Private Finance Projects and off-balance sheet debt - Economic Affairs Committee Contents


CHAPTER 4: PRIVATE FINANCE IN PRACTICE

PFPs—on time and on budget?

62.  One driver behind PFPs was the cost overruns of traditionally procured projects. Data is limited but a survey in 1999 found that in 73% of construction projects costs to the public sector exceeded the price agreed at contract and 70% of projects were delivered late. The lion's share of projects surveyed were traditional procurement.[16]

63.  Traditionally procured projects that ran over budget include the Thames Barrier, Scottish Parliament, British Library and Phase III of Guy's Hospital in London (PPP Forum p 218, John Laing p 211). The problem is international. For example, a survey of over a hundred major traditionally procured transport projects, mostly in Europe and North America, found that substantial cost escalation is the rule rather than the exception—for rail, average cost escalation is 45%, for tunnels and bridges it is 34% and for roads 20%. The projects were completed between 1927 and 1998.[17]

64.  Although not directly comparable, NAO surveys suggest many more PFPs are completed on time and on budget. A 2003 survey by the NAO showed less than a quarter of PFPs were delivered late and a similar proportion running over budget.

65.  Payments to private finance contractors do not start until the building is completed. As contractors usually have financed the project with some equity and lots of debt they apply rigour in planning and execution so that more private finance projects are on time and on budget.

66.  The banks providing the debt finance add another layer of due diligence designed to help ensure projects are successful and loans repaid. Ms Mingay said: "The advantage of private finance debt is that it does do that upfront due diligence on behalf of the lenders and the contractor is suitably incentivised to work through any problems and not walk away from their obligations through the life of their contract" (Department for Transport Q 536).

67.  NAO surveys also suggest the gap between the performance of traditional procurement and private finance is narrowing. A survey of projects scheduled to be completed from 2003-2008 found 31% of those procured under PFP were delivered late and 35% ran over budget which suggested a weaker performance than the 2003 survey. Under traditional procurement 37% were delivered late with 46% over budget.[18]

68.  The NAO surveys indicate that the performance of traditional procurement has improved. Ms Margie Jaffe of Unison said: "Procurement has moved on apace since the days of the 1960s and 1970s which was the last big construction phase" (Q 571).

69.  There is strong evidence that PFPs have a better record of on time and on budget delivery than traditionally procured projects, although it appears this gap is narrowing. Nonetheless, too many PFPs are delivered late, albeit contractors rather than public authorities are liable to the consequent financial penalties.

PRICE RISES

70.  Bidding processes for PFPs are longer because private finance contracts are more complex, including servicing and maintenance over 25-30 years, while traditional procurement contracts only cover construction. Although more PFI projects are completed on-time and on-budget, some witnesses argued this masked large cost increases which arose during the much longer bidding process. Ms Jaffe said: "Mysteriously, the price between the outline business case, which is at the start of that process, and the final business case at the end goes up fantastically, and so for the first wave of PFI hospitals, for example, it was mostly between 20 and 220 per cent. Some of that may be the public sector saying we want you to add all the twiddles and it has got to be gold-plated and so on, but a lot of it is because the consortia are protecting themselves from failing to provide to cost" (Q 571).

71.  These price rises often occur during the preferred bidder stage when the public sector enters into exclusive negotiations with one consortium. The Centre for International Public Health Policy at Edinburgh University noted: "During this period, the private sector can 'hold-up' the public sector, pushing up prices … meanwhile, the scope for public authorities pulling out of such negotiations is limited by the unavailability of other procurement routes" (p 133). The Centre added: "A project that is delivered to time and to budget (in post-contractual terms) may represent poor value for money if the price paid for the risk transfer that led to that outcome was too high" (p 134).

72.  The National Audit Office found preferred bidder negotiations lasted on average 15 months for PFPs finalised between 2004 and 2006. In one third of these projects the value of the contract varied on average by 17% (upwards and downwards) of the total project value. The NAO conclude: "Value for money is most at risk during the final stage of negotiations, when negotiation is with a single preferred (or final bidder) and competitive tension is at its weakest" (p 107).

73.  Common EU procedures—known as Competitive Dialogue—were introduced in 2006. They seek to eliminate changes late in the procurement process. But the NAO reported: "Our recent study on Building Schools for the Future found some early indications that at least some changes are still being made late in the process. Kent County Council's project experienced seven months delay after the selection of final bidder" (p 107).

74.  Preferred bidder negotiations are not exclusive to PFPs and are widely used in conventional procurement projects as well. While competition is reduced at the preferred bidder stage, it should be easier during this stage for a public body to walk away from cost increases than after construction has begun, as can happen in traditional procurement.

75.  Substantial price increases are undesirable late in the bidding process whatever procurement path is chosen. Despite the longer bidding process under PFPs—and the associated higher costs—the greater likelihood of projects being completed on time and on budget after the contracts have been signed can be a benefit worth some extra expense to the public sector at the initial stage.

Risk transfer

76.  A key benefit attributed to PFPs is that risk is transferred from the public sector to the private sector.

77.  PFPs aim to allocate risks to the parties best able to manage them. This should lead to better management of risk overall which should be more cost efficient (NAO p 88). But not all risks can or should be transferred to the private sector. Dr Stone said: "You have to understand what risks both sides can and should manage and control" (Q 10).

WHAT RISKS ARE TRANSFERRED TO THE PRIVATE SECTOR?

78.  The private sector is usually best placed to manage construction risk—such as building on time and on-budget—and the risk of providing maintenance over the asset's lifetime (Mr Buxton Q 91). Private contractors have a greater incentive to build a project on-time and on-budget as they only start receiving payments once construction is complete. Making the private sector responsible for maintenance aims to encourage the contractor to build a high quality asset that will require little maintenance over the course of the contract—usually 25-30 years.

79.  Besides construction and maintenance, it is unclear what other risks the public sector seeks to transfer and to what extent. Ms Rachel Lomax said that when she was Permanent Secretary at the Department for Work and Pensions private finance would not be used for a core function of the Department: "There is just no way you can transfer the risk of something which is fundamental to the Department's purpose and statute." As a result the Department for Work and Pensions did not use private finance in benefit administration "because we felt that was what the Department was all about". Private finance was instead used to provide medical services, which are not a core function of the Department (Q 216).

80.  With private finance projects so far, the public sector usually retains risks related to demand (Mr David Belton, Sheffield City Council, p 281). So if the local population falls so much that a PFP-built school or hospital needs to close then the public sector bears the costs of closing it before the private finance contract expires.

81.  Construction and maintenance risks are usually seen as suitable for transfer to the private sector; whereas activities over which the private contractor is seen as having little or no influence have not been transferred.

DEBT REFINANCING

82.  Special Purpose Vehicles (SPVs) set up by contractors to deliver a given PFP often seek to rearrange the terms of their borrowing once building is complete. Lower interest rates may well become available because the risk of problems arising during construction has been removed.

83.  At first, contractors kept the gains from refinancing PFPs. The Government then negotiated arrangements with the private sector to share the refinancing gains. For PFP contracts signed since 2002 the public sector is entitled to 50% of the gains from the refinancing. In 2008 the public sector's share of the gains rose to 70% for some new contracts. In pre-2002 contracts with no mechanism to share in the benefits of refinancing, the public sector receives 30% of the gains (NAO p 109).

84.  The NAO, which criticised the Norfolk and Norwich Hospital refinancing for securing for the public sector only 29% of the refinancing gain while increasing the contract's termination costs, said of the refinancing : "New sharing arrangements appear to be working well, but there have been exceptions" (p 109).

85.  We welcome the Government's action to secure for the public sector a substantial share of refinancing gains in PFPs. We recommend that the Government should continue to learn from experience in order to ensure that the public sector enjoys a fair share of benefits from improvements in financing arrangements.

WHAT HAPPENS WHEN THINGS GO WRONG?

86.  Critics, such as Unison, argued risk transfer in PFI projects is "often illusory". They added: "Failed PFI contracts, on too many occasions, have had to be rescued by the public sector meeting additional costs" (p 258).

87.  However, Mr Metter argued risk has still been transferred because when the Government has to rescue a project the private sector has already been hit hard: "By the time you get to that point, the equity will have lost their money, the debt will have lost their money, the contractors will probably have lost their money, the insurers will probably have lost their money and then you get to the point where the Government stand in. For the most part business risks are transferred very, very successfully" (Q 469).

88.  The PPP Forum lists the National Physical Laboratory, Cornwall Schools project, Dudley Hospital and Croydon Tramlink as projects where the private sector lost millions of pounds which shows, it argues, that risk was transferred (p 219).

89.  Mr Adrian Ewer of John Laing relayed his experience of building the National Physical Laboratory. He said: "We lost £60 million on the construction and we basically lost our equity as well and the private sector in total lost over £100 million on that project" (Q 470).

90.  Mr Ewer argued the private sector lost out due to risk transfer while the public sector was largely protected and ended up with high quality laboratories at a good price. He said: "We kept pouring money into this black hole. At the end of the day also the public sector has an excellent asset which delivers 98 per cent of what the scientists required and paid a lot less for it than it would have paid if we had known what we were trying to build in the first place" (Q 470).

91.  But the NAO were less positive about the laboratories meeting the needs of the public sector side, overseen in this case by the former Department of Trade and Industry: "The contract protected the taxpayer effectively from the wasted costs of construction and the termination was value for money. But the project did not achieve the DTI's aims" (p 89).

LESSONS FROM THE SPECIAL CASE OF LONDON UNDERGROUND

92.  With the National Physical Laboratory the private sector clearly had taken on some risk and lost funds when the project went awry. But the private sector fared much better when Metronet—a consortium upgrading the London Underground—went into administration in 2007.

93.  The London Underground PFP was a unique case. Unlike most other private finance projects Metronet was not building a new asset but maintaining and upgrading an existing asset. Furthermore, Transport for London guaranteed 95% of Metronet's debt obligations. Debt guarantees are not part of standard private finance contracts.

94.  The NAO said: "As a consequence of this guarantee, Metronet's lenders did not protect their investment as anticipated because only five per cent of their investment was at risk" (p 88).

95.  So when Metronet failed, the Department for Transport had to make a £1.7 billion payment to help Transport for London meet the guarantee of Metronet's borrowing. The NAO estimated a direct loss to the taxpayer of between £170 million and £410 million (p 88).

96.  Mr Allen said: "The banks being 95 per cent guaranteed did blunt some of the incentives that you usually expect to see from private finance and some of the rigour that you look for in terms of their policing of the contracts" (Q 387).

97.  The guarantees stemmed from the public sector's uncertainty over whether Metronet could borrow enough funds. Mr Allen said: "I think there was a perception at the time that this was what was required, you had three large contracts to design and a limited appetite in the bank market to provide that debt and they wanted some contractual underpinning in order to take on those risks" (Q 387). Mr Allen went on: "I am not sure that the economic arguments were very strong; I think it was more a pragmatic argument of what you needed to do in order to sign a contract" (Q 387).

98.  Mr Allen added that any private finance project which needed such extensive underwriting as Metronet should serve as a wake-up call that there may be problems ahead. He said: "When somebody says that in order to get these contracts away we need to be able to offer this sort of underpinning to the banks ... that should be a very strong warning light that this is not a contract that can be let to the market on a sensible basis" (Q 387).

99.  Furthermore, the companies behind the Metronet consortium put relatively little of their own money—or equity—into the project. When a company collapses the equity is usually lost. Banks usually get first claim on remaining assets to repay as much of the outstanding debts as possible. Usually nothing is left over for shareholders. So if shareholders have put lots of equity into a company they will be very reluctant to let it collapse because they will nearly always be left with nothing.

100.  But when "shareholders have a very limited amount of equity in the company there comes a point when actually they would rather let the company fail than continue to support [it]," said Mr Allen. He added: "The risk you transfer effectively to the company is limited by the amount of equity that the shareholders put in, in the first place, and if the risks that the company is trying to bear are larger than that it may be that shareholders walk away from it. That is certainly what happened with Metronet" (Q 387).

101.  The failure of the London Underground Metronet PFP gave private finance projects in general a bad name. Yet this project was exceptional because huge debt guarantees together with a typically narrow equity base limited risk transfer. We recommend that the state should not guarantee large amounts, and a high proportion, of debt as a means to make highly geared PFPs happen. For such exceptionally large and complex projects alternative procurement approaches should be used.

Bundling of construction, servicing and maintenance into whole life contracts

BETTER MAINTENANCE

102.  A fundamental aspect of PFPs is that the builders will also be contracted to maintain the building over 25-30 years. This encourages the contractor to put up a more durable building, requiring less maintenance over its lifetime. With lower maintenance costs the contractor can make higher profits.

103.  Most witnesses agreed PFPs led to better maintenance than had been the case under traditional procurement (for example see NAO p 90, International Project Finance Association p 316). Previously, under traditional procurement, a contractor put up a building and there was usually no further involvement. So the contractor did not have an incentive to build an asset that required little maintenance.

104.  Furthermore, under PFPs, maintenance which the private contractor provides is ring-fenced for the length of the contract and funded by the public sector. The NAO reported: "PFI provides a contractual guarantee that the public client will fund the ongoing maintenance of the building" (p 90). In the past, using traditional procurement, maintenance was not ring-fenced. So maintenance was often cut when public sector budgets were squeezed: (Sir John Gieve Q 214, Ms Susan Anderson, CBI, Q 149). According to the NAO having maintenance ring-fenced under private finance projects ensures problems are not left to fester which might otherwise cause damage requiring more expensive work to be undertaken later (p 90).

HOW MUCH DOES BETTER MAINTENANCE COST?

105.  Better maintenance is, of course, good. But some fear it has been too expensive. Dr Mark Porter, chair of the consultants committee at the BMA, said: "Anything can be bought but the price at which it is bought is too high, we would say" (Q 559).

106.  The Foreign & Commonwealth Office, which used a PFP to build and service the British embassy in Berlin, reported: "Our own experience with Berlin indicates that we have a very well designed and built-to-time embassy which is operated and maintained to an extremely high standard against agreed performance measures. It is doubtful that traditional funding mechanisms would give us the same high quality of maintenance. However, this has come at a very high price" (p 302).

107.  Due to data limitations the NAO could not say whether maintenance under private finance was cheaper or not. They said: "Whether it will lead to an overall reduction in whole-life costs would be very difficult to prove" (p 90).

108.  Private finance has led to a much needed focus on maintenance of public infrastructure. Public authorities should however keep a watchful eye on the price paid for what is on balance a positive development. We also recommend that the Government should promote the bundling of construction and maintenance, and whole-life costing, in all public procurement, whether privately financed or not.

MANAGING AND MONITORING CONTRACTS

109.  For the public sector to benefit from bundling services and maintenance together the private sector providers have to be managed to ensure delivery is up to scratch at the right cost.

110.  The NAO argued that public authorities need to improve management of contracts: "A culture of focus on making the deal rather than thinking about contract management is still, however, prevalent in many quarters of the public sector" (p 81).

111.  Contractors disagreed on the quality of staff they negotiated with in the public sector today. Mr Ian Rylatt, Balfour Beatty Capital and CBI, said: "The competency of the people we negotiate with and we bid to is leaps and bounds from what it was before." He attributed the improvement partly to greater experience with PFPs and the public sector recruiting staff from the private sector with procurement skills (Q 153). But Mr Dougie Sutherland, Interserve Investments and CBI, said: "I find it amazing that we are still finding people on the public sector side who are doing it for the first time. When I look across the deals that we get involved in I think that there are some really excellent teams and there are some very poor teams" (Q 153).

112.  Monitoring and managing private finance contracts has long been a weakness of the public sector, although there have been improvements in recent years. We recommend that public authorities should do more to maintain and improve commercial skills of staff dealing with private finance projects, with emphasis on long-term contract management as well as contract negotiation.

SECONDARY MARKETS

113.  Investors in PFPs can sell their stakes. Many argue that the secondary market is very beneficial and that freedom to sell stakes makes it easier to attract funds to private finance deals in the first place (NAO p 126, Mr Philip Turville, Royal Bank of Canada Capital Markets, Q 424, Mr Olsen QQ 445-448, Mr Metter Q 462).

114.  Since the construction phase of a project is the most risky for the contractor, once construction is over "a project that is into its operational stage is often considered to be a safer investment. Consequently the equity becomes worth more and is attractive to a different type of investor seeking a lower but more constant return" (NAO p 127).

115.  We raised the concern that the ability of contractors to sell their stakes may dilute one of the key positive aspects attributed to private finance projects—that the bundling of maintenance into a contract encourages the contractor to build a higher quality asset. If contractors know they can sell out shortly after construction they might not be so diligent about building low maintenance into an asset.

116.  In the NAO's view this concern would normally be met by pre-purchase due diligence carried by buyers in the secondary market, so that a contractor with an eye on eventual sale would still build a high quality asset. "Even if the secondary market were leading to the shareholders undertaking less due diligence, it is not clear what the effect on the contract would be. The sub-contractors, lenders and public authority would still need to work together to deliver the project and their due diligence would still be crucial" (p 127).

117.  There is some concern that construction companies which can sell their stakes in PFPs shortly after a project is operational may build a lower quality asset than if they remained shareholders with responsibility for maintenance. Although due diligence and checks by buyers in the secondary market amongst other parties may meet this concern, we saw no empirical evidence in this area. We recommend that the NAO should undertake studies of the effects of secondary markets on standards of quality in PFPs.

Is private finance necessary to get the benefits of bundling?

118.  The PFP model has spread awareness of the possible benefits of whole-life costing more widely, without necessarily resorting to private finance. Sir John Bourn said: "It does not rest simply on PFI, but there is no doubt that PFI was the incentive to get this going" (Q 356).

119.  While generally opposed to PFPs, Ms Jaffe believed they had had the benefit of introducing the concept of whole life costing into all procurement: "I think these lessons from PFI have been and are being integrated into traditional procurement, and if there is a lesson that you have to keep some money ring-fenced for maintenance then I think that is one that we can carry forward" (Q 559).

120.  The NAO noted: "Private finance is not, however, the only way to ring-fence maintenance funding or consider whole-life costs. The London Borough of Lewisham, for example, has established a sinking fund to ensure its non-PFI schools are maintained to the same standard as its PFI schools" (p 90).

121.  Witnesses said the skills acquired using PFPs spill over into traditional procurement. For example, with Crossrail—which is mostly traditionally procured—assessment of risk is "much more developed", having learnt from the experience of PFPs (Ms Mingay Q 507). The Ministry of Defence sought to improve its procurement by adopting PFP methodology to evaluate all projects (Mr Jon Thompson Q 507). Mr Rylatt said skills learnt by his company in PFPs were now used in traditionally procured projects (Q 179).

122.  Traditional procurement has also benefited from the lessons learnt from private finance projects. Risk management and due diligence appear to be better in the public sector as a result of PFPs. These benefits need to be included when assessing the total benefits of private finance.

Innovation

123.  Contractors cited examples where PFPs had led to innovation. These included prisons where long wide corridors enabled better use of CCTV and improved safety for inmates and staff; hospitals where better designed corridors enabled smoother transport of patients; and better road surfacing treatment which reduced disruption to motorists (CBI p 53, John Laing p 211).

124.  But public sector consumers of PFPs—including from the ministries of health, transport and defence—disagreed. Jon Thompson, director-general of finance at the Ministry of Defence, said: "We do not think there has been a tremendous amount of innovation through PFI." (Mr Thompson Q 525, Mr Peter Coates Q 525, Sir Peter Dixon Q 339). Ms Mingay said: "When we think about PFI we do not see it necessarily as a big area of innovation but more as a whole life costing, providing better focused planning and integration and that kind of thing" (Q 527).

125.  There are barriers to innovation. During the bidding process little time is devoted to innovative ideas as it is only one factor in whether a consortium wins a bid. Cost and duration of construction may receive more attention. During tendering, clients often cannot spend time with all the bidders to collaborate on potential innovative ideas. When any innovative ideas are finally costed, they may be too expensive and be abandoned. Moreover, the intention of private finance is to allocate risk to the contractor. That can encourage contractors to play safe with tried and tested methods to lessen the risk of something going wrong and being penalised with reduced payments (NAO pp 90-91).

126.  PFPs have led to some innovation although few witnesses described this as a key reason for using private finance. It is for public sector clients to request more innovation from contractors when negotiating private finance contracts, if that is what they are seeking.

Workforce issues

127.  Private finance projects can lead to innovations in workforce practices. But this can be unpopular as it risks less favourable terms and conditions for staff who, as a result of PFPs, move from being employed by the public sector to private contractors. HM Treasury guidance states: "The value for money that PFI can deliver should not be achieved at the expense of staff terms and conditions" (NAO p 92). TUPE (Transfer of Undertakings (Protection of Employment)) regulations aim to maintain the terms and conditions of staff transferred from the public to private sector.

128.  Ms Jaffe argued staff terms and conditions sometimes change with those on low wages faring "much worse under PFI/PPPs than more skilled workers" (Q 563). On the other hand, the National Audit Office, while conceding little analysis existed in this area, said a survey of 43 PFI schemes showed pay for the least skilled was "marginally worse". Those with skilled and management roles were paid more in the private sector (p 92). The Centre for Public Service Partnerships at Birmingham University plans to study such workforce issues and their impact on services: "The industry has evidence to suggest that transferred employees have a wider range of responsibilities, better training, and better prospects for their future. However, there is also much contrary evidence" (p 290).

129.  Unison also opposed the potential for the creation of what it described as a two-tier workforce, where transferred staff's conditions are protected while new staff subsequently hired are often brought in on less favourable terms and conditions. Ms Jaffe said: "So you can have people working alongside each other on exactly the same contracts but with totally different annual leave or sick leave or pension arrangements." She suggested that this affected staff morale and led to poorer quality of service (Q 563).

130.  Public sector employees transferred to the private sector during the course of a PFP are protected by TUPE (Transfer of Undertakings (Protection of Employment)) regulations and employees recruited directly are protected by general employment law. Pay and conditions of the two categories of employees may well differ, at least at the outset. Where average labour costs subsequently fall, in a PFP transferred from the public sector, such cost savings may simply indicate that the pay and conditions of the employees previously in the public sector exceeded the market rate.

Long-term commitment

131.  During the course of a private finance project contract, if a public body wants to close or change the use of part of a building (e.g. shut a hospital wing due to the local population size declining) under the terms of the contract it usually has to pay charges to the contractor.

132.  Critics argue it is impossible to predict the type and quantity of future demand for public services. For example, the demands of a hospital will be different in 20 years given new and improved treatments and changes to the demographics of the local population. With a private finance contract requiring charges for adapting to these factors over time public authorities may be deterred from making the necessary changes.

133.  Sir Peter Dixon cited the case of putting in day care facilities after the hospital had been built. These facilities had not been provided for in the original design due to a planning error before he took up his post. Rectifying this was "very expensive" because under the private finance contract the hospital was stuck with the one provider and could not get quotes from alternative contractors. "We had no ability to challenge the capital costs of our provider and of course they did it to suit them and we just had to cough up" (QQ 317-319).

134.  Sir Peter Dixon believed that further big changes will be needed over the life of the hospital: "Inflexibility is an issue and there is no doubt that in 30 years time when this project comes to an end there will have been several reincarnations of the buildings" (Q 319).

135.  But proponents of private finance argued that many of the costs involved in amending PFP contracts also arise under traditional procurement. Dr Stone said: "The vast majority of the costs of changes also exist in traditional procurement but are easier to hide where there is not a contract to renegotiate. The additional cost is a trade-off for transferring the risks for the long term condition of the infrastructure" (p 3). Under traditional procurement if, for example, the wing of a hospital was no longer needed, the costs of building it would have already been paid. Under PFPs not all the construction costs would have been paid for until the end of the 25-30 year contract. Partnerships UK noted that: "All sunk costs are inflexible and in that sense conventional procurement is as inflexible as PFI insofar as an asset no longer required still needs to be paid for" (p 188).

136.  Others argued that the long-term nature of the contract and the associated costs helped ensure clearer specification of PFPs. Mr Allen said: "One of the principal causes of cost overruns on public procurements is the procuring authority changing its specification repeatedly. So the fact that within a PFI contract there are constraints on the public authority doing that, that has been one of the reasons why you have seen fewer cost overruns once the contracts have been let" (Q 378).

137.  The PFP route can, however, lead to inflexibility at a high level of public policy decision making. Sir Peter Dixon said that not only did PFP contracts lead to inflexibility at the level of the individual hospital but that they also restricted changes to the broader health care system. If a hospital had to close in London, it was less likely to be a PFP one because of the charges involved. So the allocation of medical care within a given budget would not be driven by health needs alone: "Whatever else happens in reorganising services in central London my hospital has to stay there because it has a £43 million a year payment to a private provider. You can shut another hospital which does not have that and sell off the land, but you cannot do it with mine" (Q 324). The Institution of Civil Engineers feared the "lack of flexibility is a factor leading to a lack of resilience and flexibility in our infrastructure networks" (p 313).

138.  Inflexibility has been a feature of private finance contracts, although it has also been a key factor in forcing the public sector to plan ahead. But flexibility is negotiable, at least to some extent. Public authorities should determine how much flexibility they want, the means of achieving it in the terms of the contract and what they are prepared to pay for it; then negotiate accordingly.

139.  One route to greater flexibility in PFPs might be by adopting some of the features, such as provision for periodic review of prices, of the model applied to regulated utilities, which in Professor Glaister's view had "... worked spectacularly well" (Q 384). We recommend that the Government should explore the feasibility of importing into PFP contract terms selected features of regulatory review models for utilities.

Competition

BID COSTS AND COMPLEXITY

140.  Private finance contracts are complicated as they bundle together the provision of capital, construction and services. This means fewer companies—even coming together in consortia—may be able to bid for such contracts, thus limiting competition (Dr James Cuthbert and Ms Margaret Cuthbert, pp 295-296).

141.  This complexity can also make preparing bids a costly exercise, deterring competition. Furthermore, the Centre for Public Service Partnerships reported: "There has been an insistence on very detailed drawings and specifications from all competitors, even in the earliest stages of the bidding process" (p 290). In addition, the long and drawn out nature of the process increases the transaction costs of the bid. Few firms may be able to devote enough man-hours to such tender processes. The complexity and high bid costs may be influencing the number of players in the construction sector, driving firms to merge to enable them to compete for large complicated contracts (Institution of Civil Engineers p 311).

142.  Contractors may be put off by the complexity of the project rather than by bidding costs. Sir John Bourn said: "The worst projects were the ones that were so complicated to do, so in a way if you were not getting any bidders you really needed to ask yourselves whether it is a sensible thing to try to do it this way, is this one of the projects that would be better to do conventionally?" (Q 357).

143.  Competition was also limited during periods when lots of contracts were tendered and firms simply could not bid for everything. Sir John Bourn said: "In the early days … you could not actually find anyone to compete in the short term for all the work that was available." He added: "As time went on that was resolved to a degree" (Q 357).

CREDIT CRUNCH

144.  The impact of the credit crunch on competition in private finance projects has been unclear. Sir John Bourn said: "The credit crunch—through its limitation of access to funds, making them more expensive, lending money for a shorter period—has tended to reduce competition" (Q 357). But the slowdown in construction generally due to the downturn may have freed up more contractors to bid for private finance work. Mr Rylatt said: "In the current construction environment there is not a lot of conventional work around, for obvious economic reasons. The market is very, very much a buyer's market at the moment and is not a seller's market" (Q 185).

145.  High bidding expenses risk reducing competition for private finance projects which, in turn, could increase costs to the taxpayer. The Government should examine possible mechanisms for encouraging competition, such as returning an element of bid costs.

What projects are suitable for private finance?

LONG-TERM STABLE PROJECTS

146.  A significant part of the benefit of private finance projects comes from the whole life approach to contracts that last for 25-30 years. Since amendments incur charges, projects requiring relatively few changes are better suited to this type of procurement. If the nature of the requirement cannot be well identified at the outset then it will be difficult to write successful long-term contracts. So road projects, for example, seem particularly suitable for private finance procurement. Similarly, new schools can be well specified in advance and are thought to be more successful than refurbishment where there are more unknowns outside the contractor's control (Mr T Martin Blaiklock p 285, Mr Buxton Q 112). Sir Peter Dixon pointed out that the more unpredictable a refurbishment scheme, the more difficult it was to have a fixed price and to manage that risk appropriately (Q 316).

147.  IT projects were widely viewed by witnesses as unsuitable because they are difficult to specify and define at the outset. The pace of technological change means that requirements frequently change as well (Dr Stone Q 25, Centre for Public Service Partnerships p 287, Mr Humpherson Q 232). Councillor Richard Kemp, Local Government Association, said of IT projects: "By the time you have actually gone through the process the specification will have moved on" (Q 94).

148.  Nevertheless, problems with IT projects are not confined to those undertaken via private finance. Sir John Bourn believed that under certain conditions IT projects could be appropriate for private finance: "If you set about it in a sensible way, were not too ambitious, knew what you were doing, had trained people, consulted those who would actually have to operate the projects then you could make a success of it. I think all the difficulties have led the Treasury to think for the present time—I would not quarrel with this for the time being—that you would not attempt to use PFI for IT projects but I think the time could come when you could do that again" (Q 361).

149.  Private finance has been widely used in the NHS. But Mr Blaiklock argued that hospitals were not suited to the long-term, relatively stable ideal needed for PFP contracts "as the way patients are treated continuously evolves, requiring different public service assets, as technology advances" (p 285). However, Lord Crisp, formerly Permanent Secretary at the Department of Health, argued that for private finance across the NHS, "the positives outweigh the negatives" (Q 206).

SIZE AND COMPLEXITY

150.  Some projects are deemed too big for private finance as they would require the contractors to take on more risk than they would be prepared to. Crossrail was viewed as one such project. Mr Allen said: "You would struggle to find sufficient equity in a consortium vehicle to back that kind of risk … I think one of the lessons might be that the London Underground PPP contracts were too large to structure efficiently" (Q 379).

151.  However, private finance can be used for part of Crossrail. Ms Mingay said: "On these very large projects you often have projects within projects—that there are elements where private finance can be incorporated into the deal. Again in Crossrail it is the rolling stock and the construction of the Canary Wharf Station being done by the private sector, where the rest is being done publicly" (Q 543).

152.  The projects most suitable for private finance are those where the requirements can be clearly specified at the outset and which are of a size that consortia of private sector companies can take on their balance sheets.

EXTENDING THE REACH OF PRIVATE FINANCE

153.  Private finance could be used in more areas than hitherto, particularly in the provision of services. Mr Metter said: "In a hospital project we have a project to build a whole huge hospital and we have a whole range of services which we provide which are what we call soft services, services like laundry, cleaning, food; many of the services which feed directly into patients are provided by PFI. A natural extension of that would be to provide nursing services." He added: "Equally with the schools, there is no reason why some of the teaching could not go into the PFI project" (Q 482).

154.  Mr Adrian Ewer, chief executive of John Laing, said: "There is no reason why the private sector could not embrace the provision of the service rather than just provide the hardware from which the service is delivered" (Q 482).

155.  The CBI argued for 'payment by results' that would transfer at least some risk to the private sector for the quality of service provided. Susan Anderson, director of public services at the CBI, said: "If we are looking, for example, at education what we should be measuring it on is the quality of the education that is delivered in that school, not just whether you have a wonderfully designed building" (Q 186).

156.  Not all demand-related risk can be transferred at a reasonable price. Mr Metter said: "In the very early days of PFI they suggested that we should take the risk for the number of prisoners they put into the prison when we had absolutely no control over how many prisoners they were going to send to the prison. They realised very quickly that to make the private sector take that risk was just going to be very expensive for them" (Metter Q 469).

157.  The private sector is clearly not best suited to bear all the risks in all forms of private finance project. Experience has shown, however, that bundling certain services with construction in PFPs has delivered benefits, including the transfer of risk from the public to the private sector. We believe there is scope to transfer more demand or output-related risks. For example, with a prison such risks could be partly transferred by rewarding contractors for lower re-offending rates. In education, more risk transfer might be possible in the provision of teaching services; independent schools already take on all such risks. There is similar scope for the transfer of demand and output-related risks in relation to medical services.

158.  We recommend that the Government should examine what additional risks now borne by the public sector can sensibly be transferred to the private sector, acknowledge the lesson of experience that the risks of exceptionally complex, large projects are not suitable for transfer to the private sector, and produce comprehensive revised policy guidelines.


16   National Audit Office (2003) PFI: Construction performance, Summary, Page 3. Back

17   'How common and how large are cost overruns in transport infrastructure projects?', Bent Flyvbjerg, Mette K. Skamris Holm and Soren L. Buhl, Transport Reviews, 2003, volume 23.  Back

18   National Audit Office (2009) Performance of PFI Construction, Pages 7-8. Back


 
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