Private Finance Initiative - Treasury Contents

Written evidence submitted by BDO LLP


1.1  BDO LLP is the award-winning UK member firm of the BDO international network, the world's fifth largest accountancy organisation, with more than 1,000 offices in over 100 countries. We have a dedicated Government & Infrastructure team—our team members have worked on over 200 public sector infrastructure projects undertaken through a mixture of procurement routes. We are committed to developing our business in this sector and are committed to the delivery of infrastructure in the UK.

1.2  We are pleased to have the opportunity to submit written evidence to the Committee's inquiry into the future of the Private Finance Initiative (PFI). Our submission focuses on the areas of our direct experience. We would welcome an opportunity to give oral evidence to the Committee and are happy to provide additional information.

1.3  There have been many successful PFI projects that have been delivered to time and budget, providing well designed and well maintained buildings. There are also examples of schemes that have suffered difficulties, particularly on earlier projects. The model has been refined, and continues to be subject to further improvements.

1.4  As set out in the National Infrastructure Plan 2010, there remains a need to continue to improve the UK's infrastructure and, to do this, there is a need for private finance. PFI is a valid option for many projects, but it should not be the only option, as it has been in some cases in the past. It should be used only where it is genuinely the best method to fund and deliver the specific project.

1.5  In some sectors, a new model may be required that adopts the successful aspects of PFI, but provides more flexibility to change the usage of the assets during the concession or renegotiate/terminate where appropriate.

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

2.1  There is not sufficient room in this submission to consider all procurement routes - we have outlined some methods but, as the inquiry is into PFI, have focussed on that method.

2.2  The procurement methods covered in this submission are:

2.2.1  PFI—the public sector pays a Unitary Charge to a private sector provider that designs, builds, finances and operates the facilities, usually for a concession of at least 25 years.

2.2.2  Design and Build—the public sector enters into a contract to design and build the facility, with the design sometimes provided by the public sector. Operation of the facility is undertaken separately.

2.2.3  Leases—a private sector developer builds the facility and leases it to the public sector. The private sector owns the asset, with the public sector body responsible for maintenance and insurance during the lease term.

2.3  It should be noted that many of the perceived weaknesses of PFI are actually weaknesses in procurement or project management that would have arisen under any procurement method. For example:

2.3.1  Client specification—there are examples of projects delivering facilities that do no meet the requirements. This has often been down to the public sector getting its specifications wrong and would have been an issue under any procurement route.

2.3.2  Demand - there are instances of facilities no longer being needed. These are not caused by PFI, but by poor planning. The issue would arise whatever the procurement route, but has been compounded by the long-term nature of PFI. The capital value would have been paid under traditional procurement, but operational costs could be terminated.

2.4  Similarly, a number of the "issues" highlighted are due to inconsistent comparisons. Critics point to "expensive" PFI projects by comparing total unitary charge to the initial capital value, but do not consider the fact that this is a total whole-life cost, as opposed to a simple repayment of capital. The public sector has not historically kept detailed records of the whole-life costs of its buildings, including lifecycle, facilities management and internal resource in managing separate contracts. Therefore, cost comparisons can be flawed. PFI appears more expensive as it is the only route that accurately includes all costs.

2.5  PFI—Background

2.5.1  PFI was introduced in the early 1990s to access private finance to allow a step change in the level of investment in Government jinfrastructure.

2.5.2  Over time, the PFI model has been, and continues to be, refined, with particular reference to lessons learned from earlier projects. This has led to a more appropriate share of risk on later projects—areas where risk transfer has changed significantly include refinancing and insurance. In addition, funding costs for both debt (subject to the lack of liquidity following the banking crisis) and equity have reduced as the risks have become better understood by all parties.

2.6  PFI—Principles

2.6.1  A Unitary Charge usually covers design, build, finance and operations. This allows an accurate assessment of the total cost of building and operating a facility.

2.6.2  The concept of "no service, no fee" ensures that the public sector only pays for infrastructure that has been delivered and is functioning correctly. Any instances of unavailability, or poor performance, lead to deductions from the Unitary Charge. This encourages quality design and build, as the private sector is responsible for the ongoing standard of the facility over the full length of the concession.

2.6.3  One of the major principles of PFI is the transfer of risk to the party best suited to manage it. In most cases, the private sector is better able to manage the delivery of infrastructure and, therefore, it is a benefit to pass this risk to the private sector. If the infrastructure is poorly designed and built, or poorly maintained over the life of the concession, the public sector will not have to fund any remedial works—indeed, the public sector can make deductions from the PFI payments if the infrastructure does not meet the required standards.

2.6.4  Risk of delivery to time and budget is passed to the private sector on contract signature. The majority of PFI projects have, therefore, been delivered on time. The public sector does not pay for the service until it is delivered, which is a powerful incentive to the contractor. In addition, any cost overruns in construction are at the private sector's risk.

2.7  PFI—Lessons Learned

2.7.1  PFI has introduced private finance to government infrastructure, allowing a greater level of capital investment. This need for private finance is highlighted in the National Infrastructure Plan 2010. However, PFI should be one of a number of options to access this funding, and should be used only on suitable projects and where the long-term payments are affordable.

2.7.2  PFI has led to a robust and rigorous procurement process. The involvement of private sector funders, and the due diligence required by these funders, has been one of the factors in this. However, due to its complexity, the procurement process can be lengthy and costly - early projects typically took over 24 months to procure. Standard documentation and commonly used principles have shortened procurement timescales to, typically, 12-18 months, with scope for further reductions.

2.7.3  The Unitary Charge allows simpler budgeting for public sector bodies and ring-fencing of budgets to cover lifecycle in future years and ensure that the assets are properly maintained. This has brought benefits but also added to the perception that PFI is expensive as this maintenance (and associated cost) is mandatory and accurately recorded. Historically, the public sector has not always properly maintained its estate-this is cheaper in the short-term but can lead to poorly maintained facilities and expensive remedial works when the need arises.

2.7.4  One of the fundamental principles of PFI is risk transfer. However, it must be appropriate risk transfer. On early projects, there was a push to transfer as much risk as possible, but this came at a cost. This has been, and continues to be, refined so that the principle is based on the risks being managed by the party best placed to do so. Experience of operational projects also provides a more accurate quantification of the value of risks, which leads to better pricing and negotiation of contracts. However, it is still difficult to accurately compare against other procurement routes as the data is not as accurately recorded. PFI may appear expensive but, in reality, it includes costs that are not included in headline figures for other routes.

2.7.5  It is generally accepted that the private sector can apply a contingency to cover risks transferred. However, in some early cases this contingency was disproportionate to the risk. There is currently no mechanism for the public sector to share in any savings on unused excessive historic contingencies. This is being refined on some new projects, and is also being revisited on some operational projects.

2.7.6  There have been examples of expensive projects due to excessive performance standards being specified by the public sector client. This can be the case on non-PFI projects, but is exacerbated by the long-term nature of PFI. Currently, many public sector bodies are considering renegotiating contracts based on relaxing these standards to more realistic levels, for example wider temperature ranges. In addition, the public sector has recognised this issue and it is not as prevalent on newer projects.

2.7.7  There can be a lack of flexibility during the operations stages. This can range from difficulties in changing the usage of the asset, to disproportional legal and funding costs in providing small-value works to remodel the facility. This remains an important issue and one which is being further refined in newer projects. This should be considered in any new mechanisms.

2.7.8  The complexity of the PFI contractual documentation, coupled with a lack of resource and/or experience in public sector bodies, has often led to contracts being poorly managed. Many public sector bodies do not enforce the contract due to a lack of understanding, or a lack of time or appropriately qualified resources to check the deductions. There needs to be better monitoring by the public sector.

2.8  PFI is a sound model, and one that has been adopted successfully in a number of countries. There have been project failures, but these are rare. Lessons from these failures have been used to continually refine the process to provide a robust model of procurement that also provides access to private sector funding.

2.9  However, it must be applied correctly—it could be one of a number of procurement options available for infrastructure projects, and used only where it is genuinely the best method to fund and deliver the project.

2.10  Design and Build

2.10.1  Strengths include:

(a)  simpler and quicker procurement route than PFI. In addition, there is a lower cost of procurement and less need for external advisers. However, external advice should still be used as appropriate, for example on technical issues;

(b)  contractual documentation is simpler than PFI;

(c)  flexibility during the construction stage—designs can be updated and the design & build contract renegotiated;

(d)  different contracts can be let for different services, eg build and operations, or they can be delivered in-house, to ensure that each is provided by the most suitable organisation rather than a "one-stop shop"; and

(e)  flexibility to change usage of the asset and/or remodel at a later stage.

2.10.2  Weaknesses include:

(a)  risk of projects being delivered late and over budget (the public sector's track record was one reason cited for the introduction of PFI). The public sector maintains the risk of these overruns but is not always well placed to control them. There can less discipline in design which leads to costly changes during the build phase;

(b)  flexibility during construction is costly; and

(c)  assets have not been maintained properly, leading to an outdated estate that, in many cases, does not meet legal requirements for Health & Safety or DDA. When maintenance is undertaken, it is often reactive and more costly than if it had been undertaken before the problems had arisen.

2.11  Leasing and developer projects

2.11.1  Strengths include:

(a)  procurements can be faster than PFI;

(b)  no need for upfront capital funding—the asset will be leased on an annual basis; and

(c)  greater flexibility to change usage, or end the agreement. However, there are still limits and any remodelling will need to be agreed by the developer.

2.11.2  Weaknesses include:

(a)  public sector will never own the building. At the end of the lease, it must either negotiate an extension or find alternative premises;

(b)  potential penalties for the public sector if the asset is not maintained or insured;

(c)  as the developer owns the asset at the end of the lease, it will factor the cost of converting the building for alternative use into the lease cost. This can be excessive if the asset is a specialised building; and

(d)  borrowing costs are more expensive than the rates at which the public sector can borrow itself, or can be accessed for PFI projects (due to their long-term nature).

2.11.3  This route is best suited to facilities that are easily convertible to alternative uses, for example offices or non-specialised courts.

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?

3.1  The balance sheet treatment of PFI debt was undoubtedly an influencing factor in the use of PFI. As the granting of PFI funding was dependent on debt being off-balance sheet, there were examples of structuring projects to ensure the correct balance-sheet treatment, rather than to provide the best value for money. However, in recent years accounting standards have changed, leading to most PFI debt being accounted for as on-balance sheet for individual Government Bodies, and the use of PFI has continued with structures best suited to the projects, rather than the accounting treatment.

3.2  In future, PFI deals should be accounted for in line with International Accounting Standards. The accounting treatment should not be a deciding factor in the use of PFI—the procurement route should be assessed based on the best delivery vehicle for each project.

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

4.1  PFI has seen a genuine transfer of risk from public sector. Essential to the success of a project is not "how far is risk transferred?", but "have the most appropriate risks been transferred?"—any risk transferred is done so at a cost and, if the private sector is not able to control the risk, it will increase the price to include a contingency. Some early contracts attempted to transfer unsuitable risks, leading to long negotiations and high prices.

4.2  As in other areas of PFI, risk transfer has improved in later contracts. For example, an equitable share in insurance risk is reflected in lower contingencies being applied by the private sector. Also, there has been a reduction in the size of lifecycle funds as experience of operational projects and the actual level of lifecycle required has grown.

4.3  Standard contracts have also been helpful in maintaining a consistent level of risk transfer, and in reducing the time spent negotiating this transfer.

4.4  It is important that there is sufficient risk transfer to incentivise the private sector. The underlying principle of all PFI contracts must be that there is no payment if there is no service—the risk of non-delivery must entirely lie with the private sector.

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  It is important to ensure that the risks transferred are those that can be managed by the private sector more successfully than the public sector. One of the fundamental principles of PFI was that the private sector is better at designing and building infrastructure to time and budget—therefore, the transfer of the risk of doing this is central to the model.

5.2  A risk that generally remains with the public sector is demand risk, unless the private sector can genuinely control demand (eg by providing a "better" road or promoting waste recycling). However, this has led to some facilities that are no longer needed still being paid for through a PFI arrangement. This demonstrates that projects that require flexibility of usage are not best suited to the current PFI structure.

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

6.1  It is recognised that the state stands behind all PFI transactions, which provides a stronger covenant than the private sector. This covenant has led to lower debt and equity borrowing costs than could be accessed for a similar project in the private sector, if such long-term funding is available at all to the private sector.

6.2  It should be noted that funder margins have reduced since the introduction of PFI as funders became more comfortable with the risks involved. Margins did increase post-credit crunch, but this was a reflection of the reduced liquidity in the market, rather than profiteering.

6.3  However, irrespective of covenants, the PFI payments are only made if the contractor performs to required standards.

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

7.1  As outlined in Section 2 above, PFI has a number of strengths, and it should be used to deliver services where these strengths can be applied.

7.2  The circumstances that lead to PFI being suitable for delivery include:

7.2.1  defined usage for the length of the concession—both type and demand for usage. Some refinements would be needed to the current model if significant changes were required during the concession period;

7.2.2  access is needed to private sector financing;

7.2.3  complex design and build that is better managed by the private sector; and

7.2.4  a market for the project that will lead to genuine competition and value for money.

April 2011

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© Parliamentary copyright 2011
Prepared 10 August 2011