Written evidence submitted by Meridiam
Infrastructure
EXECUTIVE SUMMARY
Meridiam is a leading long term PPP or PFI infrastructure
investment fund in Europe and North America with a highly experienced
team focusing on greenfield PPP projects in the transportation,
social and environmental sectors. Meridiam firmly believes that
PPP is the most effective form of procurement for £100 million+
single or grouped infrastructure projects due to the significant
effects of whole life costing providing enhanced long term service
provision to the public.
PPP is now being utilized around the world as an
efficient tool for service provision allowing transfer of significant
risk to the private sector.
There have been concerns that PPP contracts are inappropriately
expensive, and that private sector providers have been making
excessive profits from investing in PPP projects. Meridiam believes
strongly that PPP is the most effective form of procurement however
it does recognize that PPP procurement in the UK can and should
be improved.
What are the strengths and weaknesses of the different
public procurement methods?
1. The main strength of PPP is that it delivers
projects on time and on budget through fixed contractual arrangements
agreed at the outset. The PPP contractor takes responsibility
for the construction and the maintenance of the projects and so
eliminates the need for new spending to meet unexpected demands.
2. It used to be the norm in the public sector
(see a number of Ministry of Defence projects for example) that
constantly changing specifications not only delayed any construction
but greatly inflated the cost. And in the past the public sector
often had to meet unexpected maintenance costs as the fabric of
buildings deteriorated and resources were depleted through wear
and tear.
3. Before PPP was introduced infrastructure development
in the UK lagged behind other European countries. There are now
more PPP infrastructure projects in the UK than in any other country.
Without access to PPP funding the new build of hospitals, schools
and other infrastructure projects would not have been possible.
Its success is reflected in the number of countries now adopting
it. Meridiam believes that it will be difficult for the UK to
meet its National Infrastructure Plan targets of expenditure of
£200 billion on infrastructure without PPP as it is a well
supported and effective route for mobilising private sector capital.
4. The PPP process can be improved. Too often
it begins before the 'clients' have a clear idea of what they
want to achieve, and bidding processes have been far too long,
some projects taking two to three years to come to fruition. Protracted
negotiations can cause high costs to all amid indecision about
final outcomes. Understandably individual purchasers within the
public sector often do not have the procurement expertise—we
believe the UK should look at the Canadian model which has central
procurement bodies on a province by province basis.
5. Long term approaches are the most effective
but need real up front agreement between public and private sector.
Meridiam supports partnerships between the public and private
sectors together with sharing of risk and return. This is particularly
the case in respect of refinancing, establishing ceilings for
returns together with sharing of upside benefits on a balanced
basis.
6. Changes in policy and technology cause strain
and are invariably costly. Projects that prove the best value
for money are those clearly defined from the outset, least subject
to interference from the procuring authorities, and funded over
the long term on fixed rates.
7. It is however recognised that the public sector
requires flexibility as policy changes—Meridiam believes
that such changes are better incorporated through formula incorporated
under the overall umbrella of long term contracts rather than
shortening the overall horizon of PPP contracts. For example,
if the public sector wished to incorporate a "de-scoping"
of service provision that resulted in lower cost then the availability
payment could be decreased taking into account the overall costs
of the PPP.
8. Traditional procurement allows for direct
control and management of contracts, competitive processes, lowest
cost Government funding, potential to reach the lowest price for
a defined asset, comfort in obtaining control of design. We would
argue that the strengths are outweighed by the weaknesses of no
long term maintenance, no protection from claims or cost over-runs,
the need to dedicate from day one public budgetary resources to
finance the totality of the project's costs upfront, interface
risk assumed by the Government, directly incurred management costs.
9. Several projects using the traditional procurement
route have experienced significant cost over-runs and delays,
In the UK, the following projects: Millenium Dome, Jubilee Line
and Wembley Stadium. Elsewhere in Europe: major projects such
as the Stade de France, the Spanish high speed line rail programme
or the construction part of the Dutch high speed line rail programme.
It is not always easy to prove that a PPP route would have been
more successful but the L2 project in Marseille (France) is an
interesting example: due to numerous delays, notably caused by
difficulties in providing budgetary resources to the project in
a timely manner, the project, initiated before World War II, has
experienced significant cost overruns and redesign, eventually
leading the French Government to decide to implement it as a PPP.
10. PPPs have provided strong value for money,
consistently delivering high quality outcomes on-time and on-budget.
Indeed the performance of PPPs has been so impressive that over
20 OECD countries use PPP procurement.
11. The whole-life costing is a key component:
it considers what maintenance will be required over the PPP contract
as well as the cost of the asset. Usually under traditional procurement
only the building cost was considered and no funding for the running
costs allocated at the outset of the project.
12. PPP procurement incorporates dedicated and
focused private sector operational management allowing the public
sector to focus on such areas as policy and regulation.
13. PPP projects involve long term risk transfer
from the public to the private sector and incorporate a whole
series of costs beyond funding. They include bidding, delays,
development costs, land acquisition, lack of income from the outset
in greenfield projects, contingencies for construction risk/delay
and operational risk, management costs and contingencies for risk
sharing with the public sector.
14. Under PPP, subcontractors may be replaced
for poor performance or bankruptcy without any cost to the public
sector. Under traditional procurement the costs of such replacements
usually impacted on the public sector purse after long and protracted
negotiations which also resulted in delays in the project.
15. All these factors are potential risks to
the private sector and therefore add a premium to the government
risk free rate. And because the risks are priced from the outset
and are reflected in the contract it is not appropriate just to
focus on the funding cost when comparing traditional and PPP procurement.
16. There have been concerns that PPP projects
are inappropriately expensive and that private sector providers
have been making excessive projects from investing in PPP projects.
Sometimes this may be due to a lack of understanding of the PPP
methodology. Individual items purchased under a PPP contract are
rarely priced in the same way as items in a supermarket so it
is not sensible to compare costs of individual items. Items purchased
under a PPP contract should be considered as part of the total
package of cost including the pricing of the risks above and the
cost of outsourced management of these risks.
17. The capital structure of a PPP project contains
both debt and equity (on around an 85:15 to 90:10 ratio). Equity,
the repayment of which is not guaranteed, is required to act as
a buffer for risks. And while it is more expensive because of
the uncertainty that surrounds it, without equity funders would
require guarantees from the government, as is the case in the
'forfaiting' model for infrastructure procurement in Germany.
18. The direct comparison between actual cost
of funding for Government and for PPP SPVs is therefore unfair
at best and disingenuous at worst as it does not take into the
different allocation of risks in the two situations.
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?
19. Accounting for PPP projects off-balance sheet
was a stimulus for more projects to be undertaken when there was
an apparent lack of funds for the creation of new infrastructure,
and many countries, not only the UK, aimed to remain within the
Maastricht rules. With the changes in the accounting methods used,
and the fact that many countries are entirely in breach of Maastricht
rules in 2011, this question really just has historical interest
now. The much closer scrutiny of government balance sheets mean
that off balance sheet contingencies are more often being included
in total indebtedness, and that reasons for doing PPP procurement
are now to gain efficiency in delivery rather than some apparent
benefit in getting round rules that are not longer apparently
relevant.
20. Of the 22 countries surveyed at the annual
OECD PPP meeting in April 2010, 20 countries are using PPP and
only four said PPP would be more attractive if the debt was not
on the balance sheet. Indeed in a number of countries, until recently
less financially constrained, such as the Netherlands, Denmark,
Finland and Norway PPP was explored and is being utilized as a
long term delivery method.
How far can risk really be transferred from the
public to the private sector?
21. Construction risk is transferred in PPP projects
from the public sector to the private sector. Fixed price, date
certain contracts are the norm with no facility to make new claims
on the public sector purse if unforeseen difficulties arise. There
are a number of examples where major construction problems have
arisen but a facility has been delivered for public use such as
the A13 PPP road project, Dudley Hospital and the Croydon Tramlink.
Even if a project has to be cancelled due to construction failure,
due to the financial structure with private sector equity and
debt being drawn down to pay for construction and there being
no payment until the end of construction this mean that there
will be no public sector payment for failure. Where public sector
grants are involved, such payments are usually made only when
construction milestones are reached.
22. Maintenance contractors, if they are incompetent,
can be also be terminated at no cost to the public sector as the
risk relationship is not between the public sector and that contractor,
but between the public sector and the PPP SPV and it is the SPV
that will face payment deductions in the event of poor maintenance
performance.
23. Equity risk is transferred—investors
who put money into PPP SPVs as providers of equity are not protected
in relation to their return or indeed the security of their investment.
Debt risk is not transferred as comprehensively as debt funders
have more access to potential public sector compensation due to
contracted termination payments.
24. Bidding cost and development risk have largely
been transferred to the private sector as consortia winning for
projects rarely have a stipend to cover their lost costs if they
are unsuccessful and such costs end up on company balance sheets.
A majority of the funding, and liquidity risks have been transferred
to the private sector.It is appropriate to consider whether the
cost of transferring risks to the private sector is appropriate
to their benefit. There are a series of shared risks such as insurance,
archaeological risk, certain environmental risks that have partially
been transferred to the private sector at a cost and consideration
should be given to whether this cost indeed presents the best
value for money for PPP procurement.
Are there particular kinds of risk which are particularly
appropriate for transfer through PFI deals or particular projects
which are suited for PFI
25. PPP can ensure that a wide variety of risks
may be transferred but cost and experience are key. There is no
point in the private sector taking on a risk and making a huge
contingency in their pricing to take account of the effects of
that risk or being unable to cope with such a risk that would
cause the collapse of the company running the PPP. PPP risk transfer
needs to look closely at whether risks being transferred are at
the right cost. All the risks we say are transferable may be done
so at a cost that still meets a government private sector comparator
under competitive conditions.
26. Partial user paid risk in PPP projects can
be transferred where there is existing income from an existing
route (Nottingham Tram), public sector revenue support (Limerick
Tunnel), where an extension is involved (A5 Germany), where user
risk relates to block movements (Tours-Bordeaux High Speed Rail),
where there are limited alternative routes or to ease heavy congestion
(Texas motorways). Existing revenue makes the prospect more palatable
for investors and Meridiam (all Meridiam projects in brackets)
believes this risk can be fully transferred as part of a user
paid PPP project.
27. The benefits of using the PPP procurement
focus relate to the creation of long term and stable assets that
are the results of long term planning, and technology based PPP
projects do not exhibit these features. Meridiam believes that
IT projects are not really appropriate for PPP treatment as they
tend to require a series of technology upgrades and long term
corporate guarantees.
28. Best suited are road and rail construction
projects, bridges, tunnels, urban and high speed travel, energy,
social accommodation and environmental projects such as wastewater
and waste management that can be created as part of a long term
and agreed partnership between public and private sectors.
29. Size is another criterion—given the
development costs of PPP projects unless a project has a particular
mass, of say £100 million or more, then the costs of around
£1-2 million per project can be disproportionate to the long
term benefits gain from whole life costing.
What State guarantees are explicit or implicit
in PFI deals?
30. The state has always tried to avoid having
explicit guarantees in PPP deals where the aim was to present
PPP transactions as being off balance sheet.
31. Certain countries such as France do use explicit
state guarantees in PPP projects. In France the "cession
Dailly" is used, which is a financial mechanism enabling
lenders to bypass the project company to get direct payment by
the public authority as soon as the asset construction is considered
to have fulfilled the public authority's requirements. It is Meridiam's
conviction that such mechanisms, may create misalignment of interests
and therefore reduce the economic rationale of the use of a PPP.
There are no such mechanisms in the UK.
32. Some state guarantees may be implicit in
that if there is a project with a compensation on termination
structure, if there is project failure then the state will pay
amounts agreed under such compensation but there are a lot of
stages that need to be gone through before payment is made—it
is never an on demand guarantee from the state. If the project
is strategic and falls into difficulty then the state will be
likely to repurchase the project to ensure that it keeps working
and will effectively 'buy' the capital value of the project from
the banks.
33. PPP project creditworthiness relies on the
credit of public authorities, which under availability schemes
remunerate the private partner in exchange for performance. Investors
expect the public authority to respect its financial commitments
as soon as the private partner meets the predefined performance
requirements.
In what circumstances are PFI deals suitable for
delivery of services
34. Meridiam's vision of any PPP is that it is
linked to the delivery of services, the underlying infrastructure
asset being only a way to reach the objective in terms of service
provided to the public. The essence of PPP, compared with the
traditional procurement route, is notably to put the idea of service
and performance at the core of the infrastructure project.
35. Nevertheless, the rationale of PPP deals
for a "service only scheme", ie without the existence
of an underlying infrastructure asset, may prove not obvious and
appears close to already existing "outsourcing".
ABOUT MERIDIAM
36. Meridiam Infrastructure is an infrastructure
fund manager focused solely on public private partnership equity
investment in the transport, social and environment sectors. Based
in Luxembourg with offices in Paris, New York and Toronto, the
fund manages assets of c €1.5 billion and invests in countries
that are members of the EU, OECD in Europe and North America.
37. Meridiam acts as a bidder and developer of
PPP infrastructure projects from the first bid stage, as investor
and operational manager, and invests with no divestment for a
period of 25 years. By the end of 2011 it will have invested in
17 projects in nine countries, including the UK, with an average
investment per project of £40 million.
38. Meridiam's investors are mainly state and
municipal pension funds, insurance companies and development institutions
(EIB and the Development Bank of Japan) from member countries
of the OECD. Meridiam looks for stable returns for its investors
over the 25 year life of the fund with annual cash yields of around
5% rising to 10%-15% in the latter years of the fund.
39. The Meridiam infrastructure team is highly
experienced, bringing together international engineers, ex-government
officials, project financiers and project operators each of whom
have 10 to 20 years' background in procurement in the public and
private sectors. They have experience of different procurement
approaches and are convinced that PPP is the most efficient and
cost effective procurement vehicle in the long run.
40. PPP is used interchangeably in this note
with PFI as Meridiam believes there is really no difference between
the two descriptions in the segments where Meridiam operates.
April 2011
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