By Matthew DIllon
1 October 2009
Public bodies run costly risks when they use the Private Finance Initiative, argues Matthew Dillon. Managing special purpose companies is one of the most obvious
In the 17 years since the Private Finance Initiative was launched by John Major’s Conservative government, contracts for some 650 projects have been let. Although activity within the market has deteriorated markedly since 2008, with so many projects now operational there is a growing concern that the PFI does not offer value for money and that the public sector is not geared up to manage such complex contracts.
To see what has gone wrong, it’s useful to examine the structures and processes that are central to these contracts. The main players are the private sector PFI consortiums, which typically include a building contractor, a services contractor and an investor.
The consortium establishes a special purpose company (SPC), which sets up contracts with the relevant public authority to finance, build and operate the asset. It also subcontracts the design and construction to a building contractor and the maintenance and operation to a services contractor.
Because the SPC secures finance on a non-recourse basis to its shareholders and is thinly capitalised, it must, as a condition of its bank funding, pass all significant contractual risk to its subcontractors.
The risks that subcontractors are required to assume under the PFI are significantly greater than those under more conventional procurement routes. The initiative has doubtless caused severe financial pain for a number of UK infrastructure companies including Jarvis, Amey, Ballast and John Laing. This, together with the significant cost of tenders, results in a high bar to sector entry and reduced competition. Supporters of the PFI talk about risk transfer to the private sector but such transfers come at a hefty premium to conventional procurement and do not always protect the public sector in the event of an SPC collapse.
The golden rule is that the SPC is not entitled to any payment until the building has been certified as complete by an independent third party. After completion, the SPC is responsible for maintaining the fabric of the building throughout an operational period of up to 30 years. In return, the public authority that procured the building makes a monthly payment known as a unitary charge. The level of charge is largely fixed on the date that the contract was signed save for instructed variations to works and services, indexation, authority breaches of contract and benchmarking/market testing.
There have been many reports in the media about the excessive costs sought by SPCs in respect of minor variations. For example, in August 2006 Channel 4’s Dispatches programme reported on a contract where it cost £333 to move a light switch. Before the advent of PFI, such minor works might have been undertaken by the authority’s direct labour force, but now the authority can only request that the SPC undertake such works. The SPC then requests the same of the service contractor who will place the order with its subcontractors.
A reason for costs appearing disproportionately high is that the SPC, the services contractor and its subcontractor will all seek to apply a margin on to the cost of the works. Thus, the variation costs bear little comparison to the actual costs. Undoubtedly, variations will continue to be
disproportionately expensive under the PFI.
The costs of certain SPC services have to be assessed every five or so years to ensure that they remain competitive. This process of benchmarking and market testing allows for the movement of some costs if it is found that they are either too expensive or indeed too cheap when compared with others in the sector providing similar services. Benchmarking is supposed to be transparent, although it remains to be seen whether this provides value for money or whether it is used as a process to increase costs, perhaps to compensate for unrealistic initial bids.
Benchmarking is said to ensure competitiveness because the services contractor is at risk of being replaced if its price is no longer competitive. But the risk of a replacement is usually theoretical rather than real, due to the ever-decreasing pool of competition. In practice, the only companies able to accept the risks inherent with the PFI are those already involved in the industry. But such contractors may prefer not to participate, possibly in the hope that their competitors will reciprocate the favour when their own contracts are due for benchmarking.
Many argue that benchmarking is just another avenue for the SPC to take yet more money from the public sector. The true costs of benchmarking, both in terms of authority administration and real costs, might not become apparent until the next decade.
But it is performance monitoring and payment mechanisms that create the biggest difficulties. Payment to the SPC is performance-based, with scope for the unitary charge to be reduced where, for example, parts of the building fall below the agreed standard or pre-determined service levels have not been met.
The payment mechanism sets out the extent to which the unitary charge can be abated, although whether authorities levy anything other than nominal deductions is unclear. Indeed, a 2008 investigation undertaken by Ipsos Mori found that 42% of projects sampled suffered no deductions in the previous 12 months.
It is the SPC that self-monitors its performance and reports the results to the authority on a monthly basis, reducing the charge accordingly. The SPC will operate a helpdesk to which the authority’s representatives can report problems to comply with its contractual obligations. Likewise, the SPC is similarly obliged to report such events to ensure an accurate record of SPC performance and make sure that the appropriate deductions are made.
The problem is that the authority has to periodically monitor performance and reconcile all reports that it has made both to the helpdesk and the on-site team against the reports generated by the SPC. If not, the authority will not know whether the SPC is providing the correct level of service, is generating accurate and complete reports or is applying the appropriate deduction.
In the early days of the PFI, payment mechanisms were cobbled together on a project-by-project basis, and sometimes made little sense to anybody other than the person who drafted them. More recently, a number of standard form project agreements and payment mechanisms have been drafted. Although these have removed some of the earlier ambiguities, they remain unwieldy documents that are difficult to operate effectively. Ipsos Mori found that payment mechanisms would benefit from ‘simplification, greater clarity and explanation for managers’.
Poor contract management of PFI contracts is clearly a concern. If we consider monitoring of a school as an example, it will be the teaching staff and head teacher who are aware of any performance shortfalls and who have to report these. Head teachers should, however, be focused on the provision of an excellent education and presumably they will not want to divert valuable resources from frontline teaching to managing the SPC.
Prime responsibility for managing the SPC must, therefore, rest with the contracting authority. But to what extent does the authority have personnel at the school or understand what is occurring at the coalface? It is not uncommon for there to be a disconnect between the end user and the authority, with tensions often developing between the level of service that the school expects and the extent to which the authority is prepared to manage and join battle with the SPC.
The authority will be equally constrained by budgets, and frequently does not possess the expertise to understand the PFI contract and the payment mechanism or to tackle the SPC’s shortcomings. There are examples where long before service commencement an authority disbands the PFI team that procured the contract on its behalf so that there is nobody left with the expertise to manage the contract when it is most needed – ie, in the operational phase. When the PFI contract is signed, the authority should be increasing the team’s resources, not disbanding it or replacing it with junior staff who lack the ability to effectively manage the contract. Such an approach is a false economy.
The authority must now put in place an experienced team to monitor the provision of services and operate the payment mechanism appropriately. If it does not, there is little prospect of it receiving the service it is paying for and little prospect therefore of the PFI giving value for money.
Of course, ignorance of the finer details of the PFI contract is not a public sector monopoly. The authority would be wrong to assume that those working for the SPC necessarily understand the payment mechanism or are aware that they are perhaps seeking payment for something to which they are not entitled. This is not because of dishonesty but simply because those putting together applications for payment might have no real feel for what is taking place or any experience of operating payment mechanisms. It might well be that the SPC regularly seeks payment for the full unitary charge without any thought to its actual entitlements under the payment mechanism.
The SPC is obliged to self-monitor and report service failures as and when they are identified. The reality is that the SPC will have minimal staff on site (if any) and the obligation to self-monitor falls to the services contractor and specifically the on-site team. It should not be presumed that the on-site team will be familiar with the prescriptive definitions of service failure. Frequently they will have worked directly for the authority before the PFI contract was signed and will find it hard to adapt to a performance-based regime, particularly if support from the SPC is lacking.
All too often, the SPC is able to get away with providing a service that does not accord with the service specification, and yet the SPC seeks and is paid the full unitary charge without deduction.
As we become more experienced with the operation of PFI contracts, so more questions arise as to the advantages of procuring such projects. There can be no benefit to the taxpayer in using high-cost private finance when the government can secure such finance at considerably lower cost. Further, Lloyds, HBOS and RBS were all, before the credit crunch, involved in financing the PFI, but their continued participation hardly ensures risk transfer away from the taxpayer.
The premiums charged by the finite pool of contractors for PFI risk transfer are substantial. Further significant sums are spent by the public sector on the services of professional advisers and the burgeoning agencies set up to support public sector PFI interests. To effectively manage the private sector, significant resources must be used for contract management. Without this, there can be no certainties that the private sector will produce what it is contracted to supply. It is doubtful that the cost of this is taken into account by the public sector when determining whether or not PFI provides value for money. Many authorities have been surprised at the level and cost of managing their PFI interests when previously no such layer of management was required.
Taking all of the above into account it must be doubtful whether the PFI provides value for money. Even where it succeeds in transferring risk to the private sector, the premium is so high that it would represent far better value for money for such risk to be retained by the taxpayer.
Matthew Dillon is a solicitor who spent nine years working as in-house counsel to leading PFI companies and is currently a consultant to Silver Shemmings LLP
1 October 2009
Public bodies run costly risks when they use the Private Finance Initiative, argues Matthew Dillon. Managing special purpose companies is one of the most obvious
In the 17 years since the Private Finance Initiative was launched by John Major’s Conservative government, contracts for some 650 projects have been let. Although activity within the market has deteriorated markedly since 2008, with so many projects now operational there is a growing concern that the PFI does not offer value for money and that the public sector is not geared up to manage such complex contracts.
To see what has gone wrong, it’s useful to examine the structures and processes that are central to these contracts. The main players are the private sector PFI consortiums, which typically include a building contractor, a services contractor and an investor.
The consortium establishes a special purpose company (SPC), which sets up contracts with the relevant public authority to finance, build and operate the asset. It also subcontracts the design and construction to a building contractor and the maintenance and operation to a services contractor.
Because the SPC secures finance on a non-recourse basis to its shareholders and is thinly capitalised, it must, as a condition of its bank funding, pass all significant contractual risk to its subcontractors.
The risks that subcontractors are required to assume under the PFI are significantly greater than those under more conventional procurement routes. The initiative has doubtless caused severe financial pain for a number of UK infrastructure companies including Jarvis, Amey, Ballast and John Laing. This, together with the significant cost of tenders, results in a high bar to sector entry and reduced competition. Supporters of the PFI talk about risk transfer to the private sector but such transfers come at a hefty premium to conventional procurement and do not always protect the public sector in the event of an SPC collapse.
The golden rule is that the SPC is not entitled to any payment until the building has been certified as complete by an independent third party. After completion, the SPC is responsible for maintaining the fabric of the building throughout an operational period of up to 30 years. In return, the public authority that procured the building makes a monthly payment known as a unitary charge. The level of charge is largely fixed on the date that the contract was signed save for instructed variations to works and services, indexation, authority breaches of contract and benchmarking/market testing.
There have been many reports in the media about the excessive costs sought by SPCs in respect of minor variations. For example, in August 2006 Channel 4’s Dispatches programme reported on a contract where it cost £333 to move a light switch. Before the advent of PFI, such minor works might have been undertaken by the authority’s direct labour force, but now the authority can only request that the SPC undertake such works. The SPC then requests the same of the service contractor who will place the order with its subcontractors.
A reason for costs appearing disproportionately high is that the SPC, the services contractor and its subcontractor will all seek to apply a margin on to the cost of the works. Thus, the variation costs bear little comparison to the actual costs. Undoubtedly, variations will continue to be
disproportionately expensive under the PFI.
The costs of certain SPC services have to be assessed every five or so years to ensure that they remain competitive. This process of benchmarking and market testing allows for the movement of some costs if it is found that they are either too expensive or indeed too cheap when compared with others in the sector providing similar services. Benchmarking is supposed to be transparent, although it remains to be seen whether this provides value for money or whether it is used as a process to increase costs, perhaps to compensate for unrealistic initial bids.
Benchmarking is said to ensure competitiveness because the services contractor is at risk of being replaced if its price is no longer competitive. But the risk of a replacement is usually theoretical rather than real, due to the ever-decreasing pool of competition. In practice, the only companies able to accept the risks inherent with the PFI are those already involved in the industry. But such contractors may prefer not to participate, possibly in the hope that their competitors will reciprocate the favour when their own contracts are due for benchmarking.
Many argue that benchmarking is just another avenue for the SPC to take yet more money from the public sector. The true costs of benchmarking, both in terms of authority administration and real costs, might not become apparent until the next decade.
But it is performance monitoring and payment mechanisms that create the biggest difficulties. Payment to the SPC is performance-based, with scope for the unitary charge to be reduced where, for example, parts of the building fall below the agreed standard or pre-determined service levels have not been met.
The payment mechanism sets out the extent to which the unitary charge can be abated, although whether authorities levy anything other than nominal deductions is unclear. Indeed, a 2008 investigation undertaken by Ipsos Mori found that 42% of projects sampled suffered no deductions in the previous 12 months.
It is the SPC that self-monitors its performance and reports the results to the authority on a monthly basis, reducing the charge accordingly. The SPC will operate a helpdesk to which the authority’s representatives can report problems to comply with its contractual obligations. Likewise, the SPC is similarly obliged to report such events to ensure an accurate record of SPC performance and make sure that the appropriate deductions are made.
The problem is that the authority has to periodically monitor performance and reconcile all reports that it has made both to the helpdesk and the on-site team against the reports generated by the SPC. If not, the authority will not know whether the SPC is providing the correct level of service, is generating accurate and complete reports or is applying the appropriate deduction.
In the early days of the PFI, payment mechanisms were cobbled together on a project-by-project basis, and sometimes made little sense to anybody other than the person who drafted them. More recently, a number of standard form project agreements and payment mechanisms have been drafted. Although these have removed some of the earlier ambiguities, they remain unwieldy documents that are difficult to operate effectively. Ipsos Mori found that payment mechanisms would benefit from ‘simplification, greater clarity and explanation for managers’.
Poor contract management of PFI contracts is clearly a concern. If we consider monitoring of a school as an example, it will be the teaching staff and head teacher who are aware of any performance shortfalls and who have to report these. Head teachers should, however, be focused on the provision of an excellent education and presumably they will not want to divert valuable resources from frontline teaching to managing the SPC.
Prime responsibility for managing the SPC must, therefore, rest with the contracting authority. But to what extent does the authority have personnel at the school or understand what is occurring at the coalface? It is not uncommon for there to be a disconnect between the end user and the authority, with tensions often developing between the level of service that the school expects and the extent to which the authority is prepared to manage and join battle with the SPC.
The authority will be equally constrained by budgets, and frequently does not possess the expertise to understand the PFI contract and the payment mechanism or to tackle the SPC’s shortcomings. There are examples where long before service commencement an authority disbands the PFI team that procured the contract on its behalf so that there is nobody left with the expertise to manage the contract when it is most needed – ie, in the operational phase. When the PFI contract is signed, the authority should be increasing the team’s resources, not disbanding it or replacing it with junior staff who lack the ability to effectively manage the contract. Such an approach is a false economy.
The authority must now put in place an experienced team to monitor the provision of services and operate the payment mechanism appropriately. If it does not, there is little prospect of it receiving the service it is paying for and little prospect therefore of the PFI giving value for money.
Of course, ignorance of the finer details of the PFI contract is not a public sector monopoly. The authority would be wrong to assume that those working for the SPC necessarily understand the payment mechanism or are aware that they are perhaps seeking payment for something to which they are not entitled. This is not because of dishonesty but simply because those putting together applications for payment might have no real feel for what is taking place or any experience of operating payment mechanisms. It might well be that the SPC regularly seeks payment for the full unitary charge without any thought to its actual entitlements under the payment mechanism.
The SPC is obliged to self-monitor and report service failures as and when they are identified. The reality is that the SPC will have minimal staff on site (if any) and the obligation to self-monitor falls to the services contractor and specifically the on-site team. It should not be presumed that the on-site team will be familiar with the prescriptive definitions of service failure. Frequently they will have worked directly for the authority before the PFI contract was signed and will find it hard to adapt to a performance-based regime, particularly if support from the SPC is lacking.
All too often, the SPC is able to get away with providing a service that does not accord with the service specification, and yet the SPC seeks and is paid the full unitary charge without deduction.
As we become more experienced with the operation of PFI contracts, so more questions arise as to the advantages of procuring such projects. There can be no benefit to the taxpayer in using high-cost private finance when the government can secure such finance at considerably lower cost. Further, Lloyds, HBOS and RBS were all, before the credit crunch, involved in financing the PFI, but their continued participation hardly ensures risk transfer away from the taxpayer.
The premiums charged by the finite pool of contractors for PFI risk transfer are substantial. Further significant sums are spent by the public sector on the services of professional advisers and the burgeoning agencies set up to support public sector PFI interests. To effectively manage the private sector, significant resources must be used for contract management. Without this, there can be no certainties that the private sector will produce what it is contracted to supply. It is doubtful that the cost of this is taken into account by the public sector when determining whether or not PFI provides value for money. Many authorities have been surprised at the level and cost of managing their PFI interests when previously no such layer of management was required.
Taking all of the above into account it must be doubtful whether the PFI provides value for money. Even where it succeeds in transferring risk to the private sector, the premium is so high that it would represent far better value for money for such risk to be retained by the taxpayer.
Matthew Dillon is a solicitor who spent nine years working as in-house counsel to leading PFI companies and is currently a consultant to Silver Shemmings LLP
