefits. Most contemporary studies on economic gains in PPP are based on three basichypotheses:

PPP can reduce costs without degrading benefits. PPP can improve benefits without increasing costs. PPP can do both, i.e. reduce cost and improve benefits.2.2.Theoretical Framework of PPPs

The foundation of this section is based on The Theory of Incomplete Contracts and Private Information. This willbe key to introducing some of the very basic concepts and terminologies used in this report.

2.2.1. Incomplete Contracts and Private InformationIn principle, a perfectly fashioned complete contract could solve the motivation problem. It would specify precisely what each

party is to do in every possible circumstance and arrange the distribution of the realized costs and benefits in eachcontingency, so that each party find it optimal to abide by the contracts terms(Milgrom and Roberts, 1992).

However, in practice, not all requisites of a complete contract are satisfied. Bounded Rationality of realpeople leads to limited foresight of all probable circumstances. In events of unanticipated circumstances,parties must find a way to adapt under profit maximizing tendencies, thereby, introducing the possibilityofopportunistic behaviorand imperfect commitment. For example, road construction is extremely dependent onthe weather conditions. In event of unexpectedly high rainfall during construction, the construction

company may have to invest heavily in avoiding time overruns. In absence of clauses in favor of theprivate sector, the public sector may behave opportunistically by imposing liquidated damages for timeoverrun, or by not sharing the cost overruns. On the other hand, in absence of liquidated damages clausefor time overrun, the private sector may behave opportunistically by making no investment in reducingtime overrun.

In addition, the relevance ofprivate information is extremely high in contractual agreements. Often, one ofthe parties is ignorant of certain crucial elements prior to the contract, termed as pre-contractualinformationasymmetry. This may lead to the problem ofadverse selection. For example, there may be cases of strategic


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misrepresentation (Flyvbjerg 2008) leading to renegotiations or claims, when the terms in contract areincomplete or ambiguous to one party due to information asymmetry.

While contemporary literature considers adverse selection to be a consequence ofpre-contractualopportunism(intended), this may not always be the case. For example, the cost calculations by which thecontractor arrives at the bid quotes are often not disclosed to the public sector. In events of inaccurate

estimation of key project parameters due to optimism bias(Flyvbjerg 2005), there may be a reduction inbid value that results in winners curse. Adverse selection manifests, when the contractor does not have thecapacity to handle such inaccuracies and falters in executing the project.

OBS 1: The procurement process must aim towards reducing pre-contractual information asymmetry inorder to avoid adverse selection. This essentially relates to the pre-qualification and tendering process,

where competitiveness of bids must be subject to proper validation of project parameters used in the bidquote. The private sectors capacity in executing the project should be assessed. It is also important to

keep the contractual norms clear and unambiguous to reduce opportunism.

Post-contractualinformation asymmetryis another important aspect that needs to be considered while framingcontracts. E.g., there may be inadequate information to tell whether the terms of agreement have been

honored, or it may be costly to retrieve that information accurately. This opens the possibility of self-interested behavior, often known as moral hazard. In highway PPPs, this is particularly a problem, whenmonitoring the quality of service is difficult. In such cases, explicit incentive contracts may be ideal,making use of proxy parameters that are easy to measure.

OBS 2: In order to eliminate the problem of moral hazard arising from post contractual informationasymmetry, the quality of service in PPPs must be contractible. Use of explicit incentive contractsmay be

ideal when observing and monitoring service is difficult.

However, in certain situations, the outcome may not be representative of the action or investment, andmay be a function of many factors beyond private sector control. Disentangling such factors becomenecessary for the contract to be complete.

2.2.2. Bundling and unbundlingHart (2003) developed the HSV model further (Hart et. al. 1997) to include the case of unbundling(separate build & operate contracts) and bundling (integrated contract). Hart (2003) considers theinvestment of the builder (socially productive or unproductive) as the only parameter, and bases theanalysis on the consideration that the investment is non-verifiable and hence non-contractible. Thetradeoff is quite simple. In bundling, the builder internalizes the externalities, while he does not do sounder unbundling. He further concludes that PPP (bundling) is good where the quality of the service canbe well specified. Unbundling works where ex antespecification of service may not be that accurate.

Valila (2005) expands further on ex antespecification of service in relation to monitoring. This leads to adifferent result, but not entirely inconsistent with Hart (2003). He states that although, bundling can lead

to optimal level of quality enhancing improvements, it may also lead to high quality-sheddinginvestments where the public sector cannot monitor the service quality precisely. Under suchcircumstances, unbundling may reduce quality-shedding investments as the builder aims at fulfilling justthe construction contract.

Bennett & Iossa (2006) enhances the Hart (2003) model further by assuming verifiable investments andadding another variable (investment considerations in operation stage). They conclude that PFI(bundling) is preferred when (a) more positive is the externality (b) stronger the effects that innovationshave on the residual value of facilities.


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Grimsey and Lewis (2007) looked at the issue from whole life cycle costing (WLCC), which bases itselfon similar concept of internalization of externalities. They concluded bundling to be offering betterincentives for large upfront outlays in construction phase to achieve lower life cycle maintenance cost.Results of Iossa and Martimort (2008) remain consistent with above.

However in practice, Rintala (2004) found no such WLCC in his case study of University CollegeLondon Hospital. He concluded that this was a result of conflicting incentives that had weakened thecase of internalizing externalities.

OBS 3: Incentive-mapping techniques must be introduced in assessing the contracts. Conflictingincentives can often hold back the project from delivering desired results.

2.2.3. Transaction Cost EconomicsTCE considers transaction as a basic unit of analysis in the study of economic organisations, and anyproblem posed directly or indirectly as a contracting problem can be usefully investigated by TCE(Rahman and Kumaraswamy, 2002). TCE recognizes the existence of three categories of transaction -day-to-day purchasing, buying under long-term contract, and acquisition of "core assets. Although, all

three categories are highly relevant in PPP appraisal, PPP itself falls under the second category.

TCE makes use of three major variables: frequency, uncertainty, and asset specificity (Williamson andMasten, 1999). While asset specificity and uncertainty justifies the concept of PPPs as a whole, frequencydetermines the strength of incentives for vertical integration. Therefore, in this section, our focus isprimarily on frequency.

Frequency: There will never be a situation in which a firm would want to integrate vertically to bring ararely used provision of a good or service in-house. However, the long duration in PPP induces higherfrequency through seasonal or cyclical investment over the entire contractual period. Thus encouragingthe private sector to integrate vertically and maximize efficiency through economies of scale. (Note:integrating construction with maintenance derives benefits from economies ofscope.)

However, the quantification of long duration is a matter of concern. For the private sector, the durationmust be optimum so that the savings due to vertical integration exceeds the cost of vertical integrationitself. While the public sector may have its own views on the contract period, it may be appropriate if thecontractor is allowed to put forward bid quotes based on both (i) its preferred period and (ii) publicsectors preferred period. This provides the public sector options to choose from and may improve valuefor money.

OBS 4: It is appropriate not to predetermine the contract period and let the private sector quote basedon different ranges of contract period and its preferred period. Consequently, the cost savings through

vertical integration may be better reflected in the bid quote and the public sector have options to choosefrom.

2.2.4. Principal Agent ProblemAccording to Jensen (2003), agency theory is a kind of relationship that is a contract in which one or more persons (the principals) engage another person (the agent) to take actions on behalf of the principals that involve thedelegation of some decision-making authority to the agent. With its basic assumptions of information asymmetryand goal conflict (Caers et al, 2006), the agent may not always act in the best interests of the principal,and thus strategic behaviour might emerge (Rui et. al. 2009).


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Strategic behavior in PPP projects may manifest in several ways. Take for example a case, where theDBFO Co may use value engineering to reduce the immediate construction cost. In many of those cases,there is a possibility that the DBFO Co has undermined the whole life cycle costing approach, whichmay result in poor quality and therefore, increased defects on the road. Their solution to the maintenanceproblem may be simple: low cost patching of the defects with improved management (without use ofmore expensive repairing methods like resealing and strengthening). By this way, they may even be able

to stay within the contract (strategic misconduct). The overall result can thus be reduced bid prices. VFMcomparisons that use techniques in isolation from benefits may consider this to be an improvement.

However, there is a flipside. Increased patching results into increased friction, roughness, ride severity,and thereby adversely affecting Vehicle Operating Costs (e.g. increased fuel consumption, acceleratedtyre deterioration, accelerated shock absorber deterioration, etc). The extra road-user-costs accumulatedover 30 years may lead to a scenario of lower benefits and higher costs.

OBS 5: Private enterprises may show opportunistic behavior and this may harm public interests bydelivering lower quality of service. The quality of service should be explicitly defined, if the associated

benefits tend to bear even a little negative relation with opportunism.

OBS 6: In some cases, the massive negative impact on the services due to strategic misconduct may not

be observable due its distributed nature over a long period. In such cases, ex anteof implementation, itbecomes necessary to validate whether the innovation/investment has any detrimental effect on thepublic benefits (negative externality).

2.2.5. Optimum Risk SharingIn the very essence of the word partnership, whenever either the public or the private sector carries all therisks related to production and supply, there would be no partnership (Valila 2005, Mumford 1998).Hence, a concession agreement where the public sector carries no risk at all may not be a PPP. Even

when all the criteria above appear to be fulfilled, risk sharing may be withered down considerably by agovernment guarantee on the private borrowing to finance the construction of the asset. After all, theguarantee boils down to the fact that public sector is the ultimate risk carrier of the project (NAO 2009).

Valila (2005) classify risks into external (political, economic, etc) and internal (Construction, operation,demand, etc). Allocation of these risks are project specific, but often complex. For example, consider thecase ofdemand risk. On one hand, it is argued that the private sector partner should carry it, as this is theultimate way to incentivize the private sector to act in the principals interest and promote efficiency, sayby reducing toll prices (incentive compatibility constraint) (Iossa and Martimort, 2008). On the other hand, it isalso argued that public sector should assume the demand risk given the fact that it is largely influenced byfactors under public sector control (agents participation constraint) (Valila, 2005). In addition, there may becases where even under low toll prices, the demand may not increase significantly. Based on thearguments, it may be said that optimum sharing of demand risk to both the parties is appropriate.

OBS 7: Contracts must be designed to share the demand risk in highway PPPs, and not complete

allocation to one party.

Dewatripont and Legros (2005) attempts to disentangle the endogenous (internal) and exogenous(external) risk using economics of regulation under asymmetric information and theory of incompletecontracts. They conclude that the optimum degree of risk sharing should be such that the contractorsmarginal gain from bearing the risk should be equal or greater than marginal loss by not bearing the risk.

OBS 8: The contract must be such that the contractors marginal gain from bearing the risk should beequal or greater than marginal loss by not bearing the risk.


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Construction risk now has substantial evidence of successfully being passed on to the private sector.Demand risk has been studied in transport infrastructure PPPs, especially the toll roads. It is now evidentthat demand risk should not be subject to complete allocation, but is to be shared by the two partiesbased on the nature of the project, although in an accountable fashion.

2.2.6. Whole Life Cycle CostingWhole Life Cycle Costing (WLCC) is a mathematical method used to form or support a decision and isemployed when deliberating on a selection of options. Selection of options on a rational basis requiresthe comparison of different levels of investment at the present time compared with their respectiveconsequential future costs. For example, the adoption of higher design standards normally lead to higherinitial costs, but may lead to lower future costs of maintenance and renewal.

WLCC takes on another dimension in roads, when it also becomes appropriate to consider ongoing costsof the road user e.g. vehicle operating costs, time and delay costs, and the costs of road accidents. Theroad user costs are central to WLCC in Highways as over the life of a road, road user costs generally farexceed the costs of construction and maintenance of the road. In fact, for typical roads, road user costscan represent up to about 80% of the total transport costs over the project life (Bull 1993).

However, the fact that road user costs are extremely difficult to observe and verify restricts them frombeing entirely contractible elements in a contract. The private sector may not have any incentive tointernalize the road user costs into their WLCC, in absence of contractibility.

OBS 9: It is extremely necessary to build in appropriate provisions (proxy elements) in the contract thatare representative of road user costs and can incentivize internalization of user costs into the privatesector WLCC model.

Bull (1993) lists road user costs into five major categories: vehicle operating cost, fuel consumption,spare parts consumption, time-savings, and reduction of accidents. He also examines the key elementsthat affect the road user costs. Vertical gradient, curvature, roughness, ride severity, vehicle speed androad width are found to be the major parameters that affect road user costs. As these physical

characteristics are relatively easy to observe than road user costs like vehicle operating cost and spareparts cost, the contract may focus on regulating these physical characteristics (proxy elements) as anindirect way to regulate road user costs.

2.3. Description of Highway PPPsWhile this section aims at introducing the basic commercial aspects of a PPP, we have also used thissection to point out the issues that exist in practice.

2.3.1. Revenues in PPPs:Toll Based:

The earliest form of tolls (real tolls) used the duration of private ownership as the criteria for tendercompetitions. During the contract period, the concessionaire is allowed to collect tolls from the users,after which the asset is transferred to the public authority. In certain parts of the world, owing to politicalconsiderations, shadow tolls emerged. Here, the user does not see the cost, but the public body pays theprivate sector according to the usage. However, in both the cases, the demand risk is retained by theprivate sector. While low traffic on road was a risk to the private sector, high traffic led to excessive andunfair profits. Consequently, capped form of tolls called the Least Present Value of Revenue (LPVR)evolved (Engel, 2010a & 2010b).

Under LPVR, the tender competition is based on the lowest quote of the real revenue that is to beretrieved through tolls. In this case, the concession period ends as soon as the projects target real


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revenue is reached or the time limit is up. In the UK, this form of mechanism can be seen in both theSevern Bridges. However, the problem is the ever-increasing toll prices irrespective of the prevailingeconomic conditions (HoC 2010).

The problem as identified in the Severn bridges is twofold:

The Severn bridges enjoy natural monopoly, as the alternative route is excessively long and timeconsuming.

The payment mechanism in the Severn bridges is LPVR mechanism, but is not equipped with tollprice regulating provisions.

OBS 10: Public regulations on toll prices are essential in Real Toll based PPPs.

Unitary Payment:Performance based payment mechanisms like congestion, lane availability, and active managementinvolve unitary payments subject to bonus/deductions based on the performance. In these cases, theprivate sector is shielded from the demand risk and the focus has been shifted to higher efficiency andaccountability of private sector in its performance.

However, these mechanisms may not be ideal for all economies. With the increase in such projects, theflexibility of government expenditures face crisis due to relatively fixed payments to be made insuccessive years. Under economic crisis, the severity of this problem may have exponential impacts onthe entire economy.

2.3.2. Costs in PPPFinancing Cost:Private sector financing makes use of a combination of equity investment and debt finance (bank loansand/or bond finance). The equity contribution in UK is generally in the tune of 5% to 20% dependingon the risk profile of the project. Higher the risk, the financiers need more equity to be tied up to theproject. This ensures that the private sector consortium retains an interest in the success of the project,

while also incentivizing the consortium to maximize economic efficiency (Rintala, 2004).

Table 2: Sensitivity Analysis (Simplistic)

SENSITIVITY ANALYSIS: DBFO Cost to Increase in Interest Rate

HYPOTHETICAL PROJECT DATA

DBFO Project Cost 100 Million

Construction Period 3 Years

Debt Finance (85%) 85 Million

Equity Finance (15%) 15 Million

VARIATION

Interest Rate @ 8% @ 9%

Accumulated Interest during Construction 20.40 Million 22.95 Million

Interest as a percentage of project cost 20.40% 22.95%Increment per percent increase in interest rate 2.55%

It must be noted that the contractual framework has a very important role in the financing aspect.Stronger performance based mechanisms incentivize the private sector to improve its performance anddeliver high quality public services. However, this also translates to higher probability of fluctuations inthe revenue, and the risk premium increases accordingly (Standard & Poor, 2003). On an average, 1percent increase in the interest rate can lead to 2.55 percent increase in the interest payable duringconstruction period, expressed as a percentage of total project cost (see Table 2). This cost is ultimately


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borne by the public sector. Hence, it is essential to structure the contracts to optimize VFM while alsoreducing fluctuations in revenue, thereby, reducing risk premiums.

OBS 11: It may be appropriate for the public sector to structure procurement of PPPs in a way that doesnot affect the revenue stream of the private sector, but can incentivize the private sector to deliver

improved services.

Refinancing is one of the recent innovations in PPPs. It takes place at a time where there is substantialdecrease in project risks. The inflection point in the risk profile is normally during the period oftransition from construction to operation. This enables a lower interest rate as the design andconstruction risk of the project is reduced. In UK, the private sector is now allowed to refinance theproject with a mandatory sharing of benefits (GB, 2004 and 2007).

Capital Expenditure:According to RICS (1986), the capital cost is the total costs to the owner of acquiring an item and bringing it to thecondition where it is capable of performing its intended function. In terms of road transport, the capital cost wouldinclude the cost of acquiring land, design and construction of roads, professional fees, technologicalhardware setups like signaling systems, CCTVs, etc (depending on the scope of the project). Normally in

a road PPP, the cost of land acquisition rests with the public sector, while the rest is financed by theprivate sector.

Table 3 Probable cost segments in a Highway PPPs

Capital Expenditure Operating Expenditure Other costs4

Bid Phase Operational Phase Public sectorDesign and SPS1 development cost Periodic Maintenance2 Consultant FeesCost of obtaining Finance Non-Periodic Maintenance3 Bid ManagementLegal, advisory and Professional fees Structure Repair/Maintenance Monitoring Cost6

Construction Phase5

Lighting Repair/Maintenance RenegotiationStructures Hardware7 Maintenance Land AcquisitionMain Carriageway Data Collection Activity

Preliminaries Monitoring ActivityEarthworks SecuritySide Roads and Interchanges Insurance premiumsSign, Marking, Lights and Telecom Taxes (e.g. Service Tax, etc)Fencing/Barriers HR benefits and incrementsData Coll. and Monitoring HardwareStatutory UndertakersHorticulture, Archaeology, etc

Acomm. and Maintenance CompoundsSite Clearance

1 Service Provision Solution; 2 As per routine and winter service code, network management manual, other output specification; 3 Depending on the unanticipated conditions on road (like requirement of strengthening overlay); 4 Costs that are not projected in the

contract and are incurred by the public sector; 5 The items as listed are based on the major design components. They include the cost oflabor, plant, machinery or executive involvement from the private sector consortium; 6 - Monitoring cost as incurred by the public sector inauditing performance against output specification and thereby, release of payments; 7 Hardware refers to elements like electronic loops,CCTVs, vehicle count sensors, etc.

The cost of bidding in a PPP project forms a significant part of the entire capital cost. While all thebidders may invest significantly in developing proposal, the project is awarded to a single bidder. Thisoften renders other bidders with substantial amount of sunk cost in form of professional fees, advisoryfees, legal fees, cost of obtaining finance, etc.


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This sunk cost may lead to two different perverse possibilities. On one hand, a risk averse bidder wouldbe often discouraged from participating in the bid, thereby reducing competition. On the other hand, arisk taker may be prone to optimism biasand hence, winners curse. This may be extremely detrimental forthe project causing delays in time, overrun of costs and even cost of rewriting contracts and rebid.

OBS 12: It is essential that the procurement process in PPPs aim at reducing the sunk cost of the bidders

Operating Expenditure:Operational cost in relation to road infrastructure may be categorized as running costs and maintenancecosts. The running cost involves operation of the tollbooths and transport hardware like signals, VariableMessage Signs (VMS), cost of monitoring and collecting data to be supplied to the public data, etc. Themaintenance cost includes the cost required to ensure smooth operation e.g. road maintenances,equipment maintenance, hardware maintenance, etc.

2.3.3. Public BenefitsRoads provide an essential service by allowing mobility, diffusion of goods and people and enhancenationwide connectivity. When looking at projects in the road infrastructure development, DfT (2004and 2006) considers four basic parameters to judge the level of benefits achieved from road. The idea is

not only to provide these benefits, but also to constantly improve them in favor of the public (Bull,1993). Contractual framework plays a vital role in incentivizing such improvements.

The user benefits associated with roads are (as per COBA and TUBA):

Reduction in user time delay: This aims at reducing the congestion on the roads and thereby, savingvaluable time of the users.

Reduction in Vehicle operating costs: This aims at reducing the cost of commuting on roads arising fromfuel consumption, vehicle maintenance costs, etc.

Reduction in Accidents: This values the cost of accidents to the users. Reduction in User Charges: User charges may be in form of tolls, parking charges, fares, etc.

OBS 13: Contractual incentives must aim towards constant improvement in the desired benefits.

2.3.4. Cost and Benefit Analysis & VFM AssessmentDiscounted Cash Flow and Discount Rate: Virtually all forms of economic evaluation weigh futureagainst the present. The social time preference discount rate is related to the way people value future benefitsagainst present sacrifices, whereas the opportunity cost of capital is about alternative investments. Thetime preference rate is expected to be lower than the opportunity cost rate.

If lower rates were used as public discount rates, then the opportunity cost of public investment isgenerally understated and vice versa. However, many treasury officials prefer a discount rate based onopportunity cost of capital rather than on social rate of time preference (Taplin et. al. 2005). These ratesare in real terms so that projects are evaluated as if prices will remain constant in future.

The difficulties in selecting a rate have led some governments to establish a uniform or central discountrate, often set at a relatively high level around 10 percent, to provide a severe test of merit of alternatives.


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For example, the Chinese Governments specification of a real rate of 12 percent for road projects was inforce for over a decade.

In the UK, the basic discount rate is set out to be inflation plus 3.5 percent(GB 2009), which is rather low.It is argued, unless a lower rate is used, future generations benefits will be unduly discounted and theirinterests virtually ignored. The basic idea is that 3.5% is made up principally of two elements the social

time preference for having benefits sooner rather than later, which is put at 1.5%, added to the rate ofper capita growth in the economy. This growth rate is put at 2%, based on a past real growth of 2.1%per annum in the period 1950 to 1998 (Hanton, 2010).

Cost & Benefit Analysis: In cost and benefit analysis, costs and benefits are discounted to a suitable baseyear. The NPV comprises the discounted benefits less the discounted costs. The rate of return is the ratethat gives zero NPV, and the benefit-cost ratio is obtained by expressing the discounted benefits andassociated costs as a ratio to the constrained capital outlay. A project or investment programme will beaccepted, if the rate of return is greater than the predetermined discount rate.

VFM Assessment:VFM assessment of a PFI route against traditional route is conducted by establishing analternative business case called Public Sector Comparator. When a Public Sector Comparator is

constructed, the comparator takes into consideration just the costs (Bain 2009, TTF 1999) and not thelevel of benefits delivered. Although, it is true that ex anteof operation the benefits are non verifiable, itmust be realised that change in level of benefits can definitely influence the achieved value for money ina PFI procurement route. Lower level of benefits over a period of 30 years can easily offset the positive

value for money as reported in the PSC.

OBS 14: It is essential to setup a VFM assessment framework that also considers the level of benefitsdelivered in the PPPs. Project-specific benchmarks can be established, against which the actual VFM may

be compared each year.

2.4.Concluding Remarks

This section has put up a detailed discussion on various aspects of PPPs based on various literatures. Theemphasis has not been on justifying PPPs, but on the aspects, that procurement of PPPs must abide by.In the process, it has developed a framework that must be the basis of structuring procurement in PPPs.However, based on the scope of this research, the literature review was specifically chosen based onrelevance to two aspects of the procurement: Tendering and Payment mechanisms.

The framework that has been generated is summarized in the box below.


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OBS 1: The procurement process must aim towards reducing pre-contractual information asymmetry inorder to avoid adverse selection. This essentially relates to the pre-qualification and tendering process,

where competitiveness of the bids must be subject to proper validationof project parameters usedin the bid quote. Theprivate sectors capacity in executing the project should be assessed.

OBS 2: In order to eliminate the problem of moral hazard arising from post contractual informationasymmetry, the quality of service in PPPs must be contractible. Use of explicit incentive contractsmaybe ideal when observing and monitoring service is difficult.

OBS 3: Incentive-mapping techniques must be introduced in assessing the contracts. Conflictingincentives can often hold back the project from delivering desired results.

OBS 4: It is appropriate not to predetermine the contract period and let the private sector quotebased on different ranges of contract period and its preferred period. Consequently, the cost savingsthrough vertical integration may be better reflected in the bid quote and the public sector have options tochoose from.

OBS 5: Private enterprises may show opportunistic behavior while focusing on profit maximization, andthis may harm public interests. The quality of service should be explicitly defined, if the associatedbenefits tend to bear even a little negative relation with opportunism.

OBS 6: In some cases, the massive negative impact on the services due to strategic conduct may not beobservable due its distributed nature over a long period. In such cases, ex ante of implementation, itbecomes necessary to validatewhether the innovation/investmenthas any detrimental effect on thepublic benefits (negative externality).

OBS 7: Contracts must be designed to share the demand riskin highway PPPs.

OBS 8: The contract must be such that contractors the marginal gain from bearingthe risk should beequal or greater than marginal loss by not bearingthe risk.

OBS 9: It is extremely necessary to build in appropriate provisions (proxy elements)in the contractthat are representative of road user costs and can incentivize internalization of user costs into theprivate sector WLCC model.

OBS 10:Public regulations on toll prices areessential in Real Toll based PPPs.

OBS 11: It may be appropriate for the public sector to structure procurement of PPPs in a way that doesnot affect the revenue stream of the private sector, but can incentivizethe private sector to deliverimproved services.

OBS 12: It is essential that the procurement process aim at reducing the sunk costof the bidders

OBS 13: Contractual incentives must aim towards constant improvement in the benefits.

OBS 14: It is essential to setup a VFM assessment framework that also considers the level of benefitsdelivered in the PPPs. Project-specific benchmarks can be established, against which the actual

VFM may be compared each year.

BOX 1: THE FRAMEWORK


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3. Procurement through Public Private Partnerships in HighwaysThe purpose of this section is to deliver the first level of contractual assessment based on the guidelinesdeveloped in the previous section. Here we shall discuss two key areas: (a) Tendering Procedures and (b)Payment Mechanism.

3.1.Tendering in Highway PPPs This section will describe the tendering process used by Highways Agency. Then the guidelinesdeveloped in literature reviewsection will test the completeness of the process.

To begin with, we will provide a brief description of Competitive Dialogue, which forms the basis oftendering in Highway PPPs.

3.1.1. Competitive Dialogue A BriefIn March 2004, European Councils Directive changed the procurement law by introducing theCompetitive Dialogue procedure under Recital 31, Article 1 and Article 29 (Directive 2004/18/EC). Theprocedure is only to be used in projects, where it is difficult for the public sector to define the needs atthe outset or to have a complete knowledge of what the private sector can offer. Recital 31 considers

integrated transport infrastructure projects as appropriate for use of Competitive Dialogue.

OGC guidance on Competitive Dialogue procedure was released in January 2006. It is now being usedby most of the agencies under Department of Transport, including the Highways Agency. The mainfeatures of the competitive dialogue procedure (OGC 2006) are:

The public authorities are required to publish a contract notice as descriptive document and NOTspecification, setting out their broader needs to which different solutions may be proposed. The noticefor expressions of interest (EoI) has to be set out in the Official Journal of European Commission asper law.

Following the EoI and prequalification procedure, the number of selected candidates for invitationto dialogue (ItD) may be reduced to three, provided the perceived impact on competition is low. Dialogue is allowed with the private sector to identify solutions that best meets the needs and

requirement of the Authority. Dialogue may be conducted in successive stages, with the aim ofreducing the number of solutions/bidders.

The award is made only on the most economically advantageous tendercriteria. The criteria have to be givenrelative weighting at the outset. Where it is not possible to do so in advance, importance of criteria indescending order should be listed and bidders must be informed.

Post Tender discussions should be fair in the sense that it should not provide the tenderer withinformation that distorts competition.

As per Article 29(3), contracting authorities may reveal solutions or aspects of solutions of othercandidates on condition that they agree to such disclosure. Such disclosure without permission of thecandidate may be in violation ofIntellectual Property Rights.

3.1.2. UK Highway PPPs - Tendering ProcessThe tendering process in the Highway PPPs has undergone significant change and innovation in the pastthree years, especially with the tendering of the high profile M25 DBFO project. The process describedin this section is in line with the tendering stages in M25 DBFO and Competitive Dialogue. In addition,changes from previous practices have been highlighted and rationales that support such changes havebeen put forward. The information has been retrieved from online archives of Highways Agency, UK.

BOX 2: Competitive Dialogue Procedure


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STAGE I - Prequalification The Agency evaluates Prequalification Questionnaires (PQQ) and selects bidders based onpredetermined parameters with appropriate weightage and defined marking schemes. Theprequalification parameters that are generally taken into consideration are (HA, M25 DBFO, 2008):

Relevant Experience Management Systems Resources Operation and maintenance Construction Skills Specific Experience PPP Raising Finance Damages, etc

Certification Health and Safety Enforcement Notices Fatal Accidents

Average Workforce Turnover Litigation Financial and Economic

standing.

All respondents who meet the Agency's requirements and score above the total and individual cut-offscores go through to the next stage.

STAGE II - Invitation to Submit Outline Proposals (ISOP) The Agency issues an Invitation to Submit Outline Proposals (ISOP) to all the successful bidders inPrequalification. The ISOP questionnaire is usually accompanied by a document containing relevantbackground information about the Project.

The responses to ISOP questionnaire is treated as firm commitments to be taken forward into theInvitation to Tender (ITT) stage. The Agency evaluates the responses to the ISOP questionnaire againstthe following criteria: delivery of the required service to the required standard, processes, supportive

values and behaviors, appropriate resources (human, financial and technical), pricing methodology. TheAgency selects three bidders based on the evaluation of ISOP.

STAGE III - Invitation to Tender (ITT)Following ISOP, the agency issues full Tender Documents to the three bidders, including completecontract documentation, illustrative designs for all works, and complete or draft environmentalstatements.

Bidders submit comments on the contract during the tender period, followed by a dialogue where theagency negotiates comments with bidders and issues a revised contract. The bidders now have the libertyto deliver their bids based on their preferred choice of contract period. Thereafter, bidders submit fullydeveloped tenders, including technical proposals and provisional pricing for the entire project. Duringthis period, there is a continuous interaction between the agency and the bidders, whereby the agency canassess the externality of the bidders proposal on long-term public benefits, and comment on theacceptance of the proposal.

Under the newly adopted procurement strategy of the Highways Agency, the bidders are expected tosubmit their bids in two parts. One part shall contain the detailed proposal pointing out the deviationfrom the illustrative designs (may be termed as innovations), while the second part is expected to containdetails regarding the innovations with evidences of successful implementation from past projects. Thisfurther helps in effective assessment of the externalities related to any innovation. Finally, the agencyevaluates tenders based on the most economically advantageous tender using the same criteria as theISOP stage, and selects the Provisional Preferred Bidder (PPB).

BOX 3: Most Recent Tendering Process in UK Highway DBFO


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STAGE IV - Financial CloseThe Agency and the PPB finalize the DBFO Contract. The Agency awards the DBFO Contract, withprovisional price. The PB runs a financing competition. The provisional pricing is adjusted to reflect onlythe outcome of the funding competition. The DBFO Contract is signed, if it has not been signed beforethe financing competition.

3.1.3.

DiscussionChange in ProcessPreviously, on all of the Agency's DBFO projects, the process included a Best and Final Offer stage(BAFO). Under BAFO, after the Agency received and evaluated tenders, it shortlisted two bidders forfurther negotiation. Following those negotiations, the shortlisted bidders were asked to confirm theirbids in a best and final offer and selected the provisional preferred bidder on the basis of these BAFOs.However, this stage has been eliminated in the current process. Under the process discussed above, theagency shortlists only three bidders based on the prequalification and the ISOP stage. While thisprocedure is a significant improvement in line with OBS 12, its reliability on OBS 1 increasesexponentially.

Although, the Prequalification Questionnaire seems to be robust, it does not take into account the

bidders performance in the past projects in terms of quality of services. It might be appropriate for theHighways Agency to contact some of the former clients (both private and public) of the bidders for anobjective assessment of the quality of the services delivered in the past by the bidder. Past projectsexecuted by the bidder for the Agency is of great importance in this respect. This will help the Agency toassess any gaps that have existed in the bidders commitmentsand actual performancein the past. In such cases,the PQQ may ask the bidder to furnish an exhaustive list of their clients during a specific period, say, thepast five years. Submission of client certificates directly by the bidder (prevailing practice) may not beeffective, as the bidder then has the incentive to produce only those certificates that enhances theircredentials.

There are two problems associated with the ISOP stage. Firstly, the nature of the parameters appears tobe subjective, and therefore, there is a risk of not selecting the best three bidders. This is because the

selection is not based on complete assessment of the solutions offered by all. It restricts the completepotential of PPP to deliver VFM. Secondly, the subjective nature is also unfavorable to the bidders, asthe assessment on processes, behaviors, and pricing methodology are relative and there does not existany standard. The subjective assessment provides undesirably high power to the Agency personnel, andat times may incentivize malpractices within the Agency. The need is to set up an objective evaluationprocess in ISOP, or else at least to supplement the bidders with a standard to which the improvementscan be substantiated by the bidders and can be measured.

In the tendering stage, although the Agency provides the bidder with illustrative designs, it may beappropriate for the Agency to provide the bidders with an illustrative list of cost segments (not costsitself) within the scope of work. This may be based on Agencys prior experience in PPPs where thebidders unintentionally missed out costs. This will help in strengthening OBS1 further and avoid

winners curse. It will also demonstrate a collaborative approach from the Highways Agency.

The flexibility in choosing the preferred contract periods for bidding is a change in line with OBS4.

Financing competition post selection of PPBIn past DBFO procurements, bidders have been required to provide with their tenders, documentaryevidence of commitments from financial institutions. However, given the magnitude of the financingrequired in highway projects, holding funding competitions post selection of PPB avoids the potentialstrain on the financial market of providing commitments for such large amounts for multiple bidders.


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This also helps in obtaining the best terms for senior debts as the leverage of PPB increases overfinanciers. This is a considerable improvement in line with OBS 12.

Also, ex anteof selection of PPB, bidders are required to submit a funding plan, deliver evidence of theachievability and realism of the funding plan, and commit to those equity elements of the funding planthat will come from the Bidder. This delivers OBS 1 quite substantially.

3.2.Payment MechanismsIn this section, we shall focus on the various payment mechanisms that have been used in the UKhighway PPPs.

3.2.1. Congestion Mechanism (Performance Based) The payment mechanism in this case can be broken into three broad kinds of payment: CongestionManagement Payment, Safety Adjustments, and Construction Payments. In the following sections, we

will deal with them individually.

Congestion Management Payment

This primary function for the Congestion Management Payment is as following:

MCP = (GCP, PB, PA)

Where,

MCP = Monthly Congestion Payment

GCP = the Gross Congestion Management Payment for Contract Year nderivedfrom Base Annual Gross Congestion Management Payment and correctedaccording to the RPI index of year n.

PB = the Period Congestion Management Payment Bonus in respect ofCarriageway Section sfor Payment Periodp.The constituent of this has beenexplicated in greater details below.

PA = the Period Congestion Management Payment Adjustment in respect ofCarriageway Section sfor Payment Periodp.The constituent of this has beenexplicated in greater details below.

ns = the number of Carriageway Sections on the Project Road

As seen from the above function, the Congestion Management Payment is structured into a primarycomponent of payment, subject to either adjustment or bonus as per the performance of the projectroad. The primary payment is a pre-determined stream of service payments agreed by the DBFO Co andthe public sector before the financial close. The monthly payment starts only after the O & Mcommencement date.

PB or PA =f(TPTr, DF or BF, TS, LTS, AS, AF, DC)

BOX 4: Congestion Management Payment (Congestion based Payment Mechanism)

BOX 5: Performance Bonus / Performance Adjustment Mechanism (Congestion Based)


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Where,

DF or BF = Factor (0 or 1) based on the fulfillment of the condition criteria, which isprimarily based on the condition of the road and auxiliary requirements liketimely submission of reports. This area will be discussed further in thefollowing sections.

TPTr = the aggregate of the number of PCU Kilometres on each of the Links of theCarriageway Section sin the equivalent Payment Period on the equivalent dayof the week in each of the four Weekspreceding the Weekin which PaymentPeriodp falls.

TS = Target Speed for Carriageway Sectionsas specified

LTS = Lower Target Speed for Carriageway Section sas specified

AS = Section Average Speed in respect of Carriageway Sectionsfor PaymentPeriodp

AF = Number of PCUs recorded on the Relevant Link of Carriageway SectionsforPayment Periodp

DC = Deemed Capacity for the Relevant Link of Carriageway Section s.

The payment adjustments or bonus are based on two basic parameters: fulfillment of (i) minimumperformance criteria and (ii) congestion management. A target band is set in the traffic speed betweenthe Target Speed and Lower Target Speed. Full payment is made on exceeding the Target Speed. Thepayment deduction gradually increases as the Average Carriageway Speed reduces towards Lower Targetspeed. Payment becomes zero when Average Carriageway Speed is below than the Lower Target Speed.

There are also provisions, which incentivize the DBFO Co for bearing risks. For example, where theactual traffic exceeds the Deemed Capacity of the road, the DBFO Co is eligible for payment even if the

Average Carriageway Speed is below the Lower Target Speed. Under such circumstances, if the DBFOCo manages to achieve speed greater than Lower Target Speed, it may be eligible for appropriate bonusamounts. In addition, if the congestion is caused by an incoming traffic from a non-project road, anexcusing factor is incorporated accordingly to reduce the target speeds. However, the DBFO Co isresponsible for putting up such issues to the Highway Agency. It must also provide substantial proof toestablish the claim, and demonstrate sufficient effort to aid mitigation of the condition.

This is in line with OBS 2, OBS 8, and OBS 9. However, the use of predetermined target speeds(absolute values) reduces the incentives in line with OBS 13. In a period of 30 years, there arepossibilities of technological advancement in automobile industry that makes possible achievement ofhigher average speeds. In those cases, the DBFO Co may not be inclined in maintaining pace with theadvancement, as there is no change in the targets. Infact, it may lead to degradation of VFM, as theDBFO Co may be eligible for bonuses without any investment at all. This may be considered as a risk ofobsolescenceto the public sector, arising from inappropriate structuring of proxy element in the contract.

Construction Payments

The structure of Construction Payments is very similar to the Congestion Management Payment, and isstructured into a primary component of payment subject to either adjustment or bonus as per the


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performance of the project road. The Construction Payment is also made on a monthly basis. Thiscomplete payment is expressed as the following function:

CP = (GCP, CPA, CPB) Where,CP = Monthly Construction Payment

GCP = the Gross Congestion Management Payment for Contract Year nderivedfrom Base Annual Gross Congestion Management Payment and correctedaccording to the RPI index of year n.

TPTr = the aggregate of the number of PCU Kilometres on each of the Links of theCarriageway Section sin the equivalent Payment Period on the equivalent dayof the week in each of the four Weekspreceding the Weekin which PaymentPeriodp falls

CPA = Construction Payment Adjustment in respect of Carriageway Section sforPayment Periodp.

CPB = Construction Payment Bonus in respect of Carriageway Section sforPayment Periodp.

Ns = the number of Carriageway Sections on the Project Road

CPA or CPB =f(GCP, TPTr, CPDF or CPBF, TS, LTS, AS, AF, DC)Where,CPDF / BF = Factor based on the fulfillment of the condition criteria, which is primarily based

on the condition of the road and auxiliary conditions like submission of reports.

TS = Target Speed for Carriageway Sectionsas specified

LTS = Lower Target Speed for Carriageway Section sas specified

AS = Section Average Speed in respect of Carriageway Sectionsfor Payment Periodp

AF = Number of PCUs recorded on the Relevant Link of Carriageway SectionsforPayment Periodp

DC = Deemed Capacity for the Relevant Link of Carriageway Section s.

As seen above, the construction payment is linked to the performance in Congestion Management. The

payment is linked to the quality of constructed road through CPDF/CPBF in a limited manner based onfulfillment of minimum criteria.

The emphasis throughout the payment mechanism is on congestion management and much less on thequality of the road. This weakens the incentives for higher investment in constructing better quality ofroads, reducing the focus of the DBFO Co in internalizing vehicle operating costs and residual value(OBS9). Unless the Agency perceives time value of the user more important than long-term vehicle operatingcosts, the imbalance in the incentives may need to be rectified through incentive mapping (OBS 3).

BOX 6: Construction Payment (Congestion based)


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Safety Adjustments

The adjustment may be expressed in form of a function:

SA =f(PRpia, PRP0, CRpia, CRLn, CRL0, CRP0, LLn)

Where,

SA = Safety Adjustment

PRpia = Number of PIAs occurring on the Comparator Roads for Contract Year n.

PRP0 = The average annual Project Road performance for a given period beforecommencement of contract (The case will be different for a completely newroute with no previous record)

CRpia = Number of PIAs occurring on the Comparator Roads for Contract Year n.

CRLn = Total length of the Comparator Roads at the SP Date for Contract Year n.

CRL0 = Total length of the dual all purpose Comparator Roads as at the date ofCommencement of contract.

CRP0 = The average annual Comparator Road performance for a given period beforecommencement of contract

LLn = The total length of the Project Road on the Service Payment Date forContract Year n.

As seen above, Comparison of the DBFO road to that of a Comparator Road forms the basis of safetyadjustments. The parameter for comparison is the absolute value of the Personal Injury Accident (PIA)occurring on the two set of roads. Differences between DBFO Road and Comparator Road PIAs over acertain range yield a bonus or a deduction accordingly. The bonus and deductions are capped for anydifferences over a specified range.

However, in this case, the use of comparator road incentivizes the DBFO Co to perform just better thanthe public sector, even if it is capable of performing far better. This leads to partial fulfillment of OBS13.

BOX 7: Safety Adjustment (Congestion based)


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Payment Structure Diagram

Figure 3: Monthly Payment (modified from Briggs & Drewett, Seminar at Warsaw, Poland, 2008)

Figure 4: Safety Adjustment (modified from Briggs & Drewett, Seminar at Warsaw, Poland, 2008)3.2.2. Lane Availability Mechanism (Performance Based)Lane Availability (LA) is the most recent form of payment mechanism implemented. As opposed to theCongestion mechanism, LA uses a compact Gross Monthly Payment with various forms ofperformance-based adjustments structured around it.


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The Core Payment

One of the main features of this payment is the fact that it allows phase-wise commissioning of theproject that is trafficable and release of payments accordingly. This has been quite helpful for theconsortium to maintain the cash flow. LA appears to be especially useful for projects that involve lessnew route construction and more segregated sectional improvements like widening. The Gross Monthly

Payment on any month m of year n (GMPm, n

) will depend upon the status different parts of the

project and usability. The payments are increased (step up) on attaining the Completion Certificate andthen on issue of Permission to Use. It is determined by the following formulae:

7

1 1

,

,

,,

0,

=

=

=

=

+++=

s

s

NPCsy

y m

ypc

ys

m

ps

s

m

cs

smmDays

DaysTMPCA

Days

DaysSUP

Days

DaysSUCBaseGMP

GMPm, n 1,0, nm INDEXGMP =

Where:GMPm ,0= Gross Monthly Payment as agreed in the contract before indexation

Basem= the base payment for Monthm

SUCs = the Relevant Monthly CC Step Up Amount payable to the DBFO Co for the Upgraded Sectionsupon the issue of a Completion Certificate in respect of that Upgraded Section s.

SUPs = the Relevant Monthly PTU Step Up Amount payable to the DBFO Co for the UpgradedSection supon the issue of a Permit to Use in respect of that Upgraded Section s.

Dayss,c = the number of days in Monthm after (but including) the date of issue of the Completion

Certificate applicable to Upgraded Sections

Dayss,p = the number of days in Monthm after (but including) the date of issue of the Permit to Useapplicable to Upgraded Sections

Dayspc,y= the number of days in Monthm after (but including) the date of the occurrence of a QualifyingTraffic Management Phase Change Event y applicable to Upgraded Section s.

TMPCAs,y= the Qualifying Traffic Management Phase Change Amount payable to the DBFO Co uponthe occurrence of a Qualifying Traffic Management Phase Change y in respect of Upgraded Sections.

The Net Monthly Payment on any month m of year n (NMPm,i) is determined by the following

formulae.

NMPm,n= GMPm,n MAm-1Where,

MAm-1 = Monthly Adjustments in the previous month m-1 of a particular year.

The Monthly Adjustments for any month M is in accordance with the following formulae:

[ ] 2,* nmmnmmmm INDEXACIAECASPAFACTORARPMACAToDCAMA ++=

BOX 8: Payment Structure (Lane Availability based)


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*Note that SPAFACTORm is incorporated into the payment once at the end of every yearly cycle, basedon the performance of the entire year.

where:

ToDCAm = the Total MonthlyDelay Cost Adjustment for Monthm.

CAm = the Condition Adjustment for Monthm.

ARPMAm = the Applicable Route Performance Measure Adjustment for Monthm

ECAm = the Exceptional Circumstances Adjustment for Monthm

ACIAm = the Applicable MonthlyCritical Incidence Adjustment for Monthm-

SPAFACTORn = the Applicable YearlySafety Performance Adjustment for Yearn.

INDEXn,2 = the indexation figure for Contract Yearn.

ARPMAm, SPAFACTORm and ACIAm can be either positive (superior performance) or negative (inferiorperformance) and will act to increase the amount ofMAm when negative and decrease the amount of

MAmwhenpositive