Written evidence submitted by Hogan Lovells
1. INTRODUCTION
AND EXECUTIVE
SUMMARY
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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