Turning my “gut feeling” understanding of PPP and Project Finance into a proper hypothesis.
Public Private Partnerships (PPP) are still a very common financing mechanism for major programmes. However, most major programmes that use a PPP financing model do not include commercial and legal provisions that foster collaboration; more broadly, despite including the word “partnership” in their name, these models often don’t incorporate partnership approaches whatsoever.
Many public-sector project owners are moving toward relational contracting for the delivery of major programmes. However, programmes that adopt relational contracting as a delivery model, such as Alliance Contracting (AC) or Integrated Project Delivery (IPD) contracts, are not delivered using PPP principles or non-recourse financing, also known as Project Finance (PF).
Over the last several months, I have been seeking to better examine why relational contracting is not used within PPP structures. Rather than focusing on why government contracting authorities do not use relational contracting for PPP, I focused on answering why the Special Purpose Vehicles (SPVs) used to raise financing for PPP programmes are not using relational-type contracts with engineering, procurement and construction (EPC) contractors. Most practitioners in Canada and the United Kingdom—the jurisdictions where I can provide the most anecdotal evidence—are still trying to ascertain whether PPP and collaborative contracts are mutually exclusive. More specifically, practitioners aim to answer the following question: Can the non-recourse (private) financing feature of PPP structures be used with collaborative contracting between SPVs and EPC contractors?
A PPP contract is typically a bespoke contract developed by the government contracting authority. Depending on the jurisdiction, it is tailored to either common law or civil law.
These bespoke contracts follow generic principles found in more traditional standard contracts such as Fédération Internationale Des Ingénieurs-Conseils (FIDIC) contracts and New Engineering Contracts (NEC). However, because PPP contracts need to cover several phases of a programme (Design, Build, Finance, Maintain and Operate), they require a different set of provisions from a standard contract form that deals only with the design and build phase or operation and maintenance phase.
PPP envisions the use of non-recourse financing in order to provide financial liquidity for the programme. This financing method, which provides an alternative to corporate finance for funding capital-intensive projects, was first used in the 1970s to finance large, complex oil-extraction projects in the North Sea. Project financing, rather than corporate financing, was first developed for the North Sea oil fields because, at the time, no single company or consortium of companies had the resources or expertise to finance projects of that complexity and scale. Since the first application in the 1970s, project finance lending agreements and related covenants have been modified by government entities when procuring major programmes using non-recourse structures. These structures are now known as PPP. The modern version of PPP began in the United Kingdom in 1992, when the conservative government under John Major launched what is now known as the Private Finance Initiative (PFI), a model of project finance designed for the delivery of public-sector infrastructure projects.
Relational contracting such as Project Partnering, Project Alliance (PA), and IPD came about between the late 1980s and early 2000s. PA was first implemented by the Army Corps of Engineer in order to avoid disputes during contract execution. PA was initiated by British Petroleum in the early ‘90s in order to reduce project costs for extremely complex projects and relieve contractors of excessive risk and contingency for particularly risky projects by placing more risk on the project owner and incentivizing the contractor through alignment of party objectives and joint risk-sharing. IPD, a more recent form of contracting predominantly used in new buildings, was designed to increase collaboration amongst project stakeholders and incentivize the use of design tools such as Building Information Models (BIM).
When speaking to my peers, I discovered two, common main factors that distorted the original PF model: 1) The shift from the value-for-money analysis to lowest cost and specifically lowest of capital in order to justify the adoption of more expensive private capital versus cheaper private capital; and 2) The removal of the “off-take structure” (also known as revenue risk) from PPP transactions. An effort to reduce the internal rate of return charged by equity sponsors for taking on such a risk and avoid having to transfer the asset to the private sector. This would be necessary in a revenue transaction in order to provide collateral to debt lenders. Keeping assets under public ownership is the most important requirement for most western countries. These changes made the implementation of relational contracting between the SPV and the EPC contractor very challenging. However, there are no structural features in the non-recourse financing model that underpins the PF and PPP frameworks that would prevent the implementation of relational contracting between the SPV and the EPC contractor. The main stumbling block, however, lies in the way that public-sector major programme sponsors select PPP consortia, namely the selection of lowest-cost providers.
My peers’ and industry experts’ experiences are aligned with the evidence found in the existing academic literature. This is not a surprising result, since PPP and PF are established areas of practice with significant amounts of prior academic research over the last thirty years.
The data-gathering and literature review process I undertook has provided a significant amount of structure to the empirical knowledge I’ve gained over my twenty years of experience in the major programme industry as a practitioner. While my initial research hypothesis was generated in and of itself from the empirical experience I gained as a practitioner, this process has ultimately allowed me to turn a “gut feeling” into a proper hypothesis and methodically explore a topic quite familiar to me as a practitioner. I am now better able to articulate the rationale behind my hypothesis and provide substantiated conclusions to back up my claims.
It must be said that irrespective of the delivery model or financing model adopted by major programme sponsors, major programmes require the support of the private sector. As a colleague once stated: “… The reality is that the public authority needs private assistance to deliver infrastructure; that is what the reality of the world is. I think it’s incumbent, frankly, on the public sector to become good partners and recognize that they need true partners in delivering these things. And sure, there’s a profit motive on the private- sector side that we need to be aware of and need to be sophisticated about…”Therefore, all stakeholders of complex major programmes need to work together collaboratively, irrespective of the contractual framework, in order to achieve positive outcomes.”
Join me in this series of articles as I continue to determine whether non-recourse financing, which is widely used in PPP, is inherently incompatible with relational contracting, or whether this incompatibility is the result of changes made by the public procurement authority to the traditional PF model in order to create a PPP.