A fresh start

1 February 2012 A National Infrastructure Plan bursting with projects, and a review of a ‘broken’ funding model. Will 2012 be the year that PFI returns, and will anyone recognise it, asks Paul Jarvis
The government has spoken: PFI is broken and must be replaced. Chancellor George Osborne and Infrastructure UK (IUK) chief executive Geoffrey Spence were unequivocal in stating at the end of last year that the review of PFI would be “fundamental”.

But not everyone is convinced. “How much scope is there to ‘fundamentally’ change PPP?” asks Robert Meakin, at solicitors Clyde & Co. “There are three key aspects: payment for services not construction; long-term maintenance of a whole life design; and a payment mechanism dependent on ongoing availability and performance. You can do some work around other areas of risk allocation, and sources and structures of finance (including capital grants), but those three things probably have to stay if PFI is to continue to deliver operational efficiencies and effective risk transfer.”

For some, the review throws up more questions than answers. “Is this a commitment for wholesale change, or are we looking at more of a tweaking of the existing model?” asks Gerry Askew, of facilities management (FM) providers SGP. “Who has the balance of power here? Can the government only change what the banks will be happy with?

“Unless the people with the money are willing to play ball, will the review have any impact?”

Unlike some analyses of PFI – such as those put forward by MP committees over recent years – the industry as a whole does want to get involved in this review. There are plenty of strong opinions on what a ‘new PFI’ should look like, in particular what should and shouldn’t be included in a future model.

The mindset with which industry professionals approach this review will have an impact on how they respond to it, though. “We’re not going to spend an awful lot of time on it,” says one adviser. “It’s not going to earn us any revenues.”

Indeed, there is a certain war-weariness among professionals. Despite welcoming the government’s willingness to finally take the PFI bull by the horns, many feel much of this ground has been covered before.

Among the review document, there is a question on the potential benefits of capped equity returns – something already developed by the Scottish non-profit distributing model. The Treasury has long insisted it keeps a close eye on all alternative models developed around the world, so why is it now asking a question already answered by its nearest neighbour?

And there is also discussion of the regulated asset base model. “I thought that issue had been put to bed,” says one consultant.

“There are lots of things that can be done and people have argued this in the past,” says Nick Maltby, of lawyers Bircham Dyson Bell. “But the government had always said ‘it’s got to be SOPC4’.”

The hope is this review might be different, because it is backed by a government that despises the old version but needs to get a lot of private money into infrastructure.

Canada light
So when Treasury officials sit down and sift through the responses, what themes can they expect to see emerging?

“The Treasury is looking for advocates of something not dissimilar to the Canadian model,” says Nick Prior, at consultancy Deloitte. Indeed, the government had already done a substantial amount of work in this direction before Osborne announced the review. It clearly still resonates with Treasury officials as the best way to bring money from the private sector, and especially the coveted institutional investors.

But aside from working with pension funds and insurers to bring them into the market, there are plenty of other things on people’s hitlists for the Treasury to deal with.

One that will no doubt be near the top of most responses is for a change in the risk profile. People in both the public and private sectors agree that certain risks have been heavily priced in the UK in the past. Change in law risk and insurance risk are both considered ripe for reform, with a keenness for the public sector to be much more selective over what risks it passes to the private sector.

“The change of risk profile can be tinkered with to quite a degree,” says Liz Jenkins of Clyde & Co.

She also points to the handback arrangements. “The lifecycle provisions need quite hefty chunks of money put behind them at the end of the contract. The whole issue of lifecycle causes suspicion, because the public sector sees it as cash that is just sitting with the private sector for the life of the contract.”

SGP’s Askew agrees lifecycle can be a problem. “Companies here are bidding several years before the building is built, so the tendency is therefore to price risk highly on hard FM because at the time of pricing the company doesn’t know what the building will look like.”

This moves the debate into another area of the review likely to get a lot of attention from respondents: divorcing FM services from the PFI contract. This may prove popular with FM providers able to slash their bid costs.

“From our point of view, if we were just bidding for an FM contract, that could well be more attractive,” says Askew.

But it might end up costing the public sector more in the long run, he warns. “It could result in more risk being provisioned for. If we are involved from the start as the FM provider we can advise on the operational management implications of the design and reduce exposure to risk and cost during the lifecycle of the building.”

Another option might be to separate hard and soft FM services, so that cleaning services, for example, are kept outside the PFI deal. The new schools programme is already doing this, where it has been claimed friction has sometimes emerged between PFI contractors and the existing school caretakers.

Again, Askew warns such changes could push up the cost. “The problem is the interface, which can be complicated when more than one provider is involved, resulting in potential conflict that can affect the efficiency of operation.” One problem is potentially different performance levels required of the public sector providing soft FM services and the PFI contractor delivering the hard FM.

He also warns that if the public sector decides to outsource the soft FM services to a second contractor, costs could begin to spiral. “Public procurers may end up with two
managements, two helpdesks and a duplication of the work.”

Finding the finance
‘Value for money’ has been a key driver behind the review, with ministers often criticising PFI for failing to deliver on this count.

But most of the changes that the call for evidence will deliver – around the risk profile and what to do with FM – will have only a marginal impact on the overall cost of projects. “These different measures will still only have an impact on cost of about 2-4%,” says Maltby.

It is unclear what the government considers to be ‘good value’, or even ‘good enough value’. “If we’re only doing something that is slightly less expensive, does it really change the proposition fundamentally?” he asks.

Simply bringing institutional investors in will not have a major impact on the cost of finance – especially as most expect them to only be interested in funding the operational phase, leaving the shorter construction phase to the traditional bank funders. And any attempt to force British projects into a quick procurement process akin to that achieved in Canada is also likely to run into problems with European procurement rules.

Timing may also be an issue. The call for evidence closes on 10 February. Treasury officials are hopeful that they will have at least some conclusions prepared for the Budget at the end of March, which doesn’t give them much time to collate all the information, digest it and come up with a new model to put to the industry.

“The Treasury has set the right target [in what it is trying to do],” says Prior. “But to come up with a solution in such a short space of time that has credibility and the support of the market is very difficult.”

Industry backing – and specifically support from the funders – will be crucial to the success of the new model. And that does not necessarily mean the Treasury will bend to the every demand of the banks.

“The government doesn’t believe banks are going to be part of the new model, so they are hanging their hat on institutional investors,” explains Prior. That, though, throws up another problem, because such investors will only be willing to invest in schemes with a high credit rating.

At IUK, Spence has admitted that creating an unwrapped bond market from scratch is something the Treasury is trying to do in conjunction with the pension funds and insurers.

Prior, however, argues that even if the Treasury reaches a satisfactory deal on this, there is a more pressing issue. “The huge elephant in the room is that none of the institutional investors will make the effort to create room for this new asset class in their portfolio if there isn’t enough dealflow. I’m sure the Treasury will come up with a new model, but unless they can deliver a pipeline, they’re not going to get great signup to that model.”

Treasury officials point defensively to the National Infrastructure Plan (NIP) published in November, which included a list of 500 projects to be delivered in the coming years. “PFI is a subset of the broader infrastructure plan,” retorts Prior. “So how much is going to be delivered through the ‘PFI Mark II’ model? That is far from clear.”

Much has been made of the plan’s usefulness to the private sector. A quick glance at the document shows a variety of projects that have been running for some time. The Greater Manchester Waste project, for example, is listed, despite the PFI contract having been signed back in 2009 and the investment allocated long ago.

More than this, however, many future projects are not properly costed. “When we talk internally about ‘pipeline’, we mean a guaranteed income stream,” says Craig MacDougall, at technical consultancy Davis Langdon. “There has to be a secure pipeline that we can put our future requirements against,” he continues, suggesting that is simply not evident in the plan.

“We need to have the substance of a pipeline beneath the plan,” agrees Meakin. “We have a list of 500 projects but it’s all generally stuff we know about.”

Perhaps the Budget will provide that extra layer of clarity.

A local solution
A different way to look at the PFI debate, however, is through the prism of localism. Neil Rutledge, at consultancy Grant Thornton, says joint ventures at a local level offer a new way forward to deliver projects, but without central government involvement.

“Structured and governed well, long term joint ventures between the public and private sector can get the right combination of people and skills to deliver complex schemes covering housing, regeneration and energy efficiency programmes.

“We would like to see these develop at a city region level, for example through the use of infrastructure boards, bringing together the public and private sectors to develop investment programmes that look to the long-term sustainability of a city. These could raise bond finance at the city region level, perhaps by pooling the resources across a number of authorities to make a real difference.”

He suggests the recently created local enterprise partnerships (LEPs) could provide leadership at a local level, so that the NIP priorities are delivered and implemented regionally, rather than on a sector-by-sector basis. At this level, decisions over the appropriate amount of risk would be taken.

Rutledge believes joint ventures such as local asset-backed vehicles (LABVs) are also more appropriate in times of economic instability. “We have seen the decision-making freedom used well, for example to re-order a programme so that the right projects are brought to market at the right time.”

The scheme in Croydon – so far still the only LABV in the country to be building anything – has shown this flexibility already.

Rutledge suggests this is preferable to “the rigid PFI credit system where the availability of funding has influenced authorities toward schemes that, on occasion, have not been optimal for their long-term needs”.

Much has been said since the credit crunch about the ‘gold plating’ of PFI deals, with a range of services agreed during the boom that might be deemed unnecessary in more austere times.

While a more local version might prove popular with government policies, its infrastructure priorities mean there will have to be at least some schemes delivered centrally.

In those cases, the underlying model is likely to be familiar to most industry professionals. That, at least, should provide some comfort to the private sector – even if it fails to deliver any better, or even as good, value for the public purse.

This page was last updated on:
3 April 2012.

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