APPENDIX 1
PFI PROJECTS AND RISK TRANSFER
Letter to the Clerk of the Committee from
HM Treasury
At the Committee's meeting on 24 January the
Chairman asked me about some of the implications of risk transfer
in relation to PFI projects.
The point that concerned the Chairman was that
the assumptions being made about risk transfer might be open to
question in that the nature of many projects was such that, should
the private sector partner fail to deliver, the department had
no option but to rescue the project. Possible implications of
this that the Chairman mentioned were:
(i) if the contract dealt with this providing
the department with the power to take over the assets, and perhaps
the company operating them, it would produce a financing problem
for the private sector PFI partner as he would have nothing of
offer as security;
(ii) it could have implications for the balance
sheet treatment of the PFI project and its classification for
public expenditure purposes;
(iii) (a point made at the following week's
hearing) the price that the department has paid for nominally
transferring the risk to the private sector may not be justified
as, if the project failed, the department would pay again to pick
up the pieces.
The Chairman's point underlines the importance
of a thorough and realistic assessment of the allocation of risk
when embarking on PFI projects, as with any other procurement.
Current guidance (which did not exist at the time the Royal Armouries
project took place) emphasises that risk should be allocated to
whoever from the private or public sector is best able to manage
it. The public sector body should therefore seek the optimum,
not the maximum, transfer of risk (see, for example, para 3.18
of the Treasury's "Partnerships for Prosperity").
The importance of business continuity may be
such that the risk of ultimate failure is one that sometimes cannot
be transferred to the private sector. In the case of an operational
facility, such as a hospital, it would be normal in current contracts
to have provisions enabling the public sector partner to take
over the assets and their operation and/or to seek a new private
sector partner. The contract may provide for the private sector
partner to receive compensation for the transfer of assets to
the public sector, thus addressing the problem of security for
the project's financing that the Chairman identified.
Moreover, in general, PFI deals are structured
so that, if the contractor gets into difficulties, there is a
strong incentive on the financier to step in and either get the
contractor back on track or, if that is not possible, replace
him with an alternative. It is only where both these options fail
that the department would normally step in. In such circumstances
the financier's interests in the underlying capital asset would
be protected under the direct agreement with the department; however,
the financier would lose his other costs. It is important to bear
in mind that the power to step in and keep the service going does
not necessarily mean that the contractor will be rescued or, if
he is, that he will not pay a substantial financial price. There
is no question of compensating the contractor for his losses.
If a proper allocation of risks is identified
at the beginning in accordance with current guidance, then the
dangers that the Chairman identified should be avoided. The department
should not end up paying for the transfer of risks that in reality
have not been transferred and the balance sheet treatment of the
project (for which there are accepted accounting standards) should
not be compromised.
The Chairman may also have had in mind the possibility
of a department's views changing about the proper allocation of
risk between the time the contract is signed and a subsequent
failure of delivery. Views might perhaps change because of a change
of policy. There may be a number of options available for rescuing
a project in difficulty when this was not originally provided
for in the contract and the effect on accounting treatment may
differ depending on which option is selected. Some options may
lead to the project moving onto the department's balance sheet
and there may be public expenditure consequences. Other options
may not have those consequences.
Brian Glicksman
Treasury Officer of Accounts
9 February 2001
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