Private Finance Initiative - Treasury Contents

Written evidence submitted by Hogan Lovells


1.1  Hogan Lovells has one of the largest global legal practices covering public infrastructure and services (including PPP and PFI). We regularly represent financial institutions, project sponsors, investors, contractors, private equity funds, export credit agencies, governments and government bodies on some of the world's largest and most challenging projects in Asia, Africa, Europe, Latin America, the Middle East, and the United States. We are active in all sectors such as energy, transport, social infrastructure and defence and aerospace.

1.2  In addition to the Private Finance Initiative and other forms of Public Private Partnership, we advise clients on transactions involving the full range of public procurement delivery models, including conventional procurements (such as design and build/service agreements, DBO, service outsourcing and partnering).

1.3  We advise on a "for profit basis" but are also one of the most active firms working on a "not for profit"/pro bono basis. Our pro bono work extends to very substantial infrastructure and PPP advice on both a project and Government policy basis (including projects such as the Haitian reconstruction), working with world leading organisations. We care about best practice in the procurement of global infrastructure and public services for all.

1.4  We have no institutional preference for one procurement route over another: PFI/PPP models are just one of a number of structures available in the procurement "toolkit".

1.5  It is clear that much of the public debate around PFI in the UK has, to date, been largely political rather than based around economics or best procurement practice. Although this is inevitable, it is largely unhelpful and represents a lost opportunity.

1.6  In our view the Private Finance Initiative is not a panacea, nor is any other procurement model. Our comments here are focused on PFI due to the questions raised and we have not set out a comprehensive comparison with the other procurement models. PFI needs to be used on the "right" deals and by sophisticated procurement teams. When used properly, in our view, it has generally delivered favourable results compared to the alternative procurement models.

1.7  Clearly PFI has some weaknesses. The cost on some deals of minor variations is the most often cited example. Whilst this reveals an issue that needs to be addressed, these kinds of issues are largely irrelevant/marginal to an accurate cost/benefit analysis of PFI. Indeed there are almost certainly as many or more similar examples of the excessive cost of variations on conventionally procured projects in the public sector. Another key issue previously identified is lack of flexibility (largely in that PFI has created some large projects which have then turned out to be unwanted (or not needed as much as first thought)). Where that is the issue, the issue is one of project selection rather than procurement approach - there is no difference in the position on this as between PFI than conventionally funded projects.

1.8  It is worth noting that in evaluating issues, one needs to pay careful attention to differentiating between substance and politics/what makes a good story. One also needs to evaluate carefully whether issues which may have arisen on PFI projects have anything whatsoever to do with their being PFI (as opposed to being building projects/services in a particular industry sector).

2.  What are the strengths and weaknesses of different public procurement methods?

2.1  The different public procurement methods have substantial differences. Some key differences and brief comments, focused on PFI, are below:

(a)  Level of risk transfer. This is traditionally much higher on PFI than conventional projects. This has generally resulted in PFI achieving better performance for projects completing on time, to budget and defect free. Risk transfer could be increased on conventional projects. However, the primary instrument of risk transfer on PFI is placing the overarching risk with debt and equity over the whole life of the project and this cannot be achieved if the project is paid for up front. This feature of PFI not only underpins the risk financially but also has a dramatic effect on the quality of risk/project planning that flows from capital being at risk. This cannot be replicated simply by process (eg commitment to better planning of projects by the public sector) for a variety of reasons tried and tested over time.

    Sometimes risks have been transferred which have probably not been good value for money (eg insurance cost), but that is simply Government's choice and could apply under any procurement approach and is not inherent in PFI.

(b)  Level of public sector expertise required. PFI requires a sophisticated client at the procurement stage and there have been some poor procurements. The necessary skills are now largely available through the supporting organisations (eg PUK/IUK etc and the relevant industry sector equivalents). Post contract award a lower degree of expertise is required compared to self providing or managing a contract with a high degree of retained risk.

(c)  The extent to which whole life costing is incentivised. This is a fundamental feature of PFI and, we believe, has fundamentally improved the quality of procurement and planning/building - we doubt anyone would disagree. Inclusion of the concept has been attempted around the periphery of other procurement approaches but without long term debt and equity at risk we believe those attempts are largely meaningless.

(d)  Duration and amortisation of payment. PFI is the only method which integrates long term amortisation. The cost in terms of debt and equity return is a matter of financial evaluation.

(e)  Use of Output Specification. PFI has been key to the introduction of output specification approaches within procurement although they can be applied (and are applied) under a variety of other procurement approaches. This has been a positive development in the market. The downside has been occasional temptation by procurers to leave it to the private sector to specify what the public sector needs rather than how the private sector can best deliver the output that the public sector specifies it needs.

(f)  Performance incentives and the "no service no fee" principle. In our view PFI is strong in this area. Whether the public sector is strong in operating the contracts so as to enforce its rights, time will tell. However, in general we believe performance will be good because debt and equity will have a clear understanding of what is expected and cannot afford the consequences of failure.

(g)  Procurement duration and cost. PFI is slow and costly during the procurement phase. We believe it could be substantially improved and there are clear comparisons which show the UK in an unfavourable light compared to other jurisdictions. Again much of the issue probably comes down to UK practice, politics and the structure of procuring bodies. The important point though, is that generally "a stitch in time saves nine"; it is far better to spend time at the planning/procurement phase than to press ahead without proper planning and to pay the time and cost consequences later. Getting this wrong has been a traditional widespread problem of procurement outside of PFI for many years (in both the private and public sectors), usually driven by short term political or commercial expediency.

3.  If PFI debt had been on-balance sheet rather than off-balance sheet would PFI projects have been used as much? How should PFI deals be accounted for?

We believe this issue is better answered by others although we note that for many years, post the earliest days of PFI, the rationale has been value for money rather than off-balance sheet debt. We do not recall projects which proceeded which were evaluated as more expensive than a conventional approach simply because they were off-balance sheet.

4.  How far can risk really be transferred from the public to the private sector?

4.1  In short the answer is pretty much completely. The only real limitation on risk transfer has been the public sector's view on the value for money of transferring any particular risk. This is no different to the view that any purchaser on any procurement model takes in deciding which risks it wishes to transfer and the associated cost.

4.2  Where there have been time and/or cost overruns on PFI transactions, the associated costs have generally been absorbed by the private sector. As the procuring public sector entity does not bear the risk of such overruns, it is not privy to information as to the sums of money involved and therefore such matters receive very little coverage in government reports, inquiries or the media.

4.3  If the question is concerned with the political risk of public services failing then the protections against this are almost certainly much stronger than where they are retained by the state. Further, Government retains rights to "step-in" or take back contracts where there are problems so it is no worse off even in the worst case scenario. In contrast to conventional procurements, Government is much better protected in the case of serious risks occurring and (in the worst case) of contractor insolvency. In conventional procurement that risk is ultimately borne by the public sector. On PFI it is born by equity and debt. The contracts provide that the cost of the risk is deducted from any money due to debt/equity, on a default termination, for the value of the asset Government retains. This would not generally be the case on a conventional procurement.

4.4  The exceptions to the principle of full risk transfer are the very, very few deals where Government has given some kind of "debt underpin" (which are a matter of public record). In relation to these transactions, the use of a debt underpin was a decision made by the procuring authority: the authority made a value for money judgement on the level of risk it wished to transfer. On these very unusual deals Government chose to guarantee a certain level of debt repayment (and thereby underwrite risk) for value for money reasons. Whilst interesting in themselves these deals have nothing to tell us about the procurement technique and the ability or success of risk transfer under PFI, although they may have lessons for Government in terms of its procurement choices.

4.5  The nature of the question displays a lack of understanding of the basis on which most PFI deals have been done, and reflects the disproportionate press coverage. The better question is the transfer of which risks represent value for money for Government. This question is no different on PFI to any other procurement model. High or low degree of risk transfer is not inherent to PFI, although Government opted for comparatively high degrees of risk transfer. That could easily be changed although our personal view is that would be a mistake (save for a small number of risks which are probably not vfm). See below.

5.  Are there particular kinds of risk which are particularly appropriate for transfer through PFI deals, or particular projects which are suited for PFI?

5.1  Projects which are suited for PFI

(a)  Subject to the exceptions stated below, any project which involves substantial asset provision in which Government or the public sector/public will have an interest over the "whole life" of the asset is suited to PFI.

(b)  PFI projects need to be of a certain size in order to be value for money, given the higher procurement costs. This is reflected in the government's position that PFI is not suitable for projects with a capital value of less than £20 million. However, the degree of market commoditisation for a particular type of transaction is also a relevant factor in determining whether the procurement costs will be disproportionate.

(c)  Even where the above two conditions are satisfied, PFI is rarely suitable for procurement involving complex software development or novel technology risk which is unlikely to be financeable in the market.[45]

(d)  Finally, we would observe that what may be viewed as an "excessive price" for transfer of a particular risk on a PFI deal is obviously the price of that risk, as assessed by the market. It is therefore the "real" price of such risk, which is effectively borne by the public sector on a conventional procurement of a project involving that same risk. In some cases Government may get better value by retaining the risk because of its wider portfolio and risk spreading, but there are obvious downsides.

5.2  Risks which are appropriate for transfer through PFI

(a)  This topic has been explored in enormous detail in the Government standard forms and the endless negotiation on deals which has resulted in the current settled market view of appropriate risk allocation. We refer to the comprehensive discussion of the subject, which is broadly accurate, contained in the SoPC 4 guidance on contract terms for PFI.

(b)  There is some history of Government being very aggressive in transferring risk, where the market has pointed out that it would not be value for money to do so. An example is the approach taken in relation to increases in insurance premia, political risk, public sector credit risk and capital expenditure arising from general changes in law; similarly, the approach taken in respect of indexation on conventionally procured deals. Transfer of some of those risks in some circumstances may not be best value/sensible.

6.  What state guarantees are explicit or implicit in PFI deals?

6.1  As noted above, there have been a small number of exceptional deals which have involved explicit state guarantees by way of debt underpin.

6.2  There are no implicit guarantees inherent in PFI transactions. The question is presumably driving at whether it is implicit that Government will rescue these deals because they involve national infrastructure. Government can, but is not obliged to, take back the contract and re-let it. Where it does in almost all deals any losses/additional cost is for the private sector's account.

7.  In what circumstances are PFI deals suitable for delivery of services?

7.1  Service delivery is inherent in all PFI deals - there is no payment other than for service. We assume the question is about scope of service - this is a political issue and has much to do with the political status of the welfare state in the UK. PFI deals in themselves are suitable for the delivery of a wide range of services connected with the various assets/sectors for which the technique is used.

7.2  The private sector provides a broader range of services in many other jurisdictions' versions of PFI, when compared with the UK. In broad terms, PFI/PPP as an approach is growing as a global trend leading to an increased diversity of services being included. We are not aware of particular problems being identified (other than political issues) other than the issues identified above eg around software development services.

7.3  In summary our view is that it is for Government is to take a view on what services it wants, as a political matter, to be provided by the state and which services it wants the private sector to provide. We believe the general trend has been that private sector involvement and the efficiency and innovation that it brings is generally perceived to have positive benefits and beyond that, it is simply a question of whether the market price is acceptable to Government.

April 2011

45   Note that it is well known in the market that there was a series of catastrophic conventional procurements of IT before PFI was attempted. Back

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Prepared 10 August 2011