Written evidence submitted by Dundas &
Wilson C.S. LLP
OUR CREDENTIALS
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.
EXECUTIVE SUMMARY
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.
BACKGROUND
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".
COMMITTEE QUESTIONS
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 procurement | —
| Conventional 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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