| On the adequacy of compensation for the Prison Service's higher termination liabilities
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| (i) | There may be a good case for the public sector to make payments to the external financiers on termination of a PFI contract. It is, however, unacceptable that a department should accept without full compensation any risk of having to meet higher termination liabilities as a result of a refinancing which would greatly benefit the private sector shareholders (paragraph 14).
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| (ii) | There was ambiguity over the extent to which the Prison Service's contractual arrangements in respect of termination liabilities required it to consent to this refinancing. That ambiguity complicated the Service's efforts to seek compensation for the increased termination liabilities for which it would be liable as a result of the refinancing (paragraph 15).
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| (iii) | Departments should take early legal advice when developing PFI contracts to limit their exposure to increases in termination liabilities during the contract period. They should develop contracts which unambiguously give them the right to approve any arrangements which might increase those liabilities (paragraph 16).
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| (iv) | It is reasonable for a private sector consortium to see incentive in the prospect of refinancing benefits that may arise as a result of it outperforming the standard of service expected at the time the PFI contract was let. That does not mean that the private sector should reasonably expect to receive 100 per cent of such benefits. In this case, the Prison Service was able to negotiate a share of the benefits, which was no more than compensation for taking on additional termination liabilities as a result of this refinancing, but the compensation represented only about 20 per cent, of the £5.5 million portion of the refinancing gains which were entirely dependent on Prison Service consent (paragraph 17).
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| (v) | No department in a PFI deal can afford to relax its guard against perverse incentives which might tempt the private sector side, in adverse circumstances, to cut and run. In this case, such a risk might theoretically arise because the Prison Service's greatest exposure to additional termination liabilities would occur at a time when the private sector shareholders would have received most of the benefits of the refinancing and their company would be facing additional costs. In such a situation, the shareholders might become less concerned about their company's performance at a time when the costs to the Service of terminating the contract would be at their highest (paragraph 18).
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| (vi) | Departments should assess the risk of contract termination, taking account of changes to a consortium's cashflows which are likely to occur during the contract period. This risk assessment should then be used by departments to devise a pattern of rewards and penalties which continue to incentivise the consortium throughout the period of a PFI contract (paragraph 19).
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| On the balance of risks and rewards
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| (vii) | When this contract was let in 1995, the Service estimated that it would only deliver marginal savings of £1 million compared with conventional procurement. It was a much less attractive deal in financial terms than the Bridgend prison deal let at the same time to another consortium which was expected to deliver savings of £53 million on a similar sized contract. The refinancing appears, therefore, to give FPSL substantial further benefits on a contract which at the outset did not give the prospect of significant savings to the Prison Service (paragraph 37).
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| (viii) | The prison opened five months ahead of schedule and is considered by the Service to be an outstanding local prison which has paved the way for subsequent PFI contracts. But, given the scale of the improved benefits that have accrued to the consortium from this refinancing, the Service should have sought a more reasonable balance of risk and rewards for both the Service and FPSL. The gains should have been shared more equitably between the consortium and the Service (paragraph 38).
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| (ix) | Carillion told the Committee that it would earn a return of 15 to 17 per cent if it performed successfully on hospital projects, and that it deemed these to be more risky than prison projects. Carillion claimed that the investment return of 39 per cent which it now expected to make from the Fazakerley prison project was a misleading figure. In our opinion, however, the 39 per cent figure correctly reflects the increased returns that the FPSL shareholders will receive following the refinancing on an investment which has been reduced to a nominal amount (paragraph 39).
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| (x) | When assessing alternative PFI bids, departments should take into account the various revenues which shareholders of a consortium can earn from a PFI project, the likelihood of a refinancing occurring and how this may affect the balance of risk and reward, for both the procuring department and the service provider (paragraph 40).
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| (xi) | Although this was the first major refinancing of a PFI project, the Service chose not to make greater use of its adviser, NM Rothschild & Sons (Rothschild), in determining a negotiating strategy, and did not ask Rothschild to participate in the negotiations. Given the complexities of PFI refinancing and the potential financial consequences, departments should make appropriate use of experienced advisers in developing, and participating in, refinancing negotiations (paragraph 41).
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| (xii) | The Prison Service assured us that it has learned lessons from the Fazakerley prison refinancing, that it is securing rights to share in refinancing gains on current PFI prison contracts and that it is achieving improvements of up to 30 per cent in its PFI contract prices as a result of establishing a competitive market following the successful opening of the Fazakerley prison (paragraph 42).
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| On the need for further central guidance
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| (xiii) | Although PFI contracts with a capital value of approximately £17 billion had been let by July 2000, there was no central guidance on refinancing until July 1999, by which time most of those contracts had been let or were under development. The Treasury should aim to anticipate future issues where departments may require guidance rather than simply producing guidance in response to situations which have already developed. It should consult external experts and the National Audit Office about emerging issues where central guidance would be helpful (paragraph 51).
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| (xiv) | Many PFI projects, particularly where contracts were let in the early stages of the development of the PFI, are likely to be refinanced. The National Audit Office's analysis shows, however, that only 24 per cent of PFI projects surveyed included arrangements whereby departments are entitled to share in refinancing gains (paragraph 52).
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| (xv) | The Treasury and the PFI Policy Unit in the Office of Government Commerce (OGC) should therefore complete their planned updating of the central guidance on refinancing as a matter of priority (paragraph 53).
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| (xvi) | The opportunity for refinancing benefits appears, in part, to arise from the successful delivery of a PFI project. PFI deals should therefore reflect the benefit of the improved financing terms that are likely to arise through the successful delivery of the project. The benefit may be secured through the pricing of the deal or through a share of subsequent refinancing gains (paragraph 54).
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| (xvii) | The experience of privatisations shows that in some cases private sector investors have made much higher returns than they ever imagined. We advocated that such unexpected gains should be shared. Windfall refinancing benefits on PFI projects which have not arisen through a higher than expected standard of service from the private sector should similarly be shared between departments and the private sector. Because deals will not have been priced in anticipation of such gains arising, the prospect of sharing the gains between the public and private sectors will have no impact on the original pricing of the deals (paragraph 55).
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| (xviii) | All departments must give careful consideration to refinancing issues when they develop contractual arrangements with PFI consortia, taking account of the lessons from the Fazakerley prison refinancing and further guidance which the Treasury and the OGC may develop (paragraph 56).
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| (xix) | We look to the National Audit Office to carry out a further analysis at the end of 2001 of the extent to which PFI contracts allow departments to share in refinancing gains so that we can monitor progress on these important issues (paragraph 57).
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