A PPP contract needs to clearly specify what is expected from the private party, in terms of the quality and quantity of the assets and services to be provided. A key feature of a PPP is that performance is specified in terms of required outputs (such as road surface quality), rather than inputs (such as road surfacing materials and design) wherever possible and that performance is linked to payment and penalties. The performance and payment/penalty mechanisms are typically specified in an annex to the main PPP contract.
- The performance monitoring method: that is, the information that must be gathered, by whom, and reported to whom. This can include roles for the government’s contract management team, the private party, external monitors, regulators, and users.
- The consequences for failure to reach the required performance targets, clearly specified and enforceable, done through either penalty payments, or payment deductions for poor performance built into the payment mechanism.
- A performance warning system that defines the results of persistent unsatisfactory performance (including temporary step-in of the public authority to eventual termination).
The payment mechanism defines how the private party to the PPP is remunerated. Adjustments in payments to reflect performance or risk factors are an important means for creating incentives and allocating risk in the PPP contract.
A PPP payment mechanism can include some or all of the following elements, defined in the contract including the timing and mechanism for monitoring or making the payments in practice:
- User charges: Are payments collected by the private party directly from users of the service. In most cases, user-pays PPPs are in sectors with monopoly characteristics, and tariffs are typically regulated by government (along with service standards) to protect users. The key question for risk allocation is how tariffs will be allowed to change—for example, with changes in inflation or other economic variables, or changes in different types of cost. These charges can be controlled by establishing tariff formulae in the contract, or by regulation, or a combination of the two. Governments may define only the maximum tariff, or a maximum weighted-average tariff allowing the private party to structure the rates according to business conditions.
- Government payment: Are payments by the government to the private party for services or assets provided. These payments are typically usage or availability base. Key considerations when defining government payments include the following:
- Risk allocation implications of different mechanisms: for example, under a usage-based mechanism, demand risk is either borne by the private sector or shared; whereas an availability payment mechanism means the government bears downside demand risk.
- Provision of upfront capital subsidies: means the private party bears much less risk than if the same subsidy is provided on an availability basis over the contract lifetime.
- Links to clear output specifications and performance standards: linking payments to well-specified performance requirements is key to achieve risk allocation in practice.
- Indexation of payment formulae: as for tariff specification, payments may be fully or partially indexed to certain risk factors, so the government bears or shares the risk.
- Penalties: Under both government and user-pays PPPs, the penalty mechanism may include deductions to payments to the private party, or penalties payable by the private party, due if certain specified outputs or standards are not reached; or conversely, bonus payments due to the private party if specified outputs or standards are reached.