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PFI: benchmarking and market testing, a cause of conflict in the long run?

The ongoing Scottish case of Serco Limited v Forth Health Limited highlights the difficulties that can arise when applying benchmarking and market testing provisions in long-term maintenance and service agreements.

 

Benchmarking and market testing of long-term service and maintenance costs in PFI projects

While the use of PFI models has to some extent fallen out of favour in the United Kingdom, the model continues to be expanded in various forms into and within new markets around the world, and many of the legacy PFI projects in the United Kingdom have much of their operation and service term left to run.

A commonly criticised aspect of PFI projects has been that once constructed, these projects can be saddled with service and maintenance contracts with private sector contractors, which reflect higher (sometimes significantly higher) operating costs than if the government provided service and maintenance services to the facility directly, and/or engaged another private contractor from the market to do so.

One mechanism commonly used in PFI projects to counter this concern is to incorporate into the long-term service and maintenance contracts a mechanism for the “benchmarking” and/or “market testing” of certain service and maintenance costs, whether or not such costs and the relevant payments due are subject to service specific indexation, and/or escalated in accordance with inflation.

In broad terms, under such a mechanism the cost of certain services is compared and then benchmarked against the cost of services provided for comparable projects. If the cost of such services is found to be more than a certain level above similar costs on comparable projects, then there will either be an adjustment made to the relevant element(s) of the service charge payable under the concession agreement and the relevant services contracts, or the project may be required to “market test”, by going out and tendering the services to the market to establish whether more cost effective service providers are available.

 

Clarity is critical

The concession agreements and facility maintenance agreements used on PFI projects generally contain complex formulas for calculating the service charge payable to a contractor for service and maintenance services and provisions for benchmarking and market testing. Despite PFI transaction documents usually being closely scrutinised by all parties, given the long-term nature of such agreements and the interests of the procurer, the contractor, lenders of long-term finance and the services providers themselves, it is not unheard of for issues to often arise due to ambiguities in, or unexpected outcomes of, benchmarking/market testing mechanisms.

The case of Serco Limited v Forth Health Limited [2020] CSOH 48, currently ongoing before the Scottish courts in relation to the facility management agreement for a hospital delivered under the PFI model in Scotland, highlights the importance of clarity in benchmarking/market testing mechanisms. There, the benchmarking/market testing mechanism in the facility management agreement included the term “First Market Test Date”, which was not defined and the cause of ambiguity and disagreement between the parties as to whether the standard wage escalation formula would continue to apply to a certain category of services. Having found at the latest hearing that the interpretation of the service provider was not bound to fail, the court will now proceed to hear full evidence to determine how the mechanism should be interpreted in light of the commercial background at the time of entering into the contract, including looking at the market testing mechanism in the context of the original financial model for the project.

 

Drawbacks and limitations of benchmarking and market testing mechanisms

Even when properly drafted, the operation and outcome of benchmarking and market testing mechanisms can have limitations and drawbacks, and may have been agreed on by a misunderstanding, or more often have unintended outcomes.

  • The case of Serco v Forth Health demonstrates the perils of having a complex (though poorly drafted) benchmarking and market testing provision, and it is important that benchmarking formulas are detailed and market testing requirements are certain, making clear what services are to be benchmarked and/or market tested, and at what times.
  • Any procurement process carried out as part of a market testing mechanism often suffers from a perception that the opportunity for variety is limited, but it can and should be structured to encourage competition, rather than in a way that unduly favours the incumbent service contractor.
  • In civil law jurisdictions, parties may be entitled as a matter of law to re-open the terms of a contract, if there has been an unforeseeable material change of circumstances, which could provide a more general right to re-open the service cost price provisions in lieu of, or in parallel with, a benchmarking/market testing mechanism expressly agreed in a long-term service and maintenance agreement.

 

Looking forward

Despite the waning use of the traditional PFI model in the United Kingdom, it seems as though private finance in the UK will continue to be involved in the delivery of certain public infrastructure projects in some form. In other jurisdictions, private financing continues to play an important role in delivering infrastructure projects, including via more traditional PPP models. As government budgets come under pressure, there may even be a renewed interest in PPP and privately financed infrastructure in certain jurisdictions.

As the PFI model requires greater certainty of long-term costs than traditional forms of government procurement, the need looks set to continue for clients and their professional advisors to develop (clear) long-term contractual frameworks that establish—and where necessary rebalance—service and maintenance costs in a way that creates certainty for financiers, while offering reasonable remuneration to the service contractor and fair value for the taxpayer.

Finally, when parties are entering into lengthy, detailed and complex long-term contracts, it is often preferable for them to seek to resolve issues amicably, or to build into the contract mechanisms to encourage the resolution of disputes without going to court or arbitration.

  • As the English Court of Appeal relatively recently observed in relation to a PFI project dispute, any “contract of this character is likely to be of massive length, containing many infelicities and oddities. Both parties should adopt a reasonable approach in accordance with what is obviously the long-term purpose of the contract. They should not be latching onto the infelicities and oddities, in order to disrupt the project and maximise their own gain.”1
  • Additionally, parties may wish to incorporate some form of alternative dispute resolution (ADR) into long-term service agreements, such as determination by an expert for resolution of more technical issues, as an alternative to forcing the parties to go straight to commencing court or arbitration proceedings in order to resolve certain disputes/differences arising under the contract.

 

1 Amey Birmingham Highways Ltd v Birmingham City Council [2018] EWCA Civ 264.

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