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Risks flow downhill? Managing risks in P3 projects

This article was written by Michael Dew, a Vancouver lawyer who practices civil litigation. Click here for contact information and further details about Michael’s practice. This article provides only information, not legal advice. If you require legal advice you should consult a lawyer.

 

Douglas Sanders, P.Eng., LL.B.
Michael Dew, Articled Student
June 21, 2005
 
Abstract
Allocation of risks in a standard contract is challenging, but allocating risks contractually among the owner, concessionaire, and the subcontractors in P3 projects create new and demanding issues from philosophical and contractual perspectives. It is crucial for the contract to accurately reflect the bargain and, most importantly, the risk allocation among the various participants.
 
Introduction 
This article considers the allocation of risk in P3 (public private partnership) projects and the feasibility of flowing risk from the concessionaire (the consortium of sponsors who manage and control the project) down to the engineering, procurement and construction (EPC) contractor [also called design build contractors], the operation and maintenance (O&M) contractor, and their subcontractors and suppliers.
 
The article focuses on the allocation of specific risks between the project participants, but begins with brief outlines of the structure and lifecycle of P3 projects, the interests and bargaining powers of the project participants, and fundamental principles of efficient risk allocation.
 
As with all construction projects, P3 project participants aim to shift risk to other project participants. In P3 projects the primary financing is debt finance provided by a lender who backs the concessionaire. Lender backing is vital to P3 project implementation. Since it is unusual for the concessionaire or its subcontractors to have sufficient assets to provide security for the debt extended by the lender, lenders rely on the flow of funds under the concession agreement to secure the debt. To protect this asset, the lender will insist on certain contractual allocations of risk between the project participants. Therefore, lenders influence the allocation of risk in P3 projects and lenders’ interests should always be borne in mind when considering risk allocation.
 
Structure and Lifecycle of P3 Projects
Traditional construction projects have a main contractor responsible for implementing the design of the owner’s design professionals. P3 projects have a different structure. In P3 projects there is “a partnership between the public and private sectors and a sharing of risk, responsibility and reward, and where there is a net benefit to the public. Specifically a P3 is a partnership for some combination of design, construction, financing, operation and/or maintenance of public infrastructure which may rely on user fees or alternative sources of revenue to cover all or part of the related costs of capital (debt servicing and principal payment and return on equity if applicable), operations and capital maintenance": Government of British Columbia, Canada, Ministry of Competition, Science and Enterprise, PPP (Public Private Partnerships) Best Practice Guide, January, 1998
 
The structure of P3 projects is illustrated in Figure 1 below:
  
Figure 1 illustrates the key P3 project participants. P3 projects typically involve the development of infrastructure desired by a public entity. The public entity will enter into a concession agreement with a concessionaire who is responsible for the design, construction, and initial operation of the project before handing it over to the offtaker at the end of the operation period.
 
The concessionaire is comprised primarily of sponsors who provide equity financing and manage the implementation of the project.  The concessionaire is generally a special purpose entity formed solely for the project. Thus concessionaires may have no significant assets and a small staff.
 
The engineering, procurement and construction (EPC) contractor is responsible for the design and construction of the project. The operation and maintenance (O&M) contractor ensures the efficient running of the project during the maintenance period. 
 
A large proportion of the funding for P3 projects is provided by the lender who debt finances the concessionaire. Project finance systems are premised on a high debt : equity ratio. The level of debt which can be raised depends on the nature of the project. The greater the level of certainty of revenue to cover the debt, the higher the debt : equity ratio that will be acceptable to lenders. Conversely, in developing countries and projects aimed at volatile markets, lenders will demand lower ratios.
 
E.R. Yescombe, Principles of Project Finance (Academic Press: California, 2002) at 285 (“Yescombe”) indicates that typical ratios are:
o       90:10 for infrastructure projects with a project agreement with no usage risk e.g. a public hospital.
o       85:15 for a power or process plant projects with offtake contracts (contracts, finalised at the project initiation stage, under which the concessionaire sells the project to the offtaker)
o       80:20 for an infrastructure projects with usage risk e.g. a public transport system.
o       70:30 for a natural resources projects.
o       50:50 for a merchant power plant project with no offtake contract or price hedging.
 
The successful initiation of P3 projects depends on lender commitment. A “bankable” contract is one with terms acceptable to the lender. Bankability is used to describe not only the contract between the lender and borrower, but all of the contracts on the project.
 
Clearly both the concessionaire and the lender desire project success, but the sponsors forming the concessionaire are equity investors and on successful projects equity investors will make approximately double (Yescombe at 139) the gains of the lender. Given its lower potential rewards, the lender will be more risk averse than the concessionaire. Because the lender margins are relatively low and its financial contribution significant, the lender will insist on various measures to protect the debt.
 
Interest and bargaining power of project participants
Public entity
The principal asset in a P3 project is the flow of funds under the concession agreement. Any risk to that flow of funds places the success of the project in jeopardy. Public entities generally indicate that they are in favour of a balancing of risks with the party best able to accept a risk taking that risk. However, the same public entity then sells the P3 nature of the project to the public on the basis that all of the risk has been shifted to the concessionaire. It is not possible to have an optimal sharing of risk and cost certainty for the public entity. 
 
It is normal and proper for the public entity to bear some of the project risk. Public entities can minimise their risk by implementing policies which encourage private sector involvement. Competitive involvement by the private sector will strengthen the bargaining position of the public entity allowing it to shift a greater proportion of force majeure and other risks to the private participants.
 
The concession agreement between the public entity and the concessionaire is important because it initially splits the risk. The concessionaire will then aim to transfer the risk it accepted under the concession agreement to the EPC and O&M contractors, who may in turn try to pass it on, hence “risks flow down hill”. Therefore, although the public entity does not form contracts with the parties lower down on the project tree shown in Figure 1, the risk the public entity is prepared to take significantly affects the distribution of risk throughout the project pyramid.
 
Concessionaire
The concessionaire enters into a concession agreement with the public entity under which it takes responsibility for the design, construction, operation and maintenance of the infrastructure project.
 
The concessionaire is comprised of equity investors (sponsors) who will yield higher returns than the lender. Therefore the concessionaire will be expected to bear more risk than the lender. However, given its temporary nature, the concessionaire is generally not qualified to retain and manage risk and will aim to either transfer the risk “downhill” to other project participants, and take out insurance for those risks which it cannot transfer.
 
If the concessionaire defaults, the lender’s funds will be at risk and the lender indirectly stands to suffer from all the risks the concessionaire initially bears. Therefore, lenders insist on certain measures to protect themselves from concessionaire default (including potentially seeking personal guarantees from the sponsors, requiring equity funds to be exhausted before extending debt etc.). In this way lenders can flow risk of concessionaire default to the sponsors.
 
The concessionaire designs the structure of the pre-contract process: request for qualifications, request for proposals and preferred proponent stage. By designing a process which allows contractors to innovate and apply their preferred construction methods, concessionaires will make the procurement process more competitive. A competitive tendering process strengthens the bargaining position of the concessionaire and will allow it to transfer more risk to the contractors.
 
Lender
The lender’s primary interest is to have the debt properly serviced (i.e. the principal paid back with interest). The success of the project, and the ability of the concessionaire to repay the debt, will depend on the allocation of risk between all of the project participants. Furthermore, the likelihood of debt recovery in the event of project difficulties will depend on the allocation of risk between the project participants. Hence, the lender will have specific preferences for risk allocation between each of the project participants. 
 
Since the debt is owed by the concessionaire, the lender will want to minimise the risk borne by the concessionaire. The lender will want the obligations imposed on the concessionaire by the concession agreement to be flowed down to the EPC and O&M contractors. The lender will want these contractors to be responsible for the timely completion, quality and performance of the project and will want liquidated damages specified for failure to deliver the project as specified. The EPC contractor is a vital player in P3 projects and lenders will want to be confident in the capabilities of this contractor. Lenders will desire a suitably experienced and credit worthy EPC contractor. Lenders may be uncomfortable with an EPC contractor that relies heavily on subcontractors and may prefer the EPC contractor to undertake a joint venture with companies that might otherwise have been subcontractors.
 
“Gap risk” is that risk which the EPC and O&M contractors will not accept, most likely because it is not readily estimable or is uninsurable, and which cannot be assigned to the public entity. Gap risk is borne by the concessionaire.
 
Difficulties arise when project failure consequences are not easily quantifiable or financially measurable (e.g. what is the cost to the public entity when a road is completed late?) In such cases, the liquidated damages clauses may appear to be penalty clauses prohibited by law.
 
Because of the time value of money, any delay in the project that causes a delay in the repayment of the debt reduces lender cover ratios (ratios of the cash flows from the project against debt service) and increases financing costs. Therefore, time is critically important to the lender and special attention must be paid to schedule and potential recovery for delay.
 
To provide incentive for the concessionaire, the lender will require equity financing from the sponsors in the order of 20-40% (Bankability of Projects, December 6, 2003 http://www.mallesons.com/publications/Asian_Projects_and_Construction_Update/6993956W.htm
) and may also seek personal guarantees from the individual sponsors. If there are significant risks that the concessionaire cannot flow down to the EPC and O&M contractors, or cover by insurance or bonding, the lender will generally require a relatively larger proportion of equity funds to be invested by the sponsors to maximise sponsor incentive to complete the project successfully. Lenders will not permit sponsors to begin recovering on their investment until debt servicing has begun. Furthermore, lenders will generally require that the equity funds be exhausted before debt is extended so that unexpected difficulties encountered early in the project do not threaten lender funds.
 
EPC contractor
The EPC contractor’s primary goal is to design and construct project facilities that perform in accordance with the project specifications. However the design and build nature of P3 projects adds additional risk for EPC contractors not present in traditional construction procurement models.
 
In a traditional project structure the owner employs a contractor to implement the design of the owner’s design professionals. The design professionals are expected to perform to the standard of reasonable professionals. If the design is defective as a result of an unforeseeable complication which a reasonable professional would not have accounted for, the professional will not be held negligent and the owner will likely bear the resulting cost. Thus design professionals are said to provide a “warranty of due care”. 
 
In P3 projects the EPC contractor provides a “warranty of result” and if the project facility does not perform as specified then the EPC contractor is responsible regardless of the cause. The risk associated with the difference between the designer’s warranty of due care and the EPC contractor’s warranty of result rests with the EPC contractor. For this reason owners wishing to implement projects involving novel technologies may prefer the design build nature of P3 projects. Conversely, the EPC contractor, and the lender, will prefer well established technologies with a low probability of unforeseeable difficulties. For P3 projects involving novel technologies, or work in unusual environmental conditions, the EPC contractor may insist on broad exclusions of liability, or alternatively charge premium prices.
 
O&M contractor
The primary goal of the O&M contractor is to profitably operate the project throughout the operation period. Thus the O&M contractor will want the project to be well designed and constructed by the EPC contractor. Because the O&M contractor is responsible for running of the project during the revenue earning stage, the lender and concessionaire will be vigilant to ensure the O&M contractor is performing well. It is in the O&M contractor’s interest to have a regime of ongoing performance assessment such that diverse input can be utilised to ensure efficient operation and maximum profitability of the project.
 
The O&M contractor has an interest in having the project facilities including the operation plant exceed the current national environmental and other standards such that the facilities and plant are still usable and competitive if such standards are raised. These interests by the O&M contractor will be countered by the concessionaire wanting to restrict costly over-engineering. To use an extreme example, a $100 million road will require no maintenance, while the same road built for $50 million will require significant maintenance and rehabilitation.
 
Further interests of the O&M contractor will be to obtain certainty of operating costs, while ensuring flexibility to reduce input supply volumes if input demand (demand for the service provided by the operational project) is less than anticipated. These conflicting goals will be addressed by the terms of the input supply contracts negotiated between the O&M contractor and the input suppliers (suppliers of resources necessary for the construction or operation of the project).  
 
Subcontractors and suppliers
The obligations and interests of subcontractors and suppliers dealing with the EPC contractor will be similar to those typical in any construction project. However, additional issues emerge for subcontractors and input suppliers dealing with O&M contractors over the typically lengthy operation period.
 
The goal of operation subcontractors and input suppliers will be to secure involvement in the project while accepting as little input demand risk as possible. Thus input suppliers will want to flow up the risk of input demand being lower than expected and will bargain for clauses allowing for variation of input supply prices if input demands are low.
 
For fear of low input demand, O&M contractors will desire broad force majeure clauses which allow for reduction of input supply goods and services on the occurrence of a wide variety of events. However, the input suppliers and operation subcontractors will bargain for such force majeure clauses to work both ways allowing reduction in supply if it suits them despite the O&M contractor still requiring full quantities.
 
Bonding companies
When bonding companies bond contractors involved in implementing the design of the owner’s design professionals, they need only be concerned with the contractors cash flow and technical ability to construct the specified design. However, with the design build nature of P3 projects, bonding companies need also consider the contractor’s technical ability to successfully design and implement the project according to the performance specifications.
 
Where risks should fall
Despite the goal of all parties to minimise their personal risk, in optimum P3 projects each of the project participants will bear some of the project risk.
 
Contracts are the tool used to allocate project risks. Ideally, risks should be assigned to the party best able to manage the risk and best able to afford the consequences if the risk materializes. In other words, each party should be assigned the risks that:
o       economically impacts that party more
o       it can efficiently mitigate
o       it can transfer to a third party (i.e. an insurer)
o       is within its control
 
For certain risks the above factors may conflict. Consider a geotechnical engineer preparing a report on subsurface conditions. The engineer is clearly the party in control of managing and mitigating the risk. This suggests that the risk of additional expense due to unforeseen subsurface conditions should be placed on the engineer. However, the geotechnical engineer’s profit is likely to be less than 1% of the project cost, while increased costs from unforeseen subsurface conditions could cause project costs to increases in the order of 5%. Therefore, if the full risk of unforeseen subsurface conditions is placed on the soils engineer, on all projects the owner will be required to pay for increased geotechnical investigations to give the geotechnical engineer increased confidence in the soils report. Such additional testing expenditure is not rational because the risks flowing from limited testing would seldom materialise. Resources will be better utilised if the owner accepts the remote risk of soil conditions varying unexpectedly across the site, and then absorbs additional costs if they materialize.
 
For such risks where the party best able to manage the risk is different to the party best able to bear it, careful consideration should be given to how the risk is best allocated.    EPC contractors should bear all risks which can be rationally priced. Conversely, owners should accept uninsurable risks that have a small likelihood of occurrence, but a large cost upon occurrence. If contractors are made to carry such risks they will charge premium prices in an attempt to insure against events which even insurance companies will not cover. Furthermore, even if the contractor is persuaded to accept such low probability and large consequence risk, if the risk materializes it may bankrupt the contractor leaving the lender and concessionaire to struggle through the liquidation process, and the owner to deal with a failed project. 
 
Specific risks and who should bear them
In this section various project risks are considered alphabetically. For each risk the ideal risk bearer is considered along with risk flow issues and risk mitigation techniques.  
 
Change in law
P3 projects run over many years and changes in law may affect such projects in many ways:
o       Stricter environmental standards may influence (or even terminate) the operation of industrial projects.
o       Increased taxes may impair the profitability of projects (e.g. fuel tax will impair the profitability of diesel train line projects).
 
Change of law risks should be spread according to the nature of the law changed. For example, the risk of stricter emissions standards which affect the operation of the EPC or O&M contractors’ plant might best be borne by the EPC contractor. Similarly, changes to wage laws, income tax, or other laws of general application are best be borne by the party directly affected.
 
The public entity should bear some risk of change in law and the concession agreement should provide relief for such changes. For example, risk of changes in environmental law which are of general application, but which severely affect the project, should be borne by the public entity. The public entity should also bear the risk of adverse effects of future legislation which directly targets the project. Difficulties will arise if future governments invoke the principle of parliamentary supremacy and legislatively attack contracts entered into by previous governments. 
 
In many P3 projects, one of the areas of greatest uncertainty is the stability and assurance of payment by government. In most Canadian provinces, financial administration is based on yearly allocations of funding which cannot generally be guaranteed. Banks must get to a level of comfort in respect of this issue to lend into Canadian P3 projects.
 
Concessionaire default
The risk of concessionaire default should be borne by the concessionaire, but this is not entirely possible and in the event of such default many parties will suffer. The lender will protect itself by requiring the concessionaire to use equity funds first to maximise the incentive for the concessionaire to complete the project once debt has been extended.
 
The lender may also require indemnity from the sponsors personally and may exercise its step in rights under the direct agreements it has with the EPC and O&M contractors to take control of the project when concessionaire performance is inadequate.
 
If the concessionaire defaults when the project is already operational, the offtaker may take early control of the project. In this case the offtaker should pay a termination sum. This sum may or may not cover the full debt and should be calculated by a pre-determined termination formulae which accounts for the cost of remedying the default of the concessionaire. 
 
Under the concession agreement, the concessionaire will have construction and maintenance obligations and will be required to indemnify the public entity for breach of contract and negligence. The concessionaire will flow all of these obligations to the EPC and O&M contractors using similar clauses to those in the concession agreement. Thus if the concessionaire in default is required to make payments to the public entity, it can recover from one or both of the EPC and O&M contractors.
 
Public entities may require the concessionaire to provide performance bonds to cover its construction, operation and handover obligations. The concessionaire may flow down these bond obligations by requiring the EPC and O&M contractors to provide this security. However, if the public entity requires the bonds to cover more than defective construction and maintenance, the concessionaire may be required to top up the bonds provided by the contractors. 
 
Cost overruns
The EPC and O&M contractors are best placed to control costs. Therefore, the risk of cost overruns should generally be borne by them by way of fixed price contracts. An increase in debt with no increase in profit reduces cover ratios and therefore lenders will be reluctant to extend additional funds. Similarly sponsors will be reluctant to extend additional funds because it will reduce their returns.
 
Design / warranty / latent defects
Design risk is the risk that, after design and construction by the EPC contractor, the project will not be able to perform in accordance with the performance specifications. These risks are properly borne by the EPC contractor by way of performance and quality guarantees, and transferred to the extent possible to insurers. After the warranty period (which may be longer for latent defects or design issues) the O&M contractor will be expected to bear such risks.
 
The concessionaire and lender will desire specified liquidated damages and would prefer unlimited liability on the EPC and O&M contractors. However, no contractor will provide unlimited performance and quality guarantees. Therefore caps on liability and certain liability exclusions will be accepted, with the balance falling to insurance and to gap risk for the concessionaire. 
 
Lenders may demand that liquidated damages be used first to reduce debt and then the remainder distributed to the sponsors to mitigate their reduced returns on equity. Therefore, although the contractors are the primary bearers of defect risk, the concessionaire will bear some residual gap risk. 
 
The concessionaire should ensure that the various contracts clearly spell out which contractor is responsible for the different aspects of design, construction, operation and maintenance. Difficulties arise when it is unclear whether operational problems are caused by defective design and construction, or by poor operation. Regardless of the cause the concessionaire will be liable to the public entity. Therefore, the concessionaire should protect itself from such difficulties by requiring the parties to participate jointly in problem resolution and resolve issues of liability later, agreeing to be bound by the findings of the specified resolution process.
 
Dispute risks
Dispute risks are not easily assignable, but should be mitigated. Contracts which clearly define the rights and obligations of the respective parties are essential to avoiding disputes. The contracts should also explicitly set out the dispute resolution processes and require the parties to proceed with the project while giving notice of the dispute. This will ensure project cash flow while the dispute is resolved.
 
The concession agreement may allow for the public entity to nominate technical advisors to monitor project implementation and maintenance. These public entity representatives protect the public interest in project quality. If the concession agreement gives nominated referees authority to resolve disputes during project construction and maintenance, the concessionaire should ensure that the EPC and O&M contractors agree to be bound by the referees. All parties have an interest in ensuring that neutral referees are nominated.
 
Environmental
Environmental risk is generally borne by the EPC contractor, the public entity, or a combination thereof. The EPC contract should require the EPC contractor to comply with local environmental standards and also with the standards of any public lenders (e.g. World Bank) if their standards are stricter. The EPC contractor will generally not take responsibility for changes of environmental law or unexpected pre-existing environmental threats on site. See “Change of Law” above and “Site Conditions” below.
 
EPC contractor default
EPC contractor default may lead to non-completion, late completion and cost overrun. The risk of EPC contractor default should be placed on the EPC contractor and its bonding agent. Because the EPC contract sum is typically 60-75% of the debt extended by the lender to the concessionaire, the contractor’s bank bond will not cover the full debt. Therefore, the lender will want to ensure that only competent, credit-worthy EPC contractors are employed.
 
Force majeure incl. war, civil disobedience, acts of god
Such risks are generally spread between the public entity, insurers and the EPC and O&M contractors. Where the concession agreement requires the concessionaire to insure against specific losses, the concessionaire will either flow that requirement down to the contractors, or take out its own insurance.
 
The project contracts should carefully and completely define force majeure events and should permit significant relief (both time and money) for events outside the reasonable control of the project participants.
 
As between the EPC and O&M contractors and the concessionaire, insurance should be used to the extent possible.
 
Uninsurable losses (such as economic losses flowing from delay, physical damage from nuclear explosion etc.) will be allocated by negotiation and the lender may accept some of these risks.
 
Input supplier default
This risk of default of input suppliers (e.g. fuel suppliers for a diesel train project) should be borne by the O&M contractor or the input supplier. See “Third party default” below.
 
Input demand below input supply contract minimums
If the demand for the project, say a public transportation project, is less than expected, then project revenue will be less and many of the project participants will suffer. Risk of reduced revenues is shared by many parties, but certain associated risks such as input demand being below input supply contract minimums should be placed on the O&M contractor or the input supplier.
 
Input contracts (e.g. fuel supply contracts) should have provisions to allow reduced supply following specified force majeure events. The concessionaire and the lender will want these force majeure events broadly specified, but this may place the supply at risk if the supplier has equal option to reduce supply on occurrence of the force majeure events.
 
Offtaker default
The risk of offtaker default should be contractually placed on the offtaker. Offtake contract provisions will depend on the nature of the project. If the product or project can be sold on the free market, the offtake provisions will be less important than if the offtaker is the only possible recipient of the project after the operation period. A “take or pay” clause may require the offtaker to pay for the product even if they decline delivery. If the project yields products that the offtaker declines to accept, the offtaker should be required to pay for storage and other consequential costs, although the concessionaire will be required to mitigate such costs.
 
Operational difficulties
Under the concession agreement the concessionaire will be required to meet certain performance requirements. The concessionaire will pass these obligations on to the O&M contractor, but also to the EPC contractor who must design a project capable of meeting the performance specifications.
 
The risk of operational difficulties should be placed on the EPC contractor and the O&M contractor because they are the parties best equipped to manage that risk. O&M (and, where possible, EPC) contractor remuneration should be linked to performance with liquidated damages if performance targets are not met.
 
The EPC and O&M contractors should carefully evaluate the performance specifications set out in the concession agreement to ensure that they are unambiguous, achievable and objectively ascertainable.
 
If the EPC contractor installs new technology, long term performance guarantees may be required (i.e. longer than the 2-3 year warranties normally provided, Yescombe at156). Lenders and project companies are generally wary of new technology because of difficulties in determining causation of problems (i.e. poor design for which EPC contractor is liable or faulty operation by the O&M contractor). 
 
The public entity should take some risk of operational cost increases, generally through escalator provisions.
 
Permits (Risk of obtaining)
The risk of failing to obtain permits should be shared between the EPC contractor and the public entity. A government support agreement is an effective means of placing this risk on the public entity.
 
If permits are not obtained it is likely that many parties will suffer and therefore they all bear some risk. However, the lender may require permits to be obtained by the public entity or EPC contractor before advancing funds, although for ongoing operational permits this is not possible.
 
Project revenue
Project revenue is the primary asset which the lender relies upon to secure the debt. The risk of project revenue being lower than expected is borne by the lender, the concessionaire and the public entity. 
 
Public entity default, termination of concession agreement
Public entities typically have deep pockets. Therefore, the risk of public entity default can generally be placed on the public entity. Termination payments of debt and interest should be specified in the concession agreement. Separate clauses will be required in the concession contract to protect the lender and the concessionaire, both of whom are at risk of default by the public entity.
 
Schedule
The concessionaire will be liable to the public entity for late completion, but will pass on this obligation to the EPC contractor.
 
The risk of delayed implementation is properly placed on the EPC contractor because it is the participant in control of the construction. Incentives for timely completion can be imposed by way of a fixed completion date with liquidated damages and limited provisions for extensions of time. The provisions for extension of time and additional payment to the EPC contractor by the concessionaire will reflect the equivalent provisions in the concession agreement. Some additional entitlement to extra time or payment may be given for breach solely caused by the concessionaire.
 
EPC contractors will demand time extensions due to events whose risk they do not bear (e.g. certain force majeure events). However, no extensions will be allowed for foreseeable events such as bad winter weather. When negotiating the concession agreement, the concessionaire should be mindful of the types of risks the contractors will accept, and attempt to flow the remaining risks up to the public entity via the concession agreement. 
 
If a delay in commencement of the EPC contract is possible, a price adjustment formulae based on the consumer price index and additional impact costs should be negotiated to provide certainty of cost escalation. 
 
During construction, the lender’s technical advisor (TA) and concessionaire should both monitor critical path progress. Third parties such as input suppliers or connecting infrastructure developers may control project process and the third party contracts should put the liability for such delay on the third party. See “Third party default” below.
 
Set-off
The lender would ideally like the risk of set-off to be borne by the public entity and the EPC and O&M contractors. Lenders are very uncomfortable with any ability of the public entity to reduce monthly payments below debt service (including interest). The lender may insist that the concession agreement not permit set-offs to reduce payments below debt service and should where necessary, pro-rate set-offs over enough time to avoid this happening.
 
Site acquisition and access
The risk of the site not being available or accessible for construction should be borne by the public entity because it, with its expropriation powers, is most able to mitigate this risk.
 
The concession agreement will typically contain relief provisions for the concessionaire in the event that the public entity delays commencement or construction of the project. The concessionaire may be compensated by the public entity lengthening the operation period, increasing the proportion of revenues going to the concessionaire, or by direct monetary compensation. The concessionaire will generally agree to provide some compensation to the contractors for failure to provide access.
 
Site conditions – geotechnical
The EPC contractor will generally accept some risk of unforeseen geotechnical conditions. The concessionaire will likely be able to flow most of the risk which the EPC contactor will not accept up to the public entity, but the remainder of the risk will be a gap risk borne by the concessionaire.
 
It is possible to share risks such as geotechnical risk by having a capped contingency. For example the public entity could pay for the first $X in changed geotechnical conditions and the concessionaire / EPC contractor would pay the balance. Alternatively the concessionaire / EPC contractor could pay the first portion and the public entity could bear the balance.
 
Site conditions – environmental
The EPC contractor will generally not accept risk of extra costs due to hidden pollution or hazardous waste. If forced to accept this risk , the contractor will charge premium prices. If the public entity will not bear this risk, it will be a gap risk that the concessionaire will have to bear or attempt to flow down.
 
Site history research and preparatory testing are informative, but do not guarantee that such environmental costs will not be incurred. Furthermore, for extensive site areas typical in road or pipeline projects extensive testing and research may not be feasible. Lenders can mitigate this risk by requiring the expenditure of equity funds first in the hope that such problems will be encountered early in the project before debt is extended.
 
Canadian legislation extends liability to lenders for environmental pollution on land taken as security. Therefore risk of pre-existing site pollution or hazardous waste is not entirely transferable. Accordingly, lenders may require indemnity from the sponsors (investors who develop and lead the project through their investment in the concessionaire).
 
Site conditions – fossils or archaeological remains
The EPC contractor will generally not accept risk of delay costs due to the discovery of fossils or archaeological remains. If the public entity will not bear this risk, then it is a gap risk that the concessionaire will have to bear.
 
Step-in rights
The lender will require significant lead time on any action by the public entity to set-off, step-in or terminate. Given the length of the concession period and the unfamiliarity of lenders with details of a project that has been operating successfully for years, it may be necessary to permit the lender 6 months or more to analyze the situation before the public entity can exercise its rights of step-in etc. Contractors resist specification of long step-in periods because it lengthens the time they may be obliged to work on the project after payment has stopped.
 
Third party default
Project progress may depend on third parties such as utilities relocates (e.g. in a road project), adjoining infrastructure developers (e.g. in a hydro electric scheme) input suppliers (e.g. fuel suppliers) etc. The costs of default or delay should be passed on to these third parties as an incentive for proper and timely performance. The risk of some third party interference (e.g. protestors disrupting the EPC contract) may be shifted to the public entity. 
 
Variations – changes in specifications
Design risk lies with the EPC contractor, but this does not cover changes to the scope of the project requested by the public entity. Lender approval will be required for changes to scope of the project and the concession agreement should eliminate the option of changes in scope without re-negotiation.
 
Summary of P3 project risk allocation
Figure 2 below provides a rough guide to the risks shared by each of the project participants on P3 projects. Actual risk allocation is different in each project and in many cases particular risks will be split so Figure 2 may not be accurate or complete for any given project.
 
 
Strategies for flowing down and managing risk
Risks are allocated using the project contracts. This section considers the types of contractual provisions available to facilitate risk management and flow down. 
 
Models for concessionaire duty delegation
As explained, the concessionaire is usually a transient single purpose entity or form of joint venture that is not equipped to manage risk. The concessionaire aims to flow all of its duties and obligations under the concession agreement to the EPC and O&M contractors. Two models are available for flowing this responsibility down to the contractors and defining the scope of work to be performed by each contractor: “mirror provision delegation” and “short from delegation”.
 
Mirror provision delegation
Mirror provision delegation involves the concessionaire forming a long and detailed contract with each of the EPC and O&M contractors. Each provision of these contracts between the concessionaire and the contractors is a modified version of the relevant provisions of the concession agreement. In some cases the concession agreement clauses will be closely copied, only replacing “public entity” with “concessionaire” and “concessionaire with “contractor”. Other provisions will have to be modified to account for the fact that while the concessionaire is entirely and singly responsible to the public entity, the concessionaire delegates various aspects of its responsibilities to different contractors. 
 
Because mirror provision delegation requires lots of work by the concessionaire, it is less common than short form delegation. In addition to the extra work, mirror provision delegation is risky for the concessionaire because items may be inadvertently omitted, or the concession agreement provisions misinterpreted, leaving the concessionaire with a duty which no-one will perform without additional payment. 
 
An advantage of mirror provision delegation is that the detailed contracts between the concessionaire and the individual contractors set out the process for dealing with change orders, extensions of time, claims for damages etc. However, simply mirroring the provisions of the concession agreement will not address all issues. For example, mirror provisions will not deal with the right of the O&M contractor to claim if the EPC contractor is late in delivering the project for operation. In other words, difficulties arise with mirror provision delegation because the nature of the relationship between the concessionaire and the public entity is different to that between the concessionaire and any particular contractor who performs only part of the work.
 
Short form delegation
In this method, the concessionaire points to the concession agreement and simply tells the contractors that they are responsible for satisfying the concessionaire’s responsibilities under the concession agreement. Thus the contracts between the concessionaire and the subcontractors are relatively short documents compared to the lengthy concession agreement.
 
When using short form delegation the concessionaire may set up a triangular contractual arrangement as shown in Figure 3:
 
 
 
Under this tri-angular contractual arrangement, the EPC and O&M contractors will have obligations to one another and this will streamline the dispute resolution process when one contractor’s poor performance affects another.
 
Obviously the roles and responsibilities of the EPC and O&M contractors need to be clearly defined. There are a number of ways in which this can be done. First, the concessionaire may take responsibility for dividing up the work itself by providing each contractor with a detailed list of its responsibilities. This method is risky for the concessionaire because something may be left out and whichever contractor is asked to pick up the extra task will surely require additional payment.
 
Second, the Concessionaire may simply say that, between them, the two contractors are responsible for fulfilling the concession agreement, and that they should determine between themselves who does what. While this method requires less work by the concessionaire than the first option, the concessionaire will be less involved in the work allocation process and therefore less able to manage and control disputes between the contractors and ensure successful project implementation.
 
A third option, a detailed description of one contractor’s responsibilities, is a mix of the first two options and may be preferable. Under this option, the parties agree that certain specified tasks will be the responsibility of contractor A, and that all other work will be the responsibility of contractor B. For clarity the three parties may draw up a list outlining the work to be performed by each contractor, but if a dispute arises as to who is responsible for a given task, if it is not on the master list of work to be performed by contractor A, then it will be up to contractor B to perform the work at no additional cost.
 
Where short form delegation is used, the EPC and O&M contracts should contain clauses which confirm that the contractors have examined true copies of the concession agreement and have based their prices on the project specifications in that document.
 
In addition to defining the roles and responsibilities of the respective contractors, short form contracts should also address issues which are specific to the relationship between the concessionaire and the contractor and are not covered by the terms of the concession agreement: payment, the process for allocating work under change orders, granting extensions of time, scope, dealing with claims etc. Provisions for dealing with such issues are considered below.
 
Designing a concession agreement to facilitate risk flow
The risk distribution process begins with the division of risk by the concession agreement. A concession agreement which is structured to account for the anticipated delegation of responsibility by the concessionaire to various contractors will assist efficient work and risk flow down. In other words, the concession agreement should contemplate how the concessionaire will divide the work and design the project specifications in accordingly.
 
Tailoring project specifications to facilitate division of work will also reduce concessionaire bid costs making the procurement process more competitive.
 
Issues to be addressed by concessionaires delegating work and flowing risk
Regardless of whether the work is divided up according to the mirror provision model or short form delegation model, the contract between the concessionaire and each contractor should address the following issues relevant to the relationship between the those parties:
 
Change orders
Having multiple contractors perform the work specified in the concession agreement leads to difficulties when the public entity desires changes to the project specifications: which contractor will do the extra work?
 
Concession agreements generally require concessionaire consent to variations. Concessionaires should flow this consent requirement down to the contractors and agree that changes to the concession agreement will not be made without the consent of the affected contractors. To avoid risk, concessionaires should obtain variation order price guarantees from the affected contractors before agreeing to modify the concession agreement.
 
Dealing with disputes
Since the concessionaire delegates its responsibilities under the concession agreement to the EPC and O&M contractors, it will be required to defend the contractors work against an unsatisfied public entity, and prosecute the public entity on behalf of an unsatisfied contractor. Disputes may also arise between the contractors. In this role the concessionaire is inextricably caught in the crossfire and should, to the extent possible, try to duck.
 
Concessionaires aim to minimise project administration. Therefore, the contracts with the EPC and O&M contractors should contain clauses which state that the prosecution or defence of claims will be done in the name of the contractor, but at the sole expense and risk of the contractor, and under the joint direction of the concessionaire and the contractor.
 
Multiplicity of proceedings is inefficient and leads to inconsistent results. Such inconsistencies may result if an initial adjudicator finds the concessionaire liable to the contractor, but then a second adjudicator finds, on the same facts with no intervening act by the concessionaire, that the public entity is not liable to the concessionaire. To avoid such inconsistencies, a single dispute resolution process should be used for all project disputes.
 
The concession agreement should outline the dispute resolution process and define the forum for all disputes. As explained in section 5, the public entity may nominate referees to resolve project disputes. Since the referees will have working knowledge of the project, it may be appropriate to require even disputes between contractors which in no way involve the concessionaire or the public entity to be resolved by these referees. 
 
The concession agreement should also outline the rights of involvement in the dispute process. For example, if the public entity is unsatisfied with the performance of the project, should the relevant contractor be allowed to defend its work before the adjudicator? Since the concessionaire is likely to have little knowledge of the intricacies of the contractors work, common sense suggests that the contractor and concessionaire be permitted to jointly prosecute and defend actions against the public entity.
 
Claims and Damages
The concession agreement considers the concessionaire to be the sole party delivering the project in accordance with the specifications. The concessionaire delegating the work to a number of contractors complicates the claim and dispute process.
 
Questions arise as to how contractors claim against one another. For example, what procedure does the O&M contractor follow when claiming for late delivery by the EPC contractor? If the concessionaire recovers damages from the public entity for delays which affected both the EPC and O&M contractor, how should the concessionaire share these damages out? The concessionaire, wanting to avoid risk and minimise project administration, may prefer to have such determinations made by the referees nominated by the public entity, or, at the least, in a forum that only involves the two contractors and not the concessionaire. 
 
Delay
Damages for late delivery of the project will be specified in the concession agreement. The concessionaire should ensure that responsibility for these damages be flowed to the EPC contractor via the EPC contract. Furthermore, the contractor should be made accountable for additional inspection and administrative costs incurred by the concessionaire as a result of the delay.
 
Indemnity and Insurance
Concessionaires should ensure that they are indemnified against liability for all harm caused by the contractors failing to perform their contractual obligations. This may be done by way of a broadly worded indemnity clause that covers tortuous and other harm caused by the contractor to any project party or member of the public.
 
The insurance regime will depend greatly on the needs of the project. It will likely be cost effective to consolidate insurance needs to avoid double insurance costs. Insurance advisors should be engaged to focus on what is becoming a major driver of P3 deals.
 
Notice
The concession agreement will specify certain notice periods for submission of claims under the main contract. Such notice would have to be issued to the public entity in the name of the concessionaire.
 
The EPC and O&M contracts should require the contractors to submit notice to the concessionaire a specified number of days before the deadline for notice to the public entity. Furthermore, to protect itself against liability for failure to give notice, the concessionaire may require the contractor to give notice directly to the public entity in the name of the concessionaire before expiration of the notice period specified in the concession agreement. Concessionaires may further disclaim any liability for failure to give notice on behalf of the contractor.
 
Payment
The concessionaire should aim to avoid a situation where it has, or is obliged to, pay its contractor without having received, or being certain that it will receive, payment from the public entity. Although controversial and not well liked by contractors, pay-if-paid and pay-when-paid clauses may be used by the concessionaire for this purpose. Under pay-if-paid clauses, the concessionaire is only required to pay the contractor if it receives payment from the public entity for that item. Conversely, under pay-when-paid clauses, the contractor is assured of payment, but the timing of that payment is uncertain.
 
In the absence of conditions to the contrary, the concessionaire is generally obliged to pay its contractors for work properly performed. Therefore, even if the public entity breaches the concession agreement and refuses to pay for the work, the concessionaire will be obliged to pay the contractors fully for work delivered. However, pay-if-paid clauses place the risk of public entity default on the contractors who have no contractual relationship, and therefore no remedy, against the public entity. Because some courts have found such pay-if-paid clauses to be unfair and contrary to public policy, they may not be enforced: Construction Law – 2004 Update, Subcontract Issues, Brian M. Samuels, Continuing Legal Education, November 2004. Concessionaires will not likely be allowed to rely on a paid-if-paid clause unless they have made every effort to recover the funds from the public entity. Explicit paid-if-paid clauses describing the types of public entity default for which the contractor accepts risk are more likely to be enforced than general clauses assigning all risk of public entity default to the contractor.
  
The concessionaire may desire additional clauses in the EPC and O&M contracts that state that the contractor will not be entitled to additional compensation unless the concessionaire receives such payment from the public entity. While the pay-if-paid clause addresses payment for initially specified work, this additional clause will protect the concessionaire against being obliged to make additional payment for unexpected expenses incurred by the contractor.
 
To ensure payment of contractors by the concessionaire, the public entity may require the concessionaire to provide a labour and material bond. The ability of the contractors, and their subcontractors, to claim on the bond will depend on the details of the bond, particularly on the definition of who may be a claimant under the bond.
 
Termination
Concessionaires should include two types of termination clauses in EPC and O&M contracts. First, the concessionaire should protect itself against contractor default by securing the right to terminate the contractor for cause in accordance with the termination provisions of the concession agreement.
 
Second, the concessionaire should relieve itself of any obligation to pay the properly performing contractor if the public entity terminates for any reason, except to the extent that the concessionaire is awarded damages under the concession agreement. Such clauses are a variation of the pay-if-paid clauses referred to in the payment section above and similar issues apply.
 
Warranties
The EPC and O&M contractors are obliged to rectify design and construction defects that arise during the warranty periods. The concessionaire should ensure that the warranty periods specified in its contracts with the EPC and O&M contractors are at least as long as those specified in the concession agreement.
 
Most concession agreements will require two types of warranty: a design warranty and a construction defect warranty. Design warranties may cover up to the design life of the project. Construction defect warranties are generally much shorter and may be specified absolutely (e.g. 12 years from substantial completion), or by reference to the time of reasonable discoverability (e.g. time of discoverability plus 2 years).
 
Warranties are split between the EPC and O&M contractors. Difficulties arise when it is unclear whether the defect is a result of poor design or construction, for which the EPC contractor is responsible, or from inadequate maintenance during the early part of the operation period. To mitigate the risk of such disputes, the maintenance methods and schedule of the O&M contractor should be incorporated into the EPC contract documents and the O&M contractor should have rights to make direct claims against the EPC contractor for defects and deficiencies. The EPC contract should warrant that the EPC contractor will design a project that will last the design life assuming the specified maintenance program is properly implemented.
 
What risks and duties does the concessionaire retain
Generally concessionaires aim to avoid risk and delegate duties. Figure 2 above listed various residual risks which the concessionaire will either have to bear or assign to insurance or bonding companies.
 
There are certain tasks which the concessionaire will not be able to delegate entirely. These tasks relate to the concessionaire’s role as a project co-ordinator and may include the following:
o       Preparing monthly reports on project performance and progress.
o       Reporting on compliance with environmental regulations.
o       Where many contractors are working in close proximity, the concessionaire may be required to co-ordinate site safety and fire prevention.
o       Reporting on accidents and insurance claims.
o       Working with the various contractors to develop a project manual describing the operation of the various project systems and technologies.
 
Conclusions
The various P3 project participants each aim to reduce their personal risk. Efficient risk allocation requires that all parties bear some risk. Risk should be allocated according to who is best able to mitigate the risk, and who can best bear the risk if it materializes.
 
The risk allocation process begins with the concession agreement. Under the concession agreement, the public entity will take some risk, the remainder being transferred to the concessionaire. The concessionaire is a temporary entity who is generally unable or unwilling to mitigate and manage risk. Therefore, the concessionaire will attempt to flow the risk it takes under the concession agreement to the EPC and O&M contractors. These contractors will in turn try to flow some of the risk down to their subcontractors and suppliers.
 
Lenders are a key player and powerful negotiator in P3 projects. Lenders provide most of the financing and stand to make lesser returns than the equity investors. Therefore, lenders are risk averse and use their strong bargaining position to delegate risk and maximise the probability of proper debt servicing even in the event of project difficulties.
 
Although risks generally flow downhill, public entities cannot expect to run cost efficient projects with fair allocations of risk unless they too accept their fair share of risk.
 
Glossary of terms
o       Cover ratios = Ratios of the cash flows from the project against debt service.
o       Debt service = Payment of principal and interest instalments.
o       Debt Servicing = Repayment of principle and interest.
o       Direct Agreement = Contract between the lender and a project participant other than the concessionaire.
o       EPC = Engineering, procurement, construction management; can also be described as Design Builders
o       Input demand = Demand for the service provided by the operational project.
o       Input supplier = Supplier of resources necessary for the construction or operation of the project.
o       Lender = Bank who finances one of the project participants.
o       O&M = Operate and maintenance
o       Offtake contract = The contract under which the concessionaire sells the project to the Offtaker. This contract is finalised at the project initiation stage.
o       P3 = Public Private Partnerships (Analogous to “PRI”).
o       PFI = Private Finance Initiative (Analogous to “P3”).
o       Concessionaire = Consortium of sponsors who manage and control the project
o       Sponsors = Investors who develop and lead the project through their investment in the concessionaire.
o       TA = Technical Advisor
 
 
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