Written evidence submitted by the PPP
Forum
Established in 2001, the PPP Forum is the private
sector industry body for public private partnerships delivering
UK infrastructure. Across our membership we have been involved
in the UK PFI industry since its inception as constructors, lenders,
advisers and service providers and this expertise is now being
exported globally. The majority of our membership is also involved
in other types of UK government procurement and as such we can
lend a credible voice to the benefits and negatives of this approach
to procurement.
The PPP Forum's objectives are to:
— Demonstrate
the success the private sector is achieving in delivering modern
public services infrastructure.
— Engage
with government departments and related organisations to develop
infrastructure procurement policy and contracts.
— Take
part in public debate and present an informed and business based
perspective on infrastructure procurement and the surrounding
issues.
Since our formation, we have engaged extensively
with the main spending departments in consultation both of a formal
and informal nature in the evolution of PPP/PFI policy to meet
the Government's objectives in the delivery of public social infrastructure.
We have been involved in broad policy initiatives such as the
drafting of the standardisation documents through to more technical
areas such as the effects of the implementation of the insurance
mediation directive and the move to IFRS accounting for PFI projects.
We welcome the opportunity this inquiry presents
to offer a more balanced perspective on the PFI programme in contrast
to some of the skewed media reporting we have witnessed recently.
We would be happy to offer oral evidence in person at the Select
Committee if this is of interest.
VIEWS OF
THE PPP FORUM
On 8 March 2011, the Treasury Select Committee called
for evidence on the future of the Private Finance Initiative.
This note provides the response of the PPP Forum and its members.
1. Introduction
1.1 The Private Finance Initiative (PFI) was
established by the Conservative Government in 1992. It was aimed
at improving the poor public sector track record in infrastructure
procurement and its associated long term management: as recently
as 2003, the National Audit Office estimated that 73% of procurement
under non-PFI methods was delivered over budget and 70% was late.
1.2 PFI is one of a range of procurement tools
available to government. It uses well established project finance
techniques for the procurement of social infrastructure assets
and services, on behalf of tax payers. Project finance is a well
established private sector discipline for the construction and
long term operation of new assets (typically in capital intensive
industries) in the most financially efficient manner.
1.3 Project finance has wide application in the
utility, energy power and natural resource sectors. These sectors
believe it delivers more precise risk allocation, better risk
management and improved value for money. Large multinational corporations
choose to use project finance, even though the cost of debt finance
to a stand-alone project is higher than their own cost of debt,
because of the overall efficiency gains it achieves.
1.4 Applying project finance to public sector
infrastructure originated in the UK but was rapidly adopted by
other nations: originally France and Australia and increasingly
in continental Europe, the Middle East, Asia and, most recently,
the USA. The PFI has proven a valuable export commodity for the
UK economy.
1.5 There are a number of reasons why the PFI
was introduced in the UK and why it is now being adopted globally,
including to:
(a) improve delivery outcomes of complex procurement,
when measured against historic time and cost overrun performance;
(b) focus on the public service, not the asset
that delivers it;
(c) improve whole life design and whole life
cost planning and management of public sector infrastructure—put
bluntly emergency maintenance is more expensive in the long-run
than planned maintenance but this is hard to deliver outside a
long-term contract framework such as PFI;
(d) generate data to show how the relationship
between build cost and operating expenditure can be optimised;
(e) facilitate the reform of the public sector
through the introduction of innovative delivery techniques and
a greater degree of transparency and accountability; and
(f) provide long time stability of asset management,
to guard against short term decisions leading to long term asset
degradation.
1.6 PFI is not about accounting and balance sheet
treatment. The level of risk transfer inherent in most PFI deals
means that the debt and assets had to be classified as off balance
sheet. In the early years of PFI, government insisted this balance
sheet test was met as evidence that a minimum level of risk transfer
was achieved. However, this off balance sheet classification was
seen by some as a benefit in itself. As we describe later, the
PPP Forum believes that balance sheet classification should not
be a determining factor in favouring PFI procurement.
1.7 While the track record of PFI has been demonstrated
in numerous studies to have been beneficial, much of the popular
rhetoric and public debate has focused on criticisms of the initiative,
magnifying apparent difficulties. Criticisms of rates of return
and requests for rebates when projects are successful do not take
account of the protection to the public purse where significant
losses have been absorbed (usually unreported) by the private
sector investors, funders and contractors.
1.8 Historic coverage of PFI has often been characterised
by misunderstanding and selective reporting, with two common examples
of this being:
(a) the often claimed: "£200 to change
a plug socket". The PPP Forum recognises early examples of
this syndrome, but does not accept this is a common issue in the
majority of well structured schemes (a view supported by high
user satisfaction ratings); and
(b) the invariable media reporting of the thirty
year nominal cost of the PFI contract as a comparison to the capital
cost of the original asset—a perception that is facilitated
(indeed, enhanced) by the relative absence of asset management
data on the public sector side.
1.9 This second point is critical, because it
undermines the real value to Government of PFI-style procurement.
The true comparison that should be made (and indeed is made on
individual projects when a public sector comparator is considered)
is between:
(a) the overall cost of the private sector PFI
deal, which includes its capital cost, operating and life cycle
costs as well as its cost of finance; against; and
(b) the aggregate public sector capital, operating,
life cycle and finance costs, in each case, over the life of the
asset. PFI detractors focus on the private sector's higher cost
of capital and take this as evidence that PFI must be more expensive.
But this fails to understand the positive impact that using a
PFI approach has on capital costs, operating and life cycle costs,
where the efficiencies typically outweigh the cost of finance.
Lack of adequate public sector data exacerbates this issue.
1.10 The issue is best illustrated by an example.
Under a typical PFI hospital, the total finance raised could equal,
say, £200 million against capital build costs of £180-190
million. Operating and life cycle costs over a 30 year period
would be in the region of £600-900 million. Given these relativities,
it is easy to see how higher finance costs can be outweighed if
the use of PFI results in efficiencies far smaller in percentage
terms across the total capital and operating costs of the project.
The discipline that PFI entails allows these efficiencies to be
delivered effectively and with much greater long term certainty
than through alternative means.
1.11 The UK PPP industry recognises that the
PFI is not a panacea. However, in agreeing where and to what extent
to deploy the PFI going forward, a more collaborative approach
to public messaging between public and private sectors, and a
more rational analysis of the true comparators with the PFI, would
be welcome. This current review is an ideal opportunity for the
Government to facilitate this.
2. What are the strengths and weaknesses of
different public procurement methods?
2.1 It is instructive to scope some of the basic
features of public services procured under a PFI structure:
(a) Every service is procured using a competitive
process in a largely liquid market. This gives the public sector
confidence that it will secure the best possible pricing available
in the market at the time.
(b) The private sector bears the risk of delivering
the project to an agreed budget and of commencing the service
no later than an agreed start date, each set out in a comprehensive
contract.
(c) Some risk is retained by the public sector's
direct counterparty (the "project company"), but most
of it is allocated and managed by a contractual supply chain.
(d) The public sector pays nothing until the
service is delivered and only continues to pay to the extent that
the service is delivered to agreed standards.
(e) There are extensive structural safeguards
to ensure service continuity at no additional cost to the public
sector, regardless of a failure in any one component of the private
sector supply chain. These safeguards have been proven to work
in practice.
2.2 In the space available, it is not possible
to compare every potential public procurement approach. However,
it is instructive to contrast these basic features with a "traditional"
procurement model: where government procures a capital asset out
of general taxation (or with gilts) with no long term commitment
to maintenance:
(a) Public sector expertise: PFI requires
different skills: those of intelligent client rather than service
delivery agent and asset manager. This places an increased demand
on public servants that needs to be supported.
(b) Third party oversight: Whilst it may
not be a politically attractive message in the current climate,
oversight by third party financiers has driven a rigour in PFI
structuring that has been lacking in traditional procurement.
Explicitly, lenders will expect good performance as long as there
is debt outstanding in order to ensure they are paid ie almost
the whole contract period.
(c) Whole life cost: It is clear that
PFI drives optimal whole life cost solutions in a way that the
disaggregated traditional model cannot.
(d) Flexibility: The PFI is often accused
of lacking the flexibility of traditional procurement methods:
but one needs to consider separately the flexibility of the underlying
asset and that of the PFI contract:
(i) PFIs have been used to procure specialised
new assets such as defence equipment, hospitals and schools. In
some cases changes in demand over time mean that these assets
turn out to be the wrong size. In many cases, they are also the
wrong specification for efficient alternative use. This is not
an inefficiency of PFI—it is a risk taken wherever the public
sector builds new assets. In traditional procurement, the cost
of an asset is reflected in the cost of the gilt finance used
to pay for its construction: just as it is inherent in the finance
cost of PFI. The only difference is one of visibility. There is
no hiding from the sunk cost of having financed a redundant asset.
(ii) PFI contracts are designed to transfer long
term risk for assets, so that they are built and maintained at
the most economic and efficient cost possible over their life.
Asking a PFI company to cut its costs, for instance to defer maintenance
expenditure, would be to undermine this fundamental risk transfer.
So not surprisingly PFI contracts are fixed and difficult to alter.
We see this as an advantage of PFI, as assets are maintained at
their long term efficient level. For those desperate to cut costs,
they may not see that inflexibility as being so desirable.
(e) Operational variation: we do not accept
that PFI is fundamentally inflexible when it comes to operational
change but appreciate that the number of stakeholders involved
may make contractual change issues more complicated. Supply chain
overhead needs to be addressed in the cost of making changes—but
this is also the case in the public sector without the transparency
of the private model—and transaction costs can be high due
to the number of stakeholders involved. A PFI invoice and the
unit cost of a light bulb is a false comparison.
(f) Performance related pay: the PFI achieves
a level of incentivisation through performance related payments
that far exceeds the majority of conventional procurement.
(g) Procurement costs: for the PFI appears
much higher when compared with traditional procurement but this
is due to having a more rigorously scoped project and the level
of due diligence involved. Nevertheless, initiatives are underway
to improve PFI procurement costs, particularly in the field of
competitive dialogue processes.
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 PPP Forum believe the only reason that
PFI deals should be carried out is because they offer value for
money compared to alternative methods of procurement. Their balance
sheet treatment should be incidental to this decision.
3.2 This has been recognised by Government, as
many PFI deals have been let that are on balance sheet; normally
when the project is not purely new build (so the risk transfer
on the incremental expenditure is not sufficient to get the whole
asset, including its existing part, off balance sheet).
3.3 Because of the risk transfer inherent in
PFIs, most of them can be classified as off balance sheet under
ESA 95, the European accounting standard applied to measuring
national debt. But we think it right that the underlying future
obligations of Government for the payments inherent in PFIs are
disclosed in public sector accounts. This approach now applies
to Whole Government Accounts under IFRS which has been adopted
in the UK. This removes the false argument that the only reason
PFI is being used is for accounting purposes, to focus attention
on the real question—is a particular deal value for money?
Now that the UK discloses its PFI obligations, which we would
encourage at a relatively detailed and year on year basis, we
believe the question of balance sheet treatment should be largely
redundant.
4. How far can risk really be transferred
from the public to the private sector?
4.1 The PPP Forum believes that there is substantial
risk transfer to the private sector under a PFI procurement:
(a) PFI is a sub-set of project finance, where
risk is allocated and managed across a number of sub-contractors
and financiers. Developers of project finance transactions believe
that substantial risk transfer takes place: it should be no different
in a public-private context.
(b) There is a whole industry that underpins
the PFI regime that takes on board large construction and delivery
risks at competitive prices. The liquidity of the PFI market ensures
these are appropriately allocated and priced.
(c) The project company's supply chain contracts
clearly allocate risk, by specifying the price at which service
components are delivered: a contractual obligation come what may
to deliver with very material liquidated damages should they fail
to do so.
(d) Frequently supply chain contractors will
incur losses to meet their contractual obligations—every
contractor has examples of where they have made losses. But the
loss is invisible to government, because the supply chain continues
to meet its obligations.
(e) At the project company level many risks are
taken that cannot be sub-contracted—eg life cycle costs,
insurance premia, systems integration risks and sub-contractor
solvency. Equity bears these risks, again without frequent visibility
to government.
(f) If there are project difficulties Government
is either oblivious to these as contractors meet their commitments,
pays less until such time as the prescribed services are delivered
or (in extremis) only pays fair value for the assets if the project
company defaults.
(g) There are real signs of the cost of finance
and operating expenditure falling over time as the risks become
familiar: reductions passed on to the tax payer. This is a clear
benefit of PFI that is conveniently forgotten by its critics.
Recent high debt margins are a market issue, not a PFI issue.
4.2 We recognise that this question is closely
related to the question answered at our paragraph 6 below: namely,
is there an explicit or implicit state guarantee that underpins
a PFI project in a way that undermines the substance of this risk
allocation. We do not believe this to be the case.
4.3 There are a small number of PPP projects
that did not fully demonstrate these core risk transfer principles:
the high-profile LUL PPPs that involved 95% senior debt underpinning
for example. However, projects that do not have these characteristics
are not a good benchmark to measure against the PFI: they are
better seen as broader public-private partnership arrangements
that used some PFI techniques but diverge from core PFI principles
due to their political sensitivity, size and complexity. We do
not think it relevant to assess these projects in the context
of a PFI review, although it is instructive to note that even
where the risk allocation was skewed towards the providers of
private senior finance, investors in the parts of the LUL transaction
were exposed to considerable risk transfer.
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 Deals which are suited:
(a) Any complex asset provision where there is
a whole life asset management requirement and long term certainty
over demand for the service it produces (ie where best value is
not necessarily to build as cheaply as possible and then make
do and mend).
(b) Deals need to be of a certain size (which
depends on the degree of commoditisation) in order that the higher
procurement costs (of better scoping) are not disproportionate.
(c) Sectors where there is a pipeline of similar
transactions that can benefit from the standardisation which comes
with a PFI approach. Bespoke, one-off deals need to be larger
to bear project development costs.
(d) Even where the above conditions are satisfied,
PFI is not suitable for deals with only short term technology
certainty (eg IT deals and projects involving novel technology
risk). Certain defence projects have demonstrated that PFI is
not appropriate in all circumstances.
5.2 Risks which are suited:
(a) Risks need to be measurable and/or manageable
or they cannot be priced transparently. Risk transfer beyond this
threshold risks not being value for money.
(b) There is a history of government advisors
being aggressive in transferring risk where the market has tried
to say that it would not be value for money to do so. Examples
include insurance cost premia, indexation, political risk (eg
around major planning or certain regulation), public sector credit
risk, change in law capex risk. A revised approach to these issues
would improve value for money.
(c) Further operational risks could also be transferred,
in the way that prison outcomes are now being measured in terms
of reoffending rates. Further introduction of payment by results
could be achieved (eg, in healthcare and education) if there was
political appetite to do so.
6. What state guarantees are explicit or implicit
in PFI deals?
6.1 There are no explicit or implicit state guarantees
in PFI. The market assumes that it will only get paid for the
services it delivers or the fair value of the assets it builds:
that the public sector will meet its obligations to provide essential
public services. If there were ever an example of this not happening,
then the ramifications for future costs, not just in PFI but also
any public-private sector such as power, utilities and franchising,
would be severe.
7. In what circumstances are PFI deals suitable
for delivery of services?
7.1 PFI is just one example of private involvement
in public services. We believe there is significant scope for
private involvement in the delivery of public services: in our
view the limiting factor is political rather than capability or
suitability for application of PPP techniques.
7.2 Use of PPP should be a pricing and service
quality issue, not a trades union or political token. The government's
role is to set the scope of publicly delivered services and the
decision on how those services are provided should come down to
value for money.
7.3 The members of the PPP Forum believe that
the asset delivery and management skills learned over the last
18 years could be applied more widely to the delivery of public
services to enhance the quality and improve the productivity of
the UK's public services.
April 2011
| 
