Highways Agency - Safe roads, Reliable journeys, Informed travellers

Chapter 2 - The DBFO contract

2.1 Overview

By the time of contract award each successful consortium had formed a special purpose vehicle company (DBFO Co) to enter into the DBFO contract with the Secretary of State. Although the Secretary of State is the counter-party to the DBFO contract, the Agency has executive responsibility for its administration. The DBFO is principal legal relationship between DBFO Co and the Agency. Broadly, the DBFO contract fixes the outline design for the road schemes in the project; specifies the with the construction works must comply and gives a date for completion of construction; and specifies the operational service requirements for any existing road and any new road, once constructed. In return DBFO Co receives a payment from the Agency based on the number and type of vehicles using the project road (shadow tolls). The payment mechanism is explained in greater detail in 2.2.

References throughout this case study to the DBFO contract(s) refer to the eight contracts signed on Tranches 1 and 1A, although the case study should not be read as an interpretation of those contracts or any clause within them. The signed DBFO contracts differ in their treatment of certain provisions although the description of the contract terms is generally accurate. The terms of the DBFO contract are not set in stone. In some instances the italicised sections refer to proposed changes to the model DBFO contract (which forms the starting point for negotiation). Nothing in this case study precludes the possibility of future change to the model DBFO contract, or the procurement process, as the Agency and bidders develop the application of PFI to DBFO road projects.

The DBFO contract period is for 30 years from the commencement date. That period was selected because finance for this type of project generally has a maximum repayment period of around 20 years and the payment mechanism had to be structured to allow repayment of debt over a similar timescale (making allowance for a reduced payment stream in the initial years until the road scheme(s) are completed and a 'buffer' period after anticipated debt repayment in the event that cash flows are less than, or come on stream later than, anticipated). Since 30 years is currently beyond the range of conventional debt, the choice of period also encouraged financial innovation, use of alternative sources of funding and the possibility of re-financing after the completion of construction, all of which can provide financial benefits to the Agency. It was also important that the contract period was sufficiently long to allow DBFO Co to apply whole-life costing to the project road.

Bank funders are now prepared to look at longer repayment periods and bonds may have a repayment period of up to 25 years or more. For the next DBFO projects the Agency will allow bidders to provide variant bids based on their preferred contract period. A longer period may allow DBFO Co to introduce further cost savings, because it has greater freedom to take a strategic view on the method, and prioritisation, of road maintenance. The introduction of road schemes which have not obtained final statutory approval at the time of tender invitation (contingent schemes) may also mean that longer contract periods are attractive. As contingent schemes will take time to complete the statutory process, revenue from them will only come on stream later in the contract period. A longer contract period will allow more time for full cost recovery.

Because the DBFO contract represents a long-term obligation on DBFO Co, there is recognition that circumstances existing at the start of the DBFO contract may change. Some specified change situations represent risk which DBFO Co is asked to assume; and where the contract is silent, DBFO Co bears the risk of change. However, the Agency reserves the right to change the technical or commercial requirements under the DBFO contract. Where such a change alters DBFO Co's costs or the traffic flow on the project road, the shadow tolls are revised. The change mechanism is discussed in more depth at 2.6.

DBFO Co takes responsibility for financing the construction costs. The risk of being able to finance the costs of the project is for DBFO Co. However, because the availability of funds is so fundamental to the success of the project, the Agency was not prepared to enter into the DBFO contract without evidence of formal commitment from funders. When DBFO Co is referred to as bearing the financing risks, (ignoring the obvious risk of cost increases) this should be interpreted as bearing the risk of movement in the interest rate after contract award (which can be mitigated by the use of financial derivatives) and the risk of default under the debt and derivative facilities.

2.2 Payment Mechanisms & Incentives

Payment is made for the provision of the road service. The Agency pays DBFO Co an amount which is based on the number and type of vehicles using the road, with adjustments made for lane closure and safety performance. The payment mechanism was structured to meet Government policy objectives for the trunk road network and PFI requirements. It incorporates payment based on the following three criteria:

• Usage/demand - shadow tolls involve payment per vehicle using a kilometre of the project road, in accordance with a tolling structure. They are referred to as 'shadow', as opposed to real, tolls because the payment for usage is made by the Agency, rather than the road user. The shadow tolls increase over time in accordance with an indexation formula.
  
  Different payments are due for traffic within different traffic bands and dependent on the length of vehicle. Bidders were asked to bid the parameters of traffic levels for a maximum of four, and a minimum of two, bands, with the proviso that the top band - anything exceeding X vehicle kilometres p.a. - must have toll levels set at zero to ensure that the maximum liability of the Agency under the DBFO contract is capped.
  
  Within each traffic band the bidders specified a toll for two categories of vehicle; long vehicles (over 5.2m - which, most importantly, includes HGVs) and short vehicles (less than 5.2m). There is no available method of differentiating between the weight of vehicles, and therefore length measurement was used as a proxy for weight.

Bidders set the bands and tolls from their own assessment of traffic levels. Most bidders opted for four bands with the lowest band representing a cautious view of traffic and tolls within that band set at a level that would cover debt service requirements (but would not provide a return on equity). Figure 2.2a shows a typical banding structure proposed by bidders.

Figure 2.2

Availability of service - where the project road consists of an existing stretch of road with one or more construction schemes along its length, then (prior to the completion of any construction scheme) shadow toll payments will be made at a reduced level representing the cost of operation and maintenance for the existing road. This level varies substantially depending on the nature of the DBFO project. In the case of the M1-A1 project, which is virtually all new build, no payment is to be made until the Permit to Use is issued for the road to open to traffic.

Generally, once the Permit to Use is issued for a construction scheme and the road is open for traffic, DBFO Co receives 80% of the full level of traffic payment. When the construction works are completed and the Agency has issued the Completion Certificate, DBFO Co receives 100% of the traffic payment.

In most cases the toll payments step down again at the time when it is anticipated that the third party debt will have been fully repaid. This reflects the fact that revenue in excess of operating and maintenance costs at that stage is solely return on equity.

Figure 2.2b shows a typical payment profile, assuming no variance in traffic or adjustment for lane closure or safety performance. The increase in payment over time during each 'step' results from indexation of tolls. Issue of the Permit to Use is marked 'A', issue of the Completion Certificate is marked 'B', and 'C' shows the point at which third party debt is anticipated to be repaid.

Figure 2.2b

• For future DBFO projects, bidders will be asked to bid a fixed payment for the availability of any existing road, prior to the completion of the construction of the schemes. This will be easier to administer, given the number of possible schemes within a project, and recognises that payment reflecting availability is a sensible component of the payment structure. To incentivise scheme completion, fixed payments will be capped below the costs required to maintain the existing road.
  
• Performance - There are two aspects to performance payments: safety performance payments and lane closure charges.
  
  One of the Agency's key objectives is to reduce accident levels on the trunk road network. In order to incentivise DBFO Co to address safety it is encouraged to suggest safety improvement schemes for Agency approval. If these improvements are agreed, DBFO Co constructs and pays for the scheme and is recompensed by receiving 25% of the economic cost of each personal injury accident avoided in the following five-year period. Accidents avoided are determined by comparing the actual statistics with data over the three years prior to the implementation of the scheme.
  
  Disturbance and delay caused by lane closure is a significant performance issue to both the Agency and the road user. A deduction is made from the toll payment when lanes are closed. The size of the deduction is dependent on the number of lanes closed, the duration of the closure, the expected traffic at the time of closure (which encourages scheduled closure for maintenance at off-peak times) and the economic value of user delay which can differ between business and leisure use. Lane closure charges are only made for closure within the control of DBFO Co, for example no deduction is made for closures required by the police (in the case of accidents and emergencies) or utilities.
  
  In Tranche 1 and 1A DBFO contracts safety payments act as a bonus. To ensure that DBFO Co actively addresses safety, this payment criterion will be strengthened for future DBFO projects. The safety payment will act as a bonus and as deterrent. If the trend of road accidents on a project road is worse than national trends for a similar type of road, deductions will be made from payments due.
  
  For future DBFO projects, DBFO Co will also be required to deliver five-year rolling operational plans setting out their view on how best to operate the project road. The plans must contain proposals on issues such as safety, facilities for pedestrians and environmental protection. Although the plans will be set by DBFO Co and have no payment attached to their performance, the Agency will reserve the right to publish them so that the road user will be able to monitor performance against expectations. This is another example of the potential movement towards operational performance as the most important test of service delivery.
  
  The issue of whether shadow tolls provide the most appropriate basis for payment is highlighted on urban DBFO projects, such as the A13 and A40 projects, where traffic is consistently heavy and there is consequently little traffic risk. Therefore, in relation to these urban projects, the Agency intends to refine the payment mechanism in order to improve the incentives on DBFO Co to optimise the road space, to improve safety performance and generally to take steps to improve performance of the route to the benefit of the road user.

2.2 Service Specification

When drawing up the service specification, the Agency's engineers examined the processes which they would go through and the considerations which the Agency would have to bear in mind when designing a road scheme and procuring its construction, operation and maintenance. The engineers had to identify only the fundamental requirements for design, construction, operation and maintenance of the project road (core requirements) so that, wherever possible, the bidders would be allowed to innovate and add value. The core requirements are part of the output specification for the DBFO projects.

Core requirements for construction included compliance with the undertakings of the Agency given at Public Inquiry, adherence to the Orders made and meeting the objectives of any Environmental Statement. The Agency also provided standards, design data and its own design proposals (existing design) which would be one option for meeting the core requirements (illustrative requirements) with the Invitation to Tender. The illustrative requirements were not mandatory, but served as a benchmark for evaluation. Bidders were encouraged to offer alternative proposals and consult with the Agency's project team throughout the tender process to ensure that their proposals would be capable of delivering the same, or better, level of service as the illustrative requirements.

For the first DBFO projects full statutory approval had been gained for all road schemes before contract award. This meant that the outline design had been put to a Public Inquiry and fixed in statutory Orders which are necessary to construct the schemes and acquire the necessary land. Although the outline design was fixed, there was still scope for innovation and cost savings in working up the detailed design.

Bidders varied in their approach to proposing changes to any existing design. Some bidders seized the opportunity and proposed numerous departures from the Agency's illustrative requirements and existing design.

Some bidders also applied value engineering techniques throughout the procurement process to reduce construction costs by optimising the Agency's design. The changes to any existing design could not require any change to the land required for construction, as the acquisition of land and settling blight claims remained the responsibility and risk of the Agency. However, DBFO Co could acquire additional land, through negotiation with private landowners, to reduce construction costs.

In response to bidders' calls for more scope to innovate, the Agency is introducing with some future DBFO projects contingent schemes with a degree of planning risk attached. Some contingent schemes will have completed the approval process by the time of contract award; others are at an earlier stage, in some cases with only a preferred route announced. The Agency will set out in the Invitation to Tender its assessment of how the risks attaching to these types of schemes should be allocated between the Agency and DBFO Co. The basis for that allocation will be an assessment of which party is best able to manage the risk in question.

2.4 Penalty Points & Monitoring

One of the main operational issues for the Agency is how to ensure that DBFO Co complies with the terms of the DBFO contract post-award. Under the terms of the DBFO contract the Agency appoints representatives to monitor the construction, operation and maintenance carried out by DBFO Co to ensure that it complies with its contractual obligations. The Agency has expressed its desire to remain as 'hands-off' as possible in monitoring the contract.

Mentioned in 2.2 is the concept of operational plans, which requires DBFO Co to set its own operational standards. The requirement for delivery of operational plans is intended to ensure that DBFO Co continually addresses how best to operate the project road. The Agency reserves the right to publish the plans, so that road users will be able to monitor performance against expectation.

The DBFO contracts contain a penalty point mechanism which attributes points to failure to perform under the contract. The allocation of penalty points above a specified threshold triggers increased monitoring requirements. Once a specified number of penalty points has been exceeded, the Agency has the right to terminate the contract.

The Agency also has a number of other remedies arising from non-performance, including the right to remedy any default itself and invoice DBFO Co for its costs.

2.5 Change Procedure

The DBFO contracts represent the Agency's current approach on how to meet demands on each project road, but circumstances will change over the 30-year contract period. Therefore the Agency needed to reserve the right to change the service specification during the contract period, because it retains responsibility for strategic management of the whole network.

However, the bidders would not enter into an agreement where there was the possibility of the Agency changing the specification at extra, unanticipated cost to them. The solution was for the DBFO contract to contain scope for possible changes required by the Agency, and for the method of adjusting the payment mechanism to allow for the change in costs or effects on traffic flow. The main changes that the Agency can require are:

• change to the agreed specification of the design, construction or operation and maintenance of the project; and
• additional works on the project road (ie. in addition to the road schemes included in the DBFO project). The additional works may be procured either by DBFO Co, as project manager for the Agency, or by the Agency, in which case DBFO Co can compete for the construction works.

The method of calculating the adjustment in tolls is set out in the DBFO contract. First, the party raising the change identifies the change in costs and/or traffic. Generally, the effect of the change, either on its own or cumulatively with other change costs, must exceed a specified threshold before the toll revision mechanism is operated. If the changes or the issue of whether the threshold has been exceeded cannot be agreed they are referred to a disputes resolution process. The revised costs and/or change in anticipated revenues, caused by a change in traffic, are put into the financial model of the project to establish a revised Net Present Value (NPV) of net cash flow. Adjustment is then made to future toll levels (either up or down) to ensure that the NPV of net cash flow (as shown in the financial model) is the same as before the eligible change.

2.6 Termination Of The DBFO Contract & Step-In Rights

The DBFO contract sets out the events of default, in relation to each party, which give the other party rights to remedy and terminate. In relation to DBFO Co, events of default include:

• insolvency (which also applies to a sub-contractor or shareholder, if its insolvency would have a material effect on the ability of DBFO Co to perform its obligations under the DBFO contract);
• change of control in DBFO Co without the consent of the Secretary of State;
• serious breach of obligation, for example, abandoning construction of a road scheme or failure to complete construction by a long-stop date; and
• exceeding a maximum number of penalty points awarded within a given period.

The Agency will consider requests for consent to alter control of DBFO Co, in light of current guidance (which is to allow greater freedom on transfer of equity) and the merits of each case. The Secretary of State must also act reasonably when considering whether to approve a change of control. The Private Finance Panel generally recommends that change of control in the equity of DBFO Co should not be a default trigger, cf. HM Treasury and Private Finance Panel guidance referred to in 2.8.

If an event of default has occurred, the Agency has a range of remedies of increasing severity. The remedies include the right to suspend payment to DBFO Co, the right to call for DBFO Co to present a programme for remedy and the right to terminate the DBFO contract in full without compensation.

The events of default, in relation to the Agency, which allow DBFO Co to terminate the DBFO contract with compensation include:

• sequestration of the project road and/or facilities by the State;
• the Secretary of State ceasing to be the highway authority; and
• failure to pay amounts due to DBFO Co within a specified period.

In addition to the rights of termination above, there are the following 'no fault' termination rights:

• either party has the right to terminate after a consultation period if there is a continuing force majeure event, such as war, which materially affects either party's performance of its obligations for a specified period; and
• either party can terminate if there is a change in law rendering it illegal or impossible for DBFO Co to perform its obligations.

Once either party has served a termination notice, there is a period for challenging the notice. If the project road is not being run safely, the Agency has the right to take over its operation almost immediately. Termination of the DBFO contract does not release DBFO Co from any accrued obligation under the DBFO contract.

On termination of the DBFO contract, DBFO Co hands the project road (and any uncompleted works on it) back to the Agency. DBFO Co must transfer its interest in any construction, operation or maintenance contract let for the project road to the Agency. Once the transfer is complete, DBFO Co must vacate the project road and clear all unwanted movable equipment from it.

If termination results from DBFO Co's default, no payment is due from the Agency to DBFO Co or its funders. Figure 2.6 shows the circumstances in which the Agency will pay compensation on termination, who is compensated and what for.

Figure 2.6

^*costs/liabilities include adviser costs, liabilities to sub-contractors and internal management costs.

2.7 Expiry Of Term

Throughout the life of the DBFO contract the Secretary of State retains ownership of the road and underlying land. DBFO Co has a right of access to the road and necessary land. At the end of the term the project road and all fixed facilities on it must be handed over to the Agency and DBFO Co's right to access terminates, without cost to the Agency. This is because the Secretary of State cannot legally dispose of the road.

The DBFO contract specifies the standards which the project road must meet at the time of handback. Simply, the standards require the project road to be handed back to a specification based on the residual life of the different elements of the project road. Towards the end of the term there is a mechanism for inspection and agreeing the action which is needed to ensure that the handback criteria are met at expiry. The first joint inspection of the road surface and all structures takes place five years before expiry. A programme of works is agreed, if necessary. The second joint inspection of all the project road facilities takes place around 18 months before expiry. If the criteria are met on the expiry of the contract period, then the Agency's representative can issue the handback certificate.

From five years before expiry, the Agency can withhold 40% of payments due to DBFO Co, up to an amount equal to 40% of the estimated value of remedial works necessary, and apply these funds to remedy defects if handback criteria are not met at expiry. The Agency retains the risk that, at expiry, the funds retained are not sufficient to cover the cost of remedial works which have not been carried out (although DBFO Co would remain liable for the balance of the cost).

2.8 Bidders' Structural & Financing Issues

Equity

Bidders are required to disclose, both at the prequalification stage and in their bids, details of the proposed equity ownership of DBFO Co, including identity and percentage stake of each shareholder. The purpose of asking for this information is to enable the Agency to select bidding consortia on the basis of their members' track record, experience and commercial strength.

There were several occasions during the procurement period when the commercial identity of the members of the bidding consortia changed. One example was on the M1-A1 project where the preferred bidder was a consortium initially comprising Trafalgar House and Wimpey. Trafalgar House was subject to a take-over bid by Kvaerner, and Tarmac and Wimpey carried out an asset swap (including Wimpey's roads business). Trafalgar House had to find a partner to replace Wimpey, and Balfour Beatty joined the consortium as the replacement. There was delay but, by allowing the consortium to reassemble in a form acceptable to the Agency, the Agency retained the consortium's Best and Final Offer, which was good value for money.

Difficulties of this sort within the private sector can potentially make the procurement process more difficult for the procuring body. However, the M1-A1 example demonstrates how the public sector can handle such situations and still achieve a good value for money contract and maintain a fair competition.

The equity position is crystallised at, or before, the time of contract award when the consortium members subscribe for equity in DBFO Co. Unless DBFO Co has obtained the consent of the Secretary of State, a shareholder cannot transfer any of its equity. Although the DBFO contract initially confers absolute discretion on the Secretary of State, he is always expected to act reasonably in the exercise of any discretion.

Some contractors have indicated that they do not wish to retain a long-term involvement with a DBFO project once it enters the operational phase. They have argued for greater freedom to dispose of their equity, releasing funds to invest in other projects. Some parties argue that a maturing road-operating industry should allow for recycling of equity, with investors who are looking for a lower risk, lower return investment buying out the contractor shareholder's equity once the construction risks have passed. The argument for greater freedom on transfer of equity is set out in HM Treasury and the Private Finance Panel's guidance 'Transferability of Equity'.

Sources of finance

The sources of finance for the costs of DBFO projects are equity and debt. To date, all pure equity contribution has come from project sponsors. However, some quasi-equity, in the form of subordinated debt, has been contributed by third party investors. In future, equity may come from investment funds which have been set up to provide equity for PFI projects. So far, the nature of the commercial arrangements (particularly restriction on the transfer of equity) has either not required, or not been suitable for, third party equity.

Debt finance has been raised through commercial bank debt, funding from the European Investment Bank (EIB) and the proceeds of a bond issue. As funding costs are built into the unitary payment as a project cost, healthy competition amongst funders to reduce funding costs is to the Agency's advantage.

The bank facilities provided have had a repayment period ranging from 15 to 20 years and margins of between 120 and 140 basis points. The facilities are 'limited recourse', as the debt is serviced out of cash flow generated by the project road and the banks look only to the assets of their borrower, DBFO Co (although in certain instances the banks have taken specific shareholder guarantees).

EIB has provided funds on three projects at financial close. EIB's function, as a lending institution backed by EC member states, is to finance projects which will contribute to the balanced development of the EC. The DBFO roads programme has been designated as within the scope of its objectives. EIB is non-profit making and can therefore lend at a reduced margin above its costs of funds. It will not take construction phase risk, and therefore bank guarantees need to be in place to support its loan during the construction phase. In practice, the time and internal approval processes required by EIB to provide funds meant that it was difficult for bidders to blend EIB and commercial bank or bond funding. Some bidders found that the difficulty involved with EIB funding outweighed the potential cost saving.

A guaranteed, secured bond worth £165 million was issued by Road Management Consolidated PLC (RMC) - a company formed by the Road Management Group - to fund the construction costs of two DBFO projects (the A1(M) and A417/A419). The DBFO contracts were awarded to two subsidiaries of RMC. The repayment of the bond is to be spread over the last 20 years of a 25-year term. The bond was supported by an unconditional guarantee of principal and interest payments from AMBAC Indemnity Corporation and consequently received an AAA rating. The coupon on the bond was 9.18%.

Funders require security over the assets of the project company. In the case of DBFO Co, the principal asset is its rights under the DBFO contract. In the event that DBFO Co fails to perform, the Agency has allowed the funders 'step-in rights'; these provide that if the Agency is in a position to terminate the DBFO contract, it will first allow the funders to take over operation themselves for a limited period during which they may try to find a replacement operator. The relationship between the funders and the Agency on step-in rights is set out in the Direct Agreement.

2.9 Contract Structure

A typical contractual structure is shown in Figure 2.9. The diagram shows how DBFO Co - by means of the construction, and operation and maintenance sub-contracts - allocates a large proportion of the performance of its contractual responsibilities and risk assumed under the DBFO contract.That risk allocation is not, of course, binding on the Agency, which continues to look only to DBFO Co for performance of the service. The construction sub-contract is typically let on a fixed price, turnkey basis. The construction sub-contractor is, in turn, able to let fixed-price sub-contracts for the majority of the construction work undertaken by it.

There is no fundamental requirement for DBFO Co to have a construction company amongst its shareholders, provided that it can demonstrate an acceptable method of procuring the construction work in accordance with the core requirements.

In the UK there were no existing private sector road operators before the DBFO initiative began. Continental private sector road operators have been involved with bidding consortia and, in some cases, have taken an operation and maintenance sub-contract from DBFO Co (either solely or as a joint venture with other shareholders). The operation and maintenance contractor has, in some cases, let a contract for routine maintenance to either a company or local highway authority with maintenance agent experience. The terms of the maintenance contract are similar, in respect of winter and routine maintenance, to existing Agency maintenance arrangements. Because the maintenance contract specifies work required at fixed rates, the operation and maintenance contractor retains the real operating risk. A statutory instrument has been made to allow local highway authorities (which have traditionally provided maintenance services to the Agency) to be sub-contractors to DBFO Cos, subject to competition, provided that the sub-contract is for no longer than five years.

For the first DBFO projects there was no experience of how well the private sector would achieve the risk allocation and sub-contract management. The Agency has taken the view that it should ensure that the terms of the sub-contracts are acceptable at the time the DBFO contract is awarded. However, if the DBFO contract is structured so that payment is at risk if the service is not available or is sub-standard, then this should motivate DBFO Co to manage its sub-contractors to comply with the service levels required. The Agency expects to review its position in the light of continuing experience.

The Agency has not asked for shareholder guarantees and collateral warranties from sub-contractors. This is in line with the PFI principle that the Agency should look only to DBFO Cos to perform the DBFO contract obligations and to remedy a default situation. The Agency has required a performance guarantee from DBFO Cos in the form of a bank guarantee for an amount varying in accordance with the value of the construction costs of the project. The performance guarantees are released when a specified milestone in respect of the construction is satisfied.

Figure 2.9