The Big Break-Up

2 April 2012 Public authorities are facing increasing pressure to terminate their PFI deals to free up much-needed cash. Rachel O’Rourke asks whether such quick fixes might only create longer-term problems
After spending much of 2010 and 2011 reducing back office functions and cutting staff, many authorities are now looking around to see what else can be done to squeeze out more savings.

A growing number are beginning to turn their attentions to existing PFI contracts. Spurred on by the wave of negative public opinion against the model, together with new legislation empowering local authorities, terminating PFI deals is looking like an attractive option.

One of the first out of the blocks has been Northumbria Healthcare NHS Foundation Trust. In February, the trust revealed it had secured a £100m loan from the local council to buy out its PFI deal.

“At the time [of entering the deal], PFI was the only option to complete Hexham and Wansbeck hospitals, and without it we wouldn’t have had the facilities which have served Northumberland so well,” says Jim Mackey, chief executive at the trust. “[However], we have a duty to deliver the best value for money.”

Health trusts are particularly likely to consider terminating PFI deals at the moment. Alongside NHS chief executive Sir David Nicholson’s initiative to cut costs by £20bn by 2015, they are also being forced to become Foundation Trusts – meaning their finances must be in order.

“Early release could certainly be one way of [tightening their belt],” says Sue Slipman, chief executive of the Foundation Trust Network (FTN) lobby group. “That could deliver better long-term value to the taxpayer.”

“The Department of Health is also talking at central government level about helping a number of NHS Trusts exit deals,” adds Virginia Glastonbury, at law firm SNR Denton.

 But while the talk is of ensuring ‘value for money’, the meaning may actually be ‘affordability’. Public bodies looking to cut short-term costs are more worried about what they can afford in each year’s budget, rather than what is delivering the best ‘bang for their buck’.

Either way, public sector organisations are looking to avoid being locked into long-term PFI deals in the future. The FTN will soon open “three to four” new funding options for Foundation Trusts seeking finance for major capital projects, Slipman explains. These are likely to include prudential borrowing, private equity, pension funds and bonds.

“We are keen to support the development of a more plural investment market to ensure that estates are maintained to a high standard at a time when finances are restricted,” says Slipman. “Some lenders are increasingly willing to consider loans that do not come with a government-backed guarantee.”

Mounting costs
But is cancelling an existing PFI deal actually value for money? Ed Bartlett, co-founder of lifecycle management company Kykloud, likens early termination to “downgrading an annual motor insurance policy with no claims because your premiums are expensive – even though your car is getting older”.

He warns of “dangerous financial consequences” on public sector bodies when choosing to terminate contracts. “It is a win – but a short-lived win,” he says. “There is still a long-term exposure to high facilities management and maintenance costs. Buying out of a contract may at first seem to offer a perceived saving to the public sector authority by signalling the end to the monthly PFI repayment.

“Borrowing additional funds to buy out a PFI contract on a lower rate will certainly save on interest payments, but it’s by no means free cash.”

Some have suggested public authorities may be able to make efficiency savings by scrapping their PFI deal and bringing the maintenance costs into one agreement covering their entire estate. That might be particularly relevant for hospital trusts, where a more successful one may merge with another trust and find it has a single PFI scheme to take control of.

But Bartlett argues cleaning and maintenance standards, for hospitals at least, are not cheaper for non-PFI facilities, with costs dictated by statutory standards – not by the type of contract.

“Terminating a PFI contract doesn’t cancel the need for maintenance. In fact it would mean operating and facilities costs increase, as contracts associated with the building will need to be re-tendered and staff transferred or made redundant.”

Short-term demands on affordability appear to be driving the agenda, though. In some cases, the need to stop spending on an asset over and above the cost of construction is being confused with long-term value for money.

“My gut feeling is that [many terminations] actually won’t show value for money,” says Shona Henderson at financial consultancy PricewaterhouseCoopers.

“I think a lot of terminations are being done to get an annual cashflow benefit, or maybe just to get these assets back into the control of the local authority and maybe not taking into account the full lifecycle risk.”

Henderson suggests plenty of authorities might be considering using public finance and borrowing powers as a cheaper source of finance. “Combine that with a lower specification for services, [and] you’re really muddying the water about what is actually value for money – or whether the authority is just looking at affordability.”

As John Woolley, at SNR Denton, suggests, the public has an expectation of how they would like their public spaces to look and feel. “But in financially tough times, all that matters is the cost,” he says.

Thinking differently
“Building Schools for the Future [BSF] schools are feeling the pressure of the pricing,” adds Glastonbury. “If you speak to headmasters, they will talk of the relentless cost of a BSF contract. A headmaster who might have had a choice not to paint a wall for another couple of years is caught in a PFI cycle where it happens automatically, and the contractor has the right to do it.”

Woolley, though, suggests the public sector is going to get more forceful over its PFI assets in future. “The Localism Act coming in essentially gives local authorities the right to do things that individuals can generally do with Freedom of Information [powers], and that’s a much broader competence power than local authorities have had in the past.

“I think some local authorities are now thinking that under the broader powers, they have more ability to get involved and take back the project. This is going to be a test of that legislation as to whether they use it to terminate PFI contracts.”

Indeed, this growing boldness from the public sector may have another unexpected outcome, warns one source. “Some authorities are being hugely unreasonable about what they want,” he says. “So the private sector is also thinking about termination, which sounds like an easy enough option [for the public sector].”

However, if a rash of public bodies begin proceedings to cancel their PFI deals, that could have a big impact on the amount of PFI liabilities coming onto the public sector balance sheet, as authorities borrow to buy themselves out of contracts. That would not sit well with the Treasury, as it struggles to cut the public deficit.

It would also bring back old questions around the way the public sector manages its estate. Part of the rationale of PFI was to bring in private expertise to improve estate management.

And concerns remain that there is still a public sector skills shortage, explains Nicholas Hallett, of consultancy the Procurement Management Training Company. “The local authorities are under pressure to be more proactive, [but] the ethos around the public sector is the reluctance to take risks.”  

Henderson points out that even if a public body does choose to exit its PFI deal, it will still be left footing the bill for the assets – but may be able to work more flexibly with those buildings.

“There are different things that make it a value for money transaction that aren’t about the PFI structure and finance – it’s about getting flexibility into the assets,” she says.

Private reservations
Perhaps the biggest stumbling block to any authority seeking to terminate its PFI deal, though, will be resistance from its private sector partner.

“These contracts often take five years to be awarded, so these projects are very valuable,” says Woolley.

Glastonbury points to voluntarily termination provisions within the existing PFI documentation.

“I think the contractor is always going to be resistant of break clauses because [PFI deals] are on the basis of a long-term commitment.” Nonetheless, the threat of using such clauses could at least help the public sector to get their private partner to bend over backwards to cut costs – rather than face losing the deal altogether.

David Swarbrick, at contractor Balfour Beatty Capital, is coy on the issue. “We want to help local authorities get value for money from their PFI contracts,” he says. “If they decide to buy out the contract then that’s something we will deal with pragmatically.”

Another contractor agrees that investors and facilities management providers are doing all they can to create greater value for their public sector clients. He adds that some councils are looking at negotiating the length of deals to make them shorter, rather than terminating with immediate effect.

“They would only do that where the relationship is not working well,” he insists. So which contracts are most likely to be cancelled? Some have suggested only the smaller deals – worth under £100m – will be worthwhile exiting, because anything more expensive and the cancellation costs will prove prohibitive.

“It depends on the complexity of the project,” says Eddie Davies at technical consultancy Capita Symonds. “For bigger projects it becomes a balancing act between bond financing, sponsors, co-sponsors et cetera. Smaller projects are able to determine value for money a lot easier.”

“My view is, a lot of these are going to be too expensive to pay off,” adds Henderson. This will have an impact on the way the government approaches future projects, she says.

One ploy that could be used by authorities to drive value out of contracts without having to terminate them, is to make greater use of the existing variation clauses. “Some authorities are using variations as mechanisms to deal with their short-term capital requirements,” says the above contractor. “They are undertaking building programmes linked to variations.”

That may help councils still needing to increase their estate – for example a council needing a new building to house a growing pupil population. But it will do little to tackle the problem of annual repayments that have simply become unaffordable as budgets have been cut. So existing projects will continue to come under pressure to either reduce costs or be scrapped altogether.

“The question is, are cases like Northumbria a one off, where it proves cheaper to exit the PFI scheme,” asks Woolley. “Or are there hundreds of deals out there?”

Lawyers and advisers across the country are currently in the process of finding the answer to that. Time will tell if the existing PFI estate will shrink substantially over the coming years.

This page was last updated on:
7 June 2012.

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