Industry Insight No. 18: Is PFI the way forward or a costly proposition?

June 18, 2017

 

This article was first published by LexisPSL® on 16 June 2017.

 

Construction analysis: Sarah Schütte of Schutte Consulting Limited looks at the use of the private finance initiative (PFI) model in the UK, including what it is, the associated costs and its pros and cons. As part of this, she focusses on the ongoing Thames Tideway Tunnel PFI project (the Tideway Project).

 

What is PFI?

References: House of Commons Library Briefing Paper Number 6007 (PFI: costs and benefits)

 

PFI was initiated in 1992 by the Conservative government, with the aim of enabling the public sector to benefit from the private sector’s expertise in the deployment of large-scale projects. This followed the long privatisation programme of public infrastructure, first touted in the 1970s by the Conservative Party (which entered government in 1979 and remained in power until the Labour Party won the general election of 1997). PFI aimed to provide ongoing revenue support in service delivery to local authorities, and enable the private sector to create new or improved assets such as schools, prisons and roads.

 

The PFI model typically requires the building and financing risk to be borne by the private sector. In exchange, the public sector pays the private sector an annual fee (typically over a 25-30 year lease) for the lifetime service of the contract once the project is operational. The upfront capital investment is typically derived from a combined debt (bank borrowing) and equity (capital contributions).

 

PFI was widely used until the financial crisis of 2007/2008. At this point, it became apparent that many schemes were financially straining for the public sector client. In addition, there was wide frustration with varying quality of maintenance and responsiveness by the private sector to addressing reported operational problems. This resulted in an unacceptable situation and a decline in many services which provided a basic societal need. Some public sector clients foreclosed on their contracts and incurred significant termination fees (see below) in order to take back the work in-house or let the work on shorter contracts (in short to wrestle back control).

 

In 2012, HM Treasury conducted a thorough review of PFI to improve its cost effectiveness and transparency under the umbrella of providing better value to the taxpayer. This new form of PFI was relaunched as ‘PF2’. 

 

Under PF2, the public sector does not make payments until the services are available and being delivered (ie the project must be operational and performing at the required contractual standard). Therefore, from the point where the services are deployed, the public sector starts to pay a regular unitary charge, which represents the full ongoing cost associated with the project.

 

What are the costs associated with PFI?

1. Unitary charge

References: Private Finance Initiative and Private Finance 2 projects: 2016 summary data

 

This is the regular charge(s) typically paid by the public sector client in return for the benefits and services received. The overall unitary charge figures for PFI projects will comprise 0.5% of UK’s GDP in 2017/2018 (just over £10bn). In respect of the Tideway Project, for example, Thames Water customers will be billed an additional annual fee of £25 per customer, which commences only once the customers are deriving a benefit from the servicing of the sewage tunnels and treatment.

 

2. Financing cost

This is the premium incurred as a result of the private sector borrowing funds to pay for the project. This aspect is more controversial as it usually costs the private sector more to borrow than it would cost the public sector. In 2013/2014, for example, the interest rate for private finance was 7-8% compared to government borrowing at 3%.

 

References: Transport for London ratings

 

Financing is one of the reasons the London Underground PFI failed to deliver for the private sector and was brought back in-house. The new arrangement has been largely successful at controlling costs as Transport for London is AA rated for borrowing.

 

References: House of Commons Library Briefing Paper Number 6007 (PFI: costs and benefits)

 

According to PwC, returns on investments (RoI) in PFI projects are 2.4% higher than traditional public sector projects due to costs associated with unsuccessful bids, swap costs associated with fixed rate contracts and limited competition. The financing costs for the Tideway Project are not yet available.

 

3. Tendering costs

These are broadly the same whether a project is publicly or privately financed. The cost of going through a bid process for a significant public infrastructure project can be six figures.

 

What is the extent of the market share of PFI projects?

References: Private Finance Initiative and Private Finance 2 projects: 2016 summary data

Government response to: A new approach to public private partnerships consultation on the terms of public sector equity participation in PF2 projects

 

As of 31 March 2016, there were 686 active/operational PFI projects with a value of £59.4bn. Controversially, 90% of PFI investment is off balance sheet debt as the risk is transferred to the private sector. This is significant.

 

According to the National Infrastructure Delivery Plan Supplement published in December 2016, the UK government is calling on the private sector to fund more than half of the £500bn National Infrastructure and Construction Pipeline (see The National Infrastructure Delivery Plan 2016–2021).

 

Brexit will bring this more into the spotlight as project funding finds new ways of dealing with the impact (for more on 'Project Brexit', see Industry Insight No.15: Brexit and the construction industry).

 

The Tideway Project

The Tideway Project has an estimated £4.2bn value and is one of London’s most ambitious current projects. It will future-proof London’s sewer capacity via the construction of two tunnels (which will be 6.9km and 25km long), thereby intercepting 95% of the wastewater that would otherwise enter the Thames. Works are planned to be completed by 2023.

 

The key objectives are to:

• comply with the EU’s Urban Waste Water Treatment Directive 91/271/EEC on dissolved oxygen levels and reduction of spillage

• reduce sewage overflows
• increase the overall environmental quality of the Thames
• reduce the incidence of breaches of the Directive, which cost Thames Water approximately £227m per year in fines

 

References: NAO report: Review of the Thames Tideway Tunnel
The Tideway Project generally follows the original PFI model with a few exceptions. The initial £1bn funding for the Tideway Project is provided by Thames Water, London’s privately owned water supplier. Thames put a procurement tender out for bid to cover the remaining project cost, which was won by the consortium Bazalgette Tunnel Limited t/a Tideway. Bazalgette will design, build, finance and operate (DBFO) the tunnel, funding the remaining £3.2bn alongside a contingent financial support package from the government.

 

Pros and cons of PFI (and how does the Tideway Project fit in?)

 

Pros:

  • Opportunity—the Tideway Project creates an opportunity to deliver on a public infrastructure project that would be cost- prohibitive to finance under conventional means. A project of this magnitude is only possible due to the risk sharing arrangement between the government, Thames Water, private funding (Bazalgette) and the customers

  • Performance standards—the Tideway Project ensures that performance and scheduling targets are met through mechanisms of transparency, governance requirements and the private sector’s quality index scores. Bazalgette has committed to targeted savings through early construction completion

  • Contractual regulation—PFI projects (and public private partnership (PPP) projects generally) are more tightly regulated contractually than conventional projects, through output delivery specification measures and performance indicators. Contractors are financially penalised and not paid until the project is delivered in accordance with the performance standards

Cons:

  • Finance costs—the biggest criticism to the Tideway Project has been financial, echoing similar sentiments to opposition of PFI projects more generally. That is perhaps a philosophical wrangling: ultimately PFI projects seem to be successful (the UK government’s audit office (NAO) References: NAO report: Private Finance Projects) has reported that over 2/3 of the projects were delivered on time and just under 2/3 of projects were delivered on budget)

  • Alternative schemes—in addition, Tideway Project critics state that the same environmental goals could have been achieved with less costly measures. However, the government concluded, following ten years of testing, that the alternatives to the full tunnel proposed under the Tideway Project either failed the standards required by the Directive or were more costly than the full tunnel

  • Termination costs—the termination of a PFI contract is very costly. Northumbria Healthcare NHS Foundation Trust had to fork out £24m in costs for contact termination to buy out its PFI deal and another £4m in compensation

  • Risk of non-completion—if the Tideway Project does not complete, the cost implications would be enormous. However, the Tideway Project is already on stage three with the first two stages having been completed on time and on budget

  • RoI vs long-term cost—another criticism is the RoI paid to investors, which is generally in the range of 12-15% rising to 20% in some instances. In the instance of the Tideway Project, this is closely monitored as the public will ultimately be paying for the ongoing cost of the project therefore any returns will be subject to government accountability and open to public criticism

  • Best value to taxpayer—HM Treasury has previously criticised PFI projects for bringing poor value for money. It is not clear if the Tideway Project will avoid similar criticism.The far-reaching positive consequences for public health are socially important but intangible. What is being measured contractually is the new system’s capacity and ability to handle the sewage discharge

     

What does the future hold for PFI/PF2? 

 

References: NAO report: Savings from operational PFI contracts

  • Financial savings—the government’s Operational PFI Savings Programme, which aims to maximise monetary efficiency from PFI projects, reported a £2.1bn in savings in March 2015

  • Document and contract standardisation—this is important to ensuring uniformity on output delivery standards, quality specifications and payment

  • Legislative control delivery and approval standards for major projects

  • The launch of the UK guarantee scheme, which aims to increase taxpayer value for money

  • Payment cap—set at £70bn per year for PFI projects, which then allows for a yearly allocation of £1bn for new PF2 projects. This will spread government investment across more projects

  • The government as stakeholder—it plans to hold a significant minority equity stake (25-49%) for new PF2 projects. This will not only increase transparency but will strengthen the collaboration between the private and public sector

  • Collaboration via NEC contract—wholesale adoption by the public sector of NEC contracting is evidently working. In the instance of the Tideway Project, the government has continued to promote collaboration between the private sector, the public sector and the London population 

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