Private Finance Initiative - Treasury Contents

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.


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

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