Managing the expiry of PFI contracts Contents

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3Relationship management during contract expiry

Managing investor relationships

16.Once a PFI contract has expired, any cash remaining in the PFI company is distributed to shareholders and the company is closed. If any maintenance or rectification work is outstanding at this point, it will be almost impossible for the authority to recover any money owed. It is therefore vital that authorities monitor and enforce compliance against the PFI contract.39 PFI contracts are, in theory, self-monitoring which means the PFI company is responsible for reviewing performance and reporting back to the authority. Nevertheless, the authority still needs to monitor the PFI company’s performance to ensure it is receiving the services it has paid for.40 The NAO found that special attention needs to be paid to monitoring on-going maintenance and the lifecycle fund, a pot of money built up over the life of the project to pay for planned, periodic maintenance. It found that failure to monitor maintenance increased the risk of assets transferring to the public sector in a poor condition. It also found that, as the PFI company keeps any remaining lifecycle fund on expiry, there can be perverse incentives to underinvest in assets, making them last longer than originally planned, leaving more cash in the pot for investors.41

17.A PFI contract should grant an authority access to any information reasonably required to monitor the PFI company’s performance. The NAO found that of the survey respondents who monitor the maintenance programme, 35% reported they had insufficient access rights to allow them to do so. In one PFI hospital, the authority identified a large gap between the money paid into the lifecycle fund and what was being spent on maintenance. The difference could indicate that the PFI company was not carrying out the maintenance work as planned but the authority was unable to challenge whether this was the case because the PFI company denied it access to the relevant information. When asked whether this is acceptable, the IPA acknowledged that there were some “difficult investors” who “liked asymmetric information” on key parts of the contract. This means that the PFI company holds much more information on its performance compared to the authority, which limits the authority’s ability to challenge the PFI company. The IPA recognised that this information was “absolutely critical” in managing the expiry of PFI contracts and told us that it was working to get investors to share assets registers and the financial information needed.42 The IPA also explained that it was working with “key investors” to remind them of their responsibilities and planned to develop a protocol outlining how investors should operate during the expiry process.43

18.Local Partnerships explained that asset condition surveys are the most critical aspect of the expiry process as they tell the authority whether or not the assets are in a fit state. These surveys should identify the amount and cost of any rectification work required before expiry. Local Partnerships highlighted that if the surveys were completed too close to the end of a contract, there could be insufficient time to remedy any defects identified.44 The IPA told us that the Treasury’s standard PFI guidance recommended surveys should be conducted 18 months to two years in advance of the contract’s expiry, which the IPA believed is too late. The IPA recommended that health check reviews take place seven years before the expiry of the contract, and that this could include requiring an asset condition survey.45 In its written evidence to us, Leeds City Council was concerned that there may not be enough technical experts to complete these surveys, and that creating a “lucrative new industry overnight” may create risks such as surveyors being under-qualified, inadequate surveys being produced in order to quickly move onto the next job or high prices due to lack of competition.46

19.Authorities have tools to encourage non-cooperative PFI companies to act but they vary from contract to contract. As a minimum, all PFI contracts allow authorities to withhold a portion of their annual payments in the event of poor performance. Local Partnerships told us that authorities will be better positioned if they make these deductions while the debt providers, such as banks, are still involved in the project. It explained that the threat of debt not being repaid would encourage debt providers to put additional pressure on the PFI company to complete any outstanding work. However, the IPA noted that debt was often paid off several years before expiry, meaning authorities need to take early action.47 Withholding annual payments is not always a solution; the NAO identified an example where an authority could only make deductions on the grounds of non-performance or unavailability. This means that if information is not being shared or the assets are not being maintained, but they remain in a usable condition, then the authority cannot withhold any payment.48

20.In its written evidence to us, Affinitext told us that the primary objective of withholding annual payments was to ensure contractual compliance rather than maximising cash savings for the authority through imposing high penalties. It explained that if the process of withholding payments, which can take place many years before contract end, is seen by both parties as a means of “catching the other out,” this could damage relationships before the really challenging aspects of expiry need to be faced.49

21.Any rectification work required should be completed before the expiry of the contract. Once the PFI company has closed, authorities have limited options to reclaim any money owed. One option for protecting against this is to build a retention fund, whereby a portion of the authority’s annual payment is set aside specifically to pay for any rectification work at expiry. The NAO found that of the 28 contracts in its survey which contained a retention fund, 10 respondents did not expect it to be large enough to cover the expected rectification work.50 We asked the IPA how an authority should manage this risk. It told us that the solution was “a larger retention fund”. It recognised that the retention fund was a contractual obligation and could not be unilaterally changed, but noted that the amount paid into the retention fund is linked to the asset condition survey.51

Resolving disputes

22.In managing the expiry of a PFI contract, all parties will want to maximise value from the PFI contract. Authorities will want to inherit an asset in the best possible condition, as this will minimise any future maintenance costs and the risk that services are interrupted. Meanwhile, PFI companies have an incentive to limit expenditure on maintenance and rectification work in the final years of the contract as any savings will be passed through to investors. These misaligned incentives can lead to disputes. The NAO found that more than one-third of authorities who responded to its survey expected to have formal disputes near contract end, with the majority relating to the volume of rectification work and its cost.52

23.Each PFI contract should set out a formal dispute handling procedure. The IPA told us that typically the process required a panel of experts, selected based on the nature of the dispute, to reach a judgement. If the panel cannot reach a judgement, or either party challenges it, the dispute will go to either arbitration or the courts. It explained that, under most PFI contracts, the arbitration process has to be voluntary. Even before reaching the courts, the disputes process can be long, in some cases taking a minimum of 10 months. The NAO found that the process can be expensive, which can prohibit authorities from pursuing disputes, especially when success is not guaranteed. There are some examples of good practice in this area. Highways England has agreed an informal disputes resolution process with the PFI company. Designed to be quicker and cheaper, this informal approach takes place before the formal contractual disputes process and involves discussions between nominated individuals from both parties, first at an operational level and then at a project manager level.53

Protecting taxpayer interests

24.The authority is responsible for managing the PFI contract until expiry, at which point it inherits the assets.54 In some instances, ownership of the PFI assets can transfer between different public bodies before the contract expires, creating a potential conflict between those who will own the assets in the future, and those who are responsible for their management now. We asked the IPA how this was expected to work, particularly in areas such as the education sector. For example, an authority—usually the local authority—signed a PFI contract for a school and remained responsible for the contract until its expiry. The original contract would have stated that, on expiry, ownership of the school passed to the local authority. But in some cases, during the contract, the school was converted to an academy run by an independent trust funded by the Department for Education rather than the local authority. The NAO found that a local authority could find itself in a position that it still had to manage the PFI contract, but on expiry, the school would be transferred over to the academy trust.55

25.Over 300 PFI schools have been converted to academies. We asked whether local authorities might be incentivised to protect their budgets by limiting expenditure on managing the contract rather than maintaining the assets as they would not own them at contract expiry. The IPA accepted that this was a very complex issue and a very real risk which needed clarification. It explained that the Department for Education, which had one of the “more resourced and capable PFI teams” was “highly focused” on resolving this issue. In the example of schools, the IPA asserted that there was “every incentive to ensure that the school is in a good condition and well maintained” and that it thought the interests of academies, local authorities and the Department for Education were aligned.56 We asked the IPA whether academies were nonetheless at risk of inheriting liabilities in the form of large rectification bills to bring the assets back to a useable condition should the authority not manage the contract properly. The IPA told us that it did not expect these to be large liabilities.57