Written evidence submitted by BDO LLP
1. EXECUTIVE
SUMMARY
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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