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HM Treasury’s reform of the private finance initiative

HM Treasury’s reform of the private finance initiative

On 15 November 2011, the Chancellor announced the long expected Government review of the private finance initiative (PFI).  HM Treasury issued its call for evidence document on 1 December 2011 and responses are due back by 10 February 2012.

PFI: a background

The PFI model was introduced to the UK in 1992.

Three key elements of PFI are:

– private sector innovation

– risk transfer

– price support by way of PFI credits from HM Treasury.

The original PFI transactions broke new ground, but with time, the number of projects ballooned and the method of project delivery has become more commoditised.

Regardless of one’s views of the merits of the model, PFI has been used to deliver over 700 new facilities across the UK in a broad range of areas including waste, education, transportation, communications, justice, healthcare, policing, street lighting and defence.

The devolved administrations in Wales and Scotland have long been cool on the PFI model and, following the arrival of the Coalition Government in May 2011 and redoubled efforts on deficit reduction, it has become clear that a cold wind has arrived for the use of the traditional PFI/PPP model for England.

The Government seems to, somewhat naively, want to both capture the lessons learnt over the past 20 years of PFI (by that, ensure that private profits are capped) and also develop a new model less reliant on HM Treasury support (by that, pass additional risk to the providers of private capital and expertise).

The public sector covenant for project finance transactions remains attractive but the greatest risk seems to be the increasing unavailability of medium to long-term senior debt funding for most project transactions.   There seems to be a working assumption that pension fund money represents the ‘White Knight’ to the struggling UK infrastructure market.  The available returns may well be attractive, but one must assume that the risk profile will only increase following the Government review.  Therefore, should our pension funds really step up to the plate to fund (as principal) transactions that both our Government and our banks are either unprepared or unable to support?

The new model

Through its review, the Government aims to create a new model as a successor to the PFI/PPP model of the last 20 years which:

– is cheaper to and more flexible for public authorities;

– retains the benefits of the current PFI model, particularly the incentives to:

* innovate;
* deliver capital projects to time and to budget, and
* effectively manage risk;

– can be delivered following a quicker and cheaper procurement process (being something that can only be addressed at EU level as part of the Commission’s procurement review); and

– increases financial transparency at all levels, ensuring that each of the public authority and private contractor is “getting what it paid for” in a fair manner.

It is surely axiomatic that the more flexible the contractual arrangements, the greater the risk and therefore the greater the cost to the public sector.  However, through the review Mr. Osborne seems to want to both keep his cake and eat it.

Fundamental reassessment of PFI

The review is considered by the Chancellor to be a ‘”fundamental reassessment of PFI”, to build on steps already taken to reduce costs and improve transparency, including:

– changes to both PFI credits and Prudential Borrowing rates announced in the Spending Review 2010 to create a level playing field for all forms of public procurement;

– the introduction of new assurance and approval arrangements for all Government projects;

– the inclusion of PFI liabilities in the unaudited Whole of Government Accounts from July 2011 to improve transparency; and

– the initiative to deliver significant operational cost savings from existing English PFI contracts.

Be careful what you wish for

It is our view that the nature of the review has already been excessively dictated by political objectives and, as a result, the risk is that any new model will present a new range of defects.  We set out below some of the new potential pitfalls:

“Risk should be allocated between the public sector and the private sector to the party best placed to manage that risk”

This mantra is wrong.  For any particular contract the risk should be allocated to the party that has agreed to assume such risk (and has therefore priced and negotiated accordingly), regardless of whether the counterparty could (in theory) manage that risk better (which is itself a totally subjective judgement).  Legal certainty is a basic premise of English contract law: the deal struck between the parties should not be reopened without all commercial terms (including pricing) also being reviewed.

Capping private sector returns

A cap on economic returns to the contractor will lead to narrower, not more flexible, contracts and, unless the public authorities are very clear in what they are seeking, one can then expect more contractual variations (with upward price variations attached).  This proposal seems to run contrary to the theme of greater flexibility for the public sector, which itself seems to forget the realities of senior debt funding.

Optimising the use of public funding

There is a presumption that public funding into public projects should rank equally with private finance – such a presumption misses both:

– the opportunity for the public funding to be pinned to the risk element that the public authority can itself influence; and
– the ability to leverage the availability of small tranches of public funding to bridge the viability gap on certain projects and get them delivered.

Where will this end up?

The debate will rumble on and PFI will remain a slightly toxic label.  Eventually we expect the debate to be concluded by changes in market conditions – and at the time the ‘new model’ will bear striking similarities to the old.  However, no-one would be able to use the label of PFI!

Edward Craft

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