Private Finance Initiative - Treasury Contents

Written evidence submitted by Dundas & Wilson C.S. LLP


Dundas & Wilson is a leading legal adviser on PFI/PPP Projects throughout the UK. We have been involved in PFI projects since their inception in the mid 1990s and have a team of over 50 specialist lawyers advising public sector sponsors, bidding consortia and funders on all aspects of PFI/PPP across sectors including health, education, street lighting, transport, waste and water/wastewater. Our teams are active in the origination of PFI deals, secondary market transactions and advising infrastructure funds holding portfolios of operational PFI/PPP assets. We have advised on around 200 PFI projects and have developed particular experience in relation to distressed PFI projects having advised on a number of high profile rescue refinancings.

Our extensive and prolonged experience in the area has given us genuine insight into issues surrounding use of PFI as a procurement method and we gave evidence to the Scottish Parliament Finance Committee Inquiry into the Financing of Capital Projects which reported in December 2009.


The need for infrastructure investment is clear, in the UK and across the globe, despite constraints on public spending. It is an important catalyst to stimulate growth and support the economy. It is also clear that one cannot apply a "one size fits all" approach to infrastructure investment. Contracting authorities should be empowered to utilise whichever procurement method will derive best value for money for the taxpayer considering long term risk adjusted cost of outputs or outcomes. In some cases PFI will offer value for money and in others not. The desired outcome is not to champion one form of procurement over another but rather to focus on delivery of better public services and outcomes for the tax payer at better value for money. To this end better evidence is required to support quantitative evaluation of procurement approaches and objective comparisons.


PFI was initially developed in 1992 by the Conservative Government but was expanded significantly from 1997 onwards by the New Labour Governments on a systematic basis to deliver over £64 billion of investment in UK infrastructure whilst maintaining Public Sector Net Debt within targeted levels. By the time of the 2011 election over 800 deals had been signed including 100 new hospitals. To put this in context, PFI typically accounts for around only 10-15% of public sector investment in infrastructure.

Despite its prevalence, PFI has generally been regarded with scepticism by the public and in the media as controversial, expensive and inflexible. Much of the adverse perception stems from experience on early PFI deals where the public sector experience was limited and early adopters in the private sector derived disproportionate returns relative to the risks transferred. The Labour Government moved swiftly to develop public sector procurement skills and set up the Treasury Taskforce to standardise contract terms and issue guidance to procuring authorities to assist contract negotiation. During this period of standardisation, the costs of funding reduced considerably with debt tenures extending to 30 years and gearing ratios of around 93% not being uncommon as understanding of contract structures and risk transfer matured and competition for deals increased. The credit crisis has severely curbed the appetite of senior lenders to invest on longer tenors and funding margins have increased sharply.

As the market matured over time, a number of inquiries and reports have been commissioned into a variety of specific PFI deals and use of PFI as a procurement model which have generally concluded that projects delivered under the procurement model are more likely to be delivered on time and on budget than projects procured conventionally (although the gap appears to be narrowing as public sector procurement skills continue to develop and private sector-type rigour and due diligence is deployed on conventionally procured projects) and that whole life costing of projects is essential in assessing value for money of all projects whether procured under PFI or conventionally. However, such inquiries have been constrained by the lack of quantitative evidence against which to assess the performance of PFI when compared to other procurement approaches.

A number of developments have also presented challenges for the model, namely the advent of competitive dialogue procurement procedure applying to PFI deals resulting in significant increase in bid costs in bidding for PFI projects and the adoption of IFRS leading to the majority of signed PFI deals being "on balance sheet".


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

In our experience (which is reinforced by the various reports and inquiries prepared by NAO and other bodies into PFI and specific projects), it appears to be a matter of general acceptance that the strengths and weaknesses of different procurement methods are as follows:
Procurement Method Strengths Weaknesses
Conventional procurementConventional procurement tends to involve less rigid contract structures than privately financed investments resulting in lower procurement costs and greater flexibility during the operational phase. Public procurement has not typically taken into account the whole life costs of investment in infrastructure and has largely divorced design and construction from maintenance and lifecycle of infrastructure assets.
Public sector faces a lower cost of borrowing based on its covenant and divorced from risk transfer (whereas private sector cost of borrowing reflects risks transferred). Public procurement has not typically been subjected to the same level of due diligence, risk analysis and general rigour as investment involving private finance.
There is no ring fencing of maintenance budgets allowing for greater financial flexibility over the life of the asset (albeit at the expense of proper lifecycle maintenance of the asset). Public procurement has typically resulted in more delays and cost overruns in delivery of projects than privately financed projects.
There is a perception of greater flexibility in the use of conventionally procured assets (eg to close a school or hospital) without having to "buy-out" a PFI contract. However, this assumes that there is a zero cost of doing so where the asset has been conventionally procured (which cannot be the case given the asset has been paid for in full up front). Public sector procurement skill base has typically been considered less sophisticated than that of private sector opposite numbers.
Public sector procurement skill sets have improved significantly over the last 10 years. Risk transfer under conventional procurement is typically limited to construction risk depending on contracting model thus resulting in the public sector retaining more risks and exposure to contractor insolvency.
Whilst it is fair to say that the public sector (and indeed the private sector) has made huge strides in the above areas as a consequence of experience gained on PFI, traditional procurement cannot realistically replicate the incentives that drive performance on privately financed investments (eg in terms of penalising poor performance on a whole life basis and loss of equity return if the project does not perform in accordance with expectations).
There is a lack of data on the performance of conventionally procured assets which makes effective comparisons with privately financed assets very difficult.
Private Finance Privately financed projects take into account the whole life costs of infrastructure investments and "join up" design and construction, maintenance and lifecycle of infrastructure assets and delivery of soft services. Privately financed projects involve more rigid contract structures than conventionally procured assets resulting in higher procurement costs and inflexibility during the operational phase both for major strategic changes and in dealing with small variations.
Privately financed projects are subjected to rigorous due diligence and risk analysis. Early PFI contracts (prior to standardisation) were arguably, and with the benefit of hindsight, overly beneficial to the private sector allowing generation of disproportionate investor returns relative to the risk transferred.
Privately financed projects have typically resulted in fewer delays and cost overruns in delivery than conventionally procured projects. Private finance is best suited to projects where the need for the asset is well understood and risks can be managed effectively by the private sector at a price which represents value for money to the taxpayer.
Private sector skill base is often more sophisticated than public sector opposite numbers. The "one off" nature of a PFI contract tends to result in a more adversarial approach to contract issues than partnering structures.
Privately financed projects incentivise performance (eg by penalising poor performance on a whole life basis and the prospect of loss of equity return if the project does not perform in accordance with expectations). Procurement costs for privately financed projects are typically high under competitive dialogue compared to the capital value of the project.
Privately financed projects transfer risk on a whole life basis to private sector leading to greater risk transfer and risk management and private sector exposure to contractor performance and insolvency. Skills developed by the public sector on private finance procurements may only be deployed on the single project rather than utilised on a pipeline of projects.
Asset maintenance budgets under private finance projects are ring fenced ensuring the quality and performance of the asset over its life. Cost of debt fiancé and equity return means costs are higher.
Private finance contract terms have evolved over time to derive best value for money for the tax payer. There is a lack of data on the performance of conventionally procured assets which makes comparisons with privately financed assets very difficult.
Private finance models have been tested on distressed projects such as East Lothian Schools PPP and Aberdeen City Schools 3Rs projects. In these cases, cost overruns and consequences of delays (resulting from subcontractor and senior funder insolvency respectively) were absorbed by the private sector and not passed on to the public sector.
There is a virtuous circle between pension investment needs and financing infrastructure investment which has yet to be fully recognised by government and political parties.
Strategic Partnering Models (NHS LIFT)Models such as NHS LIFTY and the hub initiative in Scotland and BSF in England involve the benefits and weaknesses of both privately finances and conventionally procured projects but additionally involve a joint venture vehicle between the public and private sector which allows for a more partnering approach and both parties to share in the benefits/returns from projects. There is a perception that such models are expensive and bureaucratic.
The joint venture models are expected to demonstrate savings in procurement costs and cost savings over time through incentivising efficiences as well as greater transparency through open book accounting and contestability through open supply chain management.

2.  If PFI debt had been on-balance sheet rather than off balance sheet would PFI projects have been used as much?

The key test for proceeding with a procurement using PFI is not whether the project is on or off balance sheet. The key test is whether or not the project represents value for money (vfm) in terms of HM Treasury Guidance. However it will be more difficult to pass this test if the project had remained on balance sheet. Having said that there is evidence from a number of PFI projects could still pass the vfm test notwithstanding that they remained on balance sheet. One could argue that a consequence of this is that a number of existing PFI projects may not have passed the vfm test had they been on balance sheet, but that ignores the fact that a number of traditionally procured projects that remained on balance sheet were never tested in the same way to ascertain if PFI would represent vfm. Given that the value of capital spending through traditional procurement far outweighs that through PFI, that could have produced some interesting results.

3.  How should PFI deals be accounted for?

We have declined to answer this questions as it is concerns a matter beyond a legal adviser's area of remit or expertise.

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

In our experience of over 15 years advising public sector bodies, project vehicles, investors and sub-contractors, (and ignoring for this purpose high profile failures such as Metronet) where PFI is used on suitable projects, PFI contract structures are robust and transfer risks effectively to the private sector.

This is perhaps best illustrated by our experience on the distressed projects (East Lothian Schools PPP and Aberdeen City Schools 3Rs PPP). We advised the project vehicle on East Lothian Schools. The building contractor and FM provider on the project became insolvent during the most risky phase of the project (ie construction phase) following insolvency of Ballast Group UK companies. The project involved the refurbishment of 6 secondary schools and new build of two community facilities. Even after enforcement of bonds and parent company guarantees against Ballast group companies, the appointment of a replacement building subcontractor involved a significant cost increases (due to the refurbishment nature of the project and the delay/replacement costs). The facilities were ultimately delivered in accordance with the PFI contract at the price originally agreed with the Authority despite the costs of construction having increased substantially resulting in investors injecting additional equity and sub debt and senior lenders advancing additional facilities. Aside from the disruption and delay faced by the Authority, it was fully insulated from the resulting cost increases and additional financing required. The investors stepped in to rescue the project to protect their equity and sub debt investments.

A similar set of circumstances applied on the Aberdeen Schools project although in that case the funder was an Icelandic bank which collapsed during the credit crisis. Again, the private sector responded to rescue the projects injecting additional investment but without any increase to payments by the Authority despite increases in the costs of construction and financing costs.

Had the public sector been faced with these collapses under a conventionally procured project it would have been fully exposed to the resultant cost increases rather than fully insulated from such cost over-runs. Thankfully such experiences of market failure are exceptional but they do demonstrate that PFI structures have been stress tested and found to be effective and that equity investors are incentivised under the structures to step in to rescue projects to protect their investment and reputation.

In our experience advising infrastructure funds holding a portfolio of PFI assets we see on a daily basis evidence of effective risk transfer to the private sector on PFI projects - whether through the application of payment mechanism penalties for poor performance, on lifecycle maintenance issues, pursuing building contractors for latent defects and dealing with contractual mechanisms such as benchmarking and market testing and variations. Project vehicles actively manage such risks on a daily basis as they manage PFI concession contracts, enforce contractual entitlements against subcontractors, comply with funding covenants and, where possible, deliver investor returns.

In summary, risks can be and are transferred to the private sector, recognising that ultimately the public sector has the obligation to deliver the service to the public (eg in health or education) and cannot therefore "walk away" from projects.

5.  Are there any particular kinds of risk which are particularly appropriate for transfer through PFI deals, or particular projects which are suited for PFI?

In our experience and as reinforced by the reports and studies of the NAO and other bodies, PFI works best where the risks passed to the private sector are understood and can be managed by the private sector at a price which represents value for money to the taxpayer.

PFI has operated successfully on social infrastructure projects such as schools, hospitals, street lighting, transport, waste, water and waste water projects. In such projects, in essence risks such as design, build, maintenance, financing and operation of accommodation assets are transferred routinely to the private sector and operate effectively. We have also seen examples of other projects where the private sector has successfully taken on more "frontline" service provision such as the provision of training services in a training facility.

In our experience, projects involving significant refurbishment of existing facilities present a particular challenge to PFI structures given the difficulty in pricing such risks at a price which represents value for money.

It is also important that the public sector has established a long term need for the facilities in question (eg a school or hospital). Where the public service delivered is likely to change significantly over time (eg on IT projects) PFI is generally unsuitable given the long term commitment it represents and the relative inflexibility of the contracts.

There is currently debate in the industry on whether transferring certain risks such as change of law risk and insurance risk is beneficial and whether the public sector should retain such risks.

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

Except where the procuring authority is the state (eg a government department), explicit state guarantees are unusual in PFI contracts. In NHS projects, there is Department of Health underwriting of certain liabilities of NHS trusts where a Trust which has signed a PFI contract becomes a Foundation Trust but this is specific to the health sector.

More typically there are no explicit state guarantees where PFI contracts are entered into by local authorities or other public sector bodies. Generally speaking their covenant is such is that such guarantees are not required.

PFI contract structures commit contracting authorities to pay for the service it is receiving over the life of the asset and on early termination of the contract to pay compensation payments to the private sector counterparties. It is for the contracting authority to ensure the project is affordable. To this end, contracting authorities (such as local authorities) will generally require confirmation of central revenue support funding for PFI commitments as a precondition to entering into PFI contracts.

There is an implied state guarantee on substantial schemes tied to delivery of essential public revenues recognising that ultimately the public sector has the obligation to deliver the service to the public (eg in health or education) and cannot therefore "walk away" from projects as reflected in rating agencies' assessment of certain bodies/non departmental bodies.

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

Please refer to our answer to Question 5 above.

April 2011

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Prepared 10 August 2011