What's in a deal?

The power of the public-private partnership

Energy efficiency and sustainability are becoming the focus of commercial negotiations more so than ever before. Years ago, I was advising a public sector client on the public-private partnership (P3) procurement of a new accommodation facility and the discussion turned to various aspects of its service requirements, including the environmental and energy efficiency standards of the new building.

On some level, this topic didn't need to be complicated-after all, there were established regulatory guidelines and various industry standards that could be applied. The conversation could have focused on standards and deciding if this was a risk the public sector was willing to take. Looking back on what felt like a long and heated debate, it was actually an encouraging first step at coming up with a solution that worked for both parties.
When bringing the private and public sectors together, it's critical to use time wisely and have debates about topics that are important. Adding a hefty price tag and compromising on specifications are not options. Both sides care about getting it right.

Since this client negotiation a few years ago, the issue of energy efficiency and sustainability has gained even more attention, rising to the top of citizens' and politicians' agendas, and for good reason. Over half the world's population lives in cities (a statistic which is significantly higher for Alberta) and generate over 70 per cent of the world's greenhouse gases. As Canada's cities are refreshing their infrastructure, there is increasing emphasis on doing this intelligently to build sustainable, environmentally conscious solutions. It is clear that green issues, and energy in particular, will dictate the infrastructure agenda going forward.

This move is already underway. The 2012 edition of Infrastructure 100: World Cities Edition was published by KPMG in July, identifying the hundred most innovative and inspiring urban infrastructure projects. Of the six Canadian projects highlighted, three were breaking ground in the development of renewable energy, along with many other projects from around the world. I am also very pleased to see that Alberta Construction Magazine has introduced a new category this year in its Top Projects Awards feature, to recognize best in class infrastructure projects for sustainability.

It's important to remember that energy efficiency is not just about the production facilities and new smart distribution networks-a significant challenge is the buildings themselves. Building design must incorporate energy efficiency best practices, with contracts that encourage this type of sustainable energy use. When done correctly, the building is something owners, operators and tenants can be proud of. The building I'm sitting in at the moment, for example, is proudly displaying its energy efficiency certifications on the screens in every elevator.

ENERGY WILL DRIVE THE INFRASTRUCTURE AGENDA¦ BUT ISN'T THE ONLY FACTOR

I've suggested that energy issues are going to drive the infrastructure agenda, and that is true. Energy efficiency and green standards will be integrated into all classes of infrastructure design going forward. Despite its importance, energy efficiency is neither the sole focus nor the most important. Looking at the use of a building is critical-creating a safe environment for children to learn will always be the main focus when building schools. Water-treatment plants will always be about clean, safe water.

Delivering an energy-efficient agenda in a P3 environment may have its challenges, but its benefits are worth clarifying. The first is funding. Whether or not the project obtains a grant from the P3 Canada fund, the access to private finance to make essential and urgent infrastructure improvements can be a necessity in times of financial austerity, and enables the cost of the facilities to be spread over the life of the asset instead of a one-time, up-front payment.

The second major benefit P3s provide is peace-of-mind for taxpayers. Cost overruns and delays fall to the private sector partner's account, providing contractual certainty to the users on what they need to budget over an extended period of time. They also provide certainty over delivery timescales and performance quality standards, which are backed by financial incentives and contractual remedies. It is this certainty, this transfer of operational delivery risk to the private sector, which really drives the value in many public sector infrastructure projects.

THE IMPACT OF REGULATORY APPROVAL

What made my client's negotiation so challenging? It all came down to output specification. In order to realize a project's value, the service delivery requirements for the private sector partner need to be put into ‘output' form. Optimal value is reached when each risk sits with the party best able to manage it. So, if the private sector is to accept the risk of cost increases efficiently (or in other words, cheaply) they need to be in a position to manage those costs. Meaning, when in negotiations, it's critical to define the output rather than the input; saying what needs to be delivered, not how to deliver it. For example, if you need something to write with when upside-down, the contract should say exactly that, not require the purchase of a $70 pressurized cartridge ‘space pen' and therefore prevent the use of a pencil instead.

In any area of regulatory approval for facilities, factoring in industry bodies and certification agencies, the output specification would appear easy to write. Either name the existing applicable standard to get certified in, or go even wider and say applicable industry standards and guidelines. The practice, however, is more difficult. It is uncommon practice for a regulatory body to give pre-approval or comfort at a design stage, instead requiring a facility to be built (and sometimes operational) before certification. While the process might seem similar in structure to the traditional role of an Independent Certifier, the work undertaken is very different to the snagging that would typically be done on a building. At this point, any rectification that is required to bring the building up to the contractual standard could be difficult and expensive to fix, if not impossible. For a P3 contract with an availability-based payment mechanism, the deductions and time delays involved could easily put a contractor at risk of breaching deduction thresholds and long-stop dates, effectively putting a termination trigger in the control of a disinterested (from a contract perspective) third party.

The other end of the implementation spectrum has its issues too. Removing responsibility altogether from the contractor to comply with standards does exactly that. It removes any incentives for the contractor to meet the standards during both the construction and operational phases-simply not meeting the energy agenda. This puts parties back to sharing energy use risk the old fashioned way, setting a benchmark across the first few years of operations, and then applying a pain/gain share mechanism to split the costs and savings in future years. Many contracts have been signed under these conditions, but bring the challenge of integrating design and build issues into the benchmark, and can be too blunt a tool to reflect the high impact that the user has on energy consumption.

CHANGING STANDARDS, SHORTENING DURATIONS

Another consideration in applying efficiency standards to infrastructure is the contract duration. The standards put into a contract need to be appropriate for the life of that agreement, which is typically dictated by the expected useful economic life of the asset. However, the potential for volatility in environmental legislation and industry best practice may require an element of flexibility not usually associated with P3 contracts.

In more extreme examples this may be a factor in deciding to go with shorter contract duration. It's not likely to be the deciding factor for traditional accommodation-type deals, but it might be for infrastructure with a more direct impact on green issues, such as wastewater treatment plants. Reducing the contract duration introduces a number of other complexities as well, including matching lifecycle plans and dealing with the residual value of assets at the end of the agreement. The term will also impact the cost of funding if the same borrowing is required to be repaid over a shorter period.

THE ANSWER

Sadly, while the issues, risks and complexities associated with projects can be understood in general terms, there is no one-size-fits-all solution. The answer on any given project is done on a case-by-case basis. There are, however, a number of things you can do to make the process as seamless as possible:

  • Learn from other projects. This means tapping into both your own organization's knowledge and experience, and any information available from contracts signed with other public sector organizations, and of course with your external advisors and consultants.

  • Address it early, and have a realistic timeline. Coming up with a workable solution can take longer than you expect, and it's more efficient for all the parties to reach agreement on the guiding principles while it is still possible to influence the relevant aspects of the contract and design.

  • Understand the positions of all parties involved. There aren't necessarily just commercial and financial issues at play. It's just as important for contractors to understand the public sector's interest as it is for the public sector to appreciate the impact on the contractor consortium, including construction partners, operations and maintenance partners and the financial sponsors and lenders. The solution has to be acceptable to all parties.

  • Don't lose sight of the big picture. Context is everything, because long and heated discussions are only encouraging for those involved the first time around.


Editor's note: Tim Rogers is a director within KPMG's Global Infrastructure Advisory Practice based in Alberta. He has advised on nearly 50 P3 and project finance transactions from both the public sector and private sector bidder side, with an aggregate value of over $15 billion across a wide range of sectors. For more information on Infrastructure 100: World Cities Edition, visit www.kpmg.com/infrastructure100.


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