As more and more PFI funded and public private partnership projects approach expiry many public authorities and private sector partners will undoubtedly review their existing contractual arrangements and in some cases this may lead to a variation of the existing contracts.
Whilst periodic contract reviews by authorities have always been recommended and inevitable changes to the way public services are delivered have often led to changes to contracts, the approach to expiry and other external economic factors are likely to place an even greater emphasis on review and change.
Variations may be prompted by modification to the use of the assets, changes to facilities management and services, refinancing and more generally in optimising arrangements. They may also be prompted by situations of disputes in pursuit of settlement or avoiding termination.
Contract Structure and Change Protocol
The Project Agreement is the key agreement which sits at the centre of a suite of other contracts that relate to the Project; interrelationships and inter-dependencies of those various contracts would always need to be taken into account when considering a variation. A legal review will be essential to understand this.
Subject to sector specific nuances, the Project Agreement within most such contract structures, when entered into, would have included mechanisms and protocols for reviews and changes to the project. Changes are usually categorised by origin; Authority Changes, Contractor Changes, Changes in Law, distinguished by timing (in works or operations phase), by value and by impact/type. Foreseeable changes are likely to have been anticipated with adjustments to the unitary charge and the payment mechanism is set up to adjust to take account of changes. However, whilst most low value/small changes can be dealt with within the existing contracts, more complex changes or changes that alter the risk profile will likely need to be documented in a Deed of Variation with potential related variations of sub-contracts.
Most, if not all, project change mechanisms will have been set up to protect the project internal rate of return (IRR) for the project company leaving it in a ‘no better no worse’ position, such that its position is preserved in all respects irrespective of the variation event. Any private sector sponsors (either from subscription to equity in the project company or by provision of shareholder loans) involved in providing funding to the Project at the outset will have a vested interest to ensure that their return on investment is maintained.
Steps to Managing a Variation
For the proposer of the change identifying the incentives and drivers for a variation will be key. Given the complex suite of contractual documents involved, applying a cost-benefit analysis will be essential and may well end up as an iterative process to ensure the variation is worthwhile. The key steps to managing a variation will be to:
1. Carry out an Options Appraisal
- Understand existing contract and management – legal reviews will be essential
- Obtain advice, including legal, technical, financial and commercial advice
- Consider procurement implications
2. Identify a Strategy
- Identify outcomes and any consents required
- Plan the variation and serve a notice of change if required
3. Agree principles
- Agree heads of changes
- Update specifications/financial model
- Consider interfaces and stakeholder engagement
4. Negotiate and execute
- Agree and negotiate variation to the Project Agreement and related contracts
- Obtain consents from lenders/shareholders/sub- contractors/parent company guarantors
- Obtain any public body consents/approvals required
Engagement and Expiry
Aside from the contractual mechanisms, how the proposer of a variation gets engagement from the counterparty for a variation is fundamental to progressing variations. Given the long-term nature of these types of contracts, relationships may need to be preserved, and in addition to the change protocols, the authority may also have leverage to assert such as whether it levies deductions which can be used as a bargaining chip. The thorny issue of costs of the various parties involved and who will be meeting those costs will also need to be addressed as part of negotiations.
As expiry looms the timing of a variation in relation to the Project term may influence the receptiveness by the counterparty. The current context of increasing energy prices and the pressing need for carbon reduction measures provides an example of where this may be challenging. As asset-heavy projects approach expiry, authorities may consider seeking variations for the installation of energy efficiency/carbon reduction measures to address this. To pursue such variations, a fundamental assessment will be needed to ascertain whether the ongoing cost savings will outweigh the cost of effecting a variation. The cost-benefit analysis must account for the due diligence required, the number of parties and contracts which may be impacted by the variation and the flow-down of changes from Project Agreement level caused by the variation.
A variation involving capital expenditure will become less appealing as the time to recover the capital costs of a variation lessen as expiry approaches. However, there may be opportunities for extending contract terms by way of a variation to aid transition, or to modifying specifications to achieve cost savings.
As project terms approach expiry, not only will handback standards and the provisions concerning expiry be scrutinised but on a wider note public authorities will be seeking to secure the continued delivery of services and maintenance of assets and contractors will be moving to secure future income streams in connection with the delivery of and maintenance of assets and services. One way to address this may be through variations to existing contractual arrangements.
This article is part of our PFI Expiry series, to read more from this series please click here.