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HM TREASURY
PFI: meeting the
investment challenge
July 2003
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Cover images
Front (I to r):
Perry Beeches School, Birmingham
Central Library, Bournemouth
Lammas Community School, Waltham Forest
Magistrates Court, Humberside
Wythenshawe Hospital, South Manchester
Back (I to r):
Central Library, Bournemouth
Government Communications Headquarters (GCHQ), Cheltenham
Second Severn Crossing, River Severn
HM Prison, Altcourse
Midland Metro, West Midlands
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ConTENTS
I Introduction 1
2, PFI — Meeting the Investment Challenge 13
s The Governments’ Approach to PFI 27
4. PFI — An Assessment 43
5 Improving the Partnership 59
6. Employee Protection 69
a Assessing Value for Money 7
8. Improving Delivery 93
% Private Finance 105
Annexes
A- Public Sector Comparator Reform 113
B— Reporting and Accounting Issues 117
C - Pricewaterhouse Coopers Rate of Return Study 123
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il This document explains the PFI programme's small but important role in the delivery
of the Government's investment plans for public services. It explains the Government's
approach to PFI based on clear limits on its appropriate use and a rigorous assessment of
value for money with no bias in favour of any particular procurement route. It presents the
results of research conducted into the performance of PFI, and outlines the steps already
taken to improve the programme through building the partnership between public sector
client and private contractor. It also outlines the steps the Government has taken to ensure
that PFl’s value for money is not obtained at the cost of employees’ terms and conditions.
Finally, it proposes further improvements to the Government's process for assessing value for
money, its systems for delivering projects and its ability to capture efficiently the benefits of
private finance. This document is concerned only with the Government's PFI programme,
and not other forms of public private partnership (PPP). Its policy proposals have direct effect
only in England, as policy on PFI is devolved in Scotland, Wales and Northern Ireland.
MEETING THE INVESTMENT CHALLENGE
12 The Government's objective is to deliver world class public services. To achieve this,
sustained increases in investment and matching reforms are needed to deliver efficient and
responsive services, which meet public expectations throughout the country. Strong and
dependable public services lay the foundations for a flexible and productive economy. They
also promote opportunity and security for all, helping to tackle poverty and social exclusion
and improving the quality of life. Chapter 2 contains detailed information on the
Government's extensive programme of capital investment in the public services, and PFI’s
place within that programme.
13 A prerequisite for delivering high quality public services is having the right public
service infrastructure in place. In 1997, Public Sector Net Investment (PSNI)stood at just £4.9
billion — 0.6 per cent of GDP - the lowest level for more than a decade. Investment in public
services had been on a declining trend since the 1970s, resulting in falling standards in
schools, hospitals and other public service assets.
1.4 The Government is committed to reversing this legacy of under-investment in public
service infrastructure. Public Sector Net Investment will rise to 2.1 per cent of GDP by 2005-
06, while total investment - which includes PSNI, depreciation, recycled proceeds from asset
sales and estimated private sector investment in public services through PFI and PPPs ~ is set
to rise to more than £47 billion over the same period. This is the largest sustained increase in
public sector investment in over twenty years.
1.5 The vast majority - over 85 per cent — of this increased investment is conventionally
procured public investment, with the proportion of estimated private sector investment in
public services through PFI remaining relatively constant over the period 1998-9 to 2003-4 at
between 10 and 13.5 per cent of total investment. This overall picture does not change when
looked at for individual departments.
1.6 This investment programme is beginning to deliver extensive new and modernised
infrastructure to public services. PFI investment has now delivered over 600 operational new
public facilities, including 34 hospitals and over 200 new and refurbished schools. The
decision to undertake PFI investment is taken on value for money grounds alone, and
whether it is on or off balance sheet is a subsequent decision taken by independent auditors
and is not relevant to the choice of procurement route. Almost 60 per cent of PFI projects by
value are on balance sheet.
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INTRODUCTION
Chart I.1: Total Investment In Public Services
60
50
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see SE RF SE 2EE5 FG
gids oe esegaea sea 23
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[ilrsni [[] Depreciation [Jj] Asset sales lj PFI/PPP
in the year that investment tokes place,
THE GOVERNMENT’S APPROACH TO PFI
1.7 The Government only uses PFI where it is appropriate and where it expects it to deliver
value for money. In assessing where PFI is appropriate, the Government's approach is based
on its commitment to efficiency, equity and accountability and on the Prime Minister's
principles of public service reform. PFI is only used where it offers value for money, where it
can meet these requirements, and where the value for money it offers is not at the cost of the
terms and conditions of staff. The Government is committed to securing the best value for its
investment programme by ensuring there is no inherent bias in favour of one procurement
option over another. Chapter 3 lays out in more detail the Government's approach to PFI, and
its analysis of where it is appropriate and effective.
18 Evidence to date suggests PFI is appropriate where there are major and complex
capital projects with significant ongoing maintenance requirements. Here the private sector
can offer project management skills, more innovative design and risk management expertise
that can bring substantial benefits. Where it is effective, PFI helps ensure that desired service
standards are maintained, that new services start on time and facilities are completed on
budget, and that the assets built are of sufficient quality to remain of high standard
throughout their life. These are some of the value for money benefits which PFI can provide.
They are outlined in more detail in paragraph 3.14.
1.9 However, PFI is unlikely to deliver value for money in other areas, for example where
the transaction costs of pursuing PFI are disproportionate compared to the value of the
project or where fast paced technological change makes it difficult to establish requirements
in the long term.
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Box I.1: PPPs and PFis
In 2000, the Government published “Public Private Partnerships - the Government’s
Approach” which defined public private partnerships (PPPs) into three categories:
* the introduction of private sector ownership into state-owned businesses, using
the full range of possible structures (whether by flotation or the introduction of a
strategic partner), with sales of either a majority or a minority stake;
° the Private Finance Initiative (PFI) and other arrangements where the public
sector contracts to purchase quality services on a long-term basis so as to take
advantage of private sector management skills incentivised by having private
finance at risk. This includes concessions and franchises, where a private sector
partner takes on the responsibility for providing a public service, including
maintaining, enhancing or constructing the necessary infrastructure; and
© selling Government services into wider markets and other partnership
arrangements where private sector expertise and finance are used to exploit the
commercial potential of Government assets.
This document is concerned only with the Government’s PFI programme, and does not
relate to or include information about investment undertaken by other kinds of PPP.
1.10 To be effective, PFI needs to be managed as a mature relationship between the public
and private sectors that recognises their mutual responsibilities. PFI relationships are very
different from privatisation, in which the market and price mechanism defines the service
provided. The private sector has always been involved in the building and maintenance of
public infrastructure. PFI ensures that contractors are bound into long-term maintenance
contracts and shoulder the responsibility for the quality of the work they do. With PFI, the
public sector defines what is required to meet public needs and remains the client
throughout the life of the contract. The public sector also ensures, by contract, delivery of the
outputs it sets and has rights under those contracts to change the output required from time
to time. Consequently, with PFI the public sector can harness the private sector to deliver
investment in better quality public services while maintaining frontline services in the public
sector.
LIL While an effective client relationship with the private sector is important to ensure PFI
is a success, the Government places equal importance on working with both employees and
the private sector to ensure staff are protected. Equally there needs to be an optimal sharing
of risks between the private and public sector. There are certain risks that are best managed
by the Government and to seek to transfer these risks would either not be viable or not offer
value for money for the public sector.
1.12 Where this sharing of risks is done appropriately and effectively, it is the key to
ensuring that the value for money benefits in PFI projects are realised. The benefits PFI can
offer, in terms of on time and on budget delivery and whole-of-life costing, all flow from
ensuring that the many different types of risks inherent in a major investment programme —
for example construction risk or the risk associated with the design of a building — are borne
by the party who is best placed to manage them. In this way, the private sector is incentivised
by having its capital at risk to perform well, and takes responsibility for the work it
undertakes. Paragraph 3.29 gives an overview of the Government's approach to risk-
sharing.
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113° While the private sector takes on the major project performance risks, like cost
overruns and delay, key risks in an investment project are retained by the public sector in
both conventional procurement and in a PFI scheme. These include the need to make
alterations in the delivery of services necessary to reflect changing needs of the public sector
in the future. The Government also needs to protect the ongoing delivery of public services.
For those services provided through PFI, the contract entered into with the private sector
builds in major protections for the public sector to safeguard the standards of delivery by PFI
schemes in public services, and their flexibility in future.
PFI — AN ASSESSMENT
1.14 The Government is committed to ensuring that decisions on investment, whether
through conventional procurement routes or PFI, are informed by a sound evidence base and
meet its requirements of equity, efficiency, and accountability.
1.15 I Research conducted by the Government and others, particularly the National Audit
Office (NAO), confirms the largely positive impact of PFI to date and highlights areas where
there is scope for further improvements. Chapter 4 provides details of HM Treasury research
of 61 PFI projects. The key findings were:
* 89 per cent of projects were delivered on time or early;
© all PFI projects in the HM Treasury sample were delivered within public sector
budgets. No PFI project was found where the unitary charge had changed
following contract signature — other than where user requirements changed;
© 77 per cent of public sector managers stated that their project was meeting
their initial expectations; and
* there is scope to reduce procurement times, although there is evidence that
new intiatives to tackle this problem are having an impact.
1.16 As outlined in Box 1.2, the NAO undertakes a rolling review of all Government
procurement and procurement policy, including PFI procurement. In many cases the NAO’s
findings have been positive. For example, its investigation into PFI’s construction
performance demonstrated that over 75 per cent of PFI projects were delivered on time or
early, and in no case did the public sector bear the cost of construction overruns, a significant
improvement on previous non-PFI experience.
117. Equally, the NAO’s critical review function has been demonstrably beneficial in
highlighting areas of PFI procurement policy that required attention. For example:
the NAO’s recommendations on refinancing contributed to the Government's
issuing of guidance on refinancing in future PFI projects and to the drawing
up of the refinancing Code of Conduct; and
the NAO’s emphasis on the proper use of the Public Sector Comparator in the
procurement process has provided support for the need for reforms to the
value for money appraisal process laid out in Chapter 7 of this document.
118 Research has also provided valuable evidence on project performance in low capital
value schemes and in IT, the results of which have informed decisions on when PFI may not
consistently deliver value for money and where other procurement routes could offer a better
alternative in future. This research is outlined in paragraphs 4.27 to 4.56.
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Box 1.2: The National Audit Office, Public Accounts Committee and
other audit bodies
The National Audit Office (NAO) is the primary body charged with assessing the
Government’s PFI programme. In this capacity it audits procurement policy, the conduct
of procurement, and the value for money of selected individual projects, for both PFI and
non-PFI procurement routes. In its capacity as auditor of central government
Departments’ accounts, it also audits the balance sheet treatment of Departments’ PFI
projects.
The Public Accounts Committee (PAC) frequently follows up reports produced by the
NAO with hearings and reports of their own, placing Government policy and activity under
Parliamentary scrutiny, and making recommendations on policy areas. Individual
Departments are accountable for projects they procure. HM Treasury is accountable for
overall PFI policy.
The NAO and PAC not only investigate, report and make recommendations based on
significant individual PFI projects, but also conduct systematic reviews of important PFI
policy areas or other aspects of the programme. Recent examples include the NAO’s
reports on construction performance in PFI and public sector contract management, and
the PAC’s overview report on securing value for money in PFI procurement.
The NAO have published 31 reports to date on PFI, and the PAC has published 24 further
reports. The majority of NAO reports (26) have investigated individual projects such as the
redevelopment of the West Middlesex University Hospital. Five reports have looked at
sector or general PFI issues, for example construction performance and PFI prisons.
The full text of the NAO’s reports is available on their website at www.nao.gov.uk.
Reports published by the PAC are available, along with the Government's response to
each report, on the House of Commons website at www.publications.parliament.
uk/pa/em/cmpubacc.htm
The NAO now produces a database of its recommendations and those of the PAC on PFI
policy - and also on PPPs and aspects of privatisation - which can be searched by topic
area. It is available on the Internet at www.nao.gov.uk/recommendation.
A number of other audit bodies have areas of PFI procurement within their remit,
including the Audit Commission and Audit Scotland. The Audit Commission is responsible
for auditing public money spent by local authorities, NHS bodies and others in England and
Wales and has published reports on PFI in these areas. Audit Scotland plays a similar role
for the Scottish Executive and public bodies in Scotland.
IMPROVING THE PARTNERSHIP
1.19 Strong procurement skills are vital for delivering quality investment on time and in a
way that secures value for money for the public sector. It is important that authorities have
the capacity and the support needed to pursue both conventional procurement and PFI
effectively. PFI requires relevant expertise - like other large and complex procurements —
because it involves long-term options appraisal, significant use of specialist advisers and
what can be complex contract negotiations reflecting the Government's approach to risk
sharing. The steps that the Government has already taken to raise the skills level across public
procurement are set out in Chapter 5.
1.20 The Government has therefore already introduced a number of measures to support
the public sector in its role as a client in PFI and other procurement. To ensure that strong
procurement skills are developed across the public sector, the Government has established
Partnerships UK. Partnerships UK is a public private partnership whose principal objective is
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to support all parts of the public sector, including the devolved administrations, by providing
specialist procurement expertise. Procuring authorities are able to call upon Partnerships UK
to help them identify and remove obstacles to the successful and timely implementation of
particular projects. The Office of Government Commerce has also introduced the Gateway
process as a performance management tool to ensure successful delivery. The Gateway
process provides the framework for a rigorous assessment of the deliverability of projects,
including PFI schemes, throughout the procurement process. In this way it helps ensure that
any potential problems in the procurement process can be identified and addressed at an
early stage. These measures are outlined in more detail in Chapter 5
1.21 In recognition of the particular needs of local authorities, who may only be engaged in
‘one-off’ procurements the Public Private Partnership Programme (4Ps) was established. This
provides support to local authorities through the provision of advice and guidance notes on
PFI projects and is working with the Government to increase the standardisation of local
authority contracts. The Government also introduced the Project Review Group to review the
progress of local authority projects so that best practice can be shared more effectively.
1.22. The Government is also committed to ensuring that bid costs for both private and
public sectors are kept as low as possible, and that the PFI procurement process runs
smoothly and without delay. High costs or long delays in the PFI bidding process slow
delivery and impact on value for money for the public sector and, if unchecked, may reduce
competition for PFI projects. Similarly, high bid costs may influence the returns sought by the
private sector from PFI projects. Improving the public sector's ability to procure PFI projects
plays a key part in helping reduce bid costs and deliver more effective projects. The
importance of partnership between the public and private sectors in PFI procurement is
highlighted in paragraphs 5.27 to 5.35.
EMPLOYEE PROTECTION
1.23 The Government is committed to ensuring fair and reasonable treatment for workers
in PFI projects. The value for money that PFI provides should not be achieved at the expense
of staff terms and conditions. Chapter 6 sets out the Government's approach to ensuring fair
and reasonable treatment for staff in PFI projects, and the principles which lie behind it. It
goes on to outline the steps taken since 1997 to protect employees in PFI schemes, including:
e the Fair Deal for Staff Pensions, announced in June 1999, which stated that
staff who transfer from the public sector should continue to have access to a
good quality broadly comparable occupational pension scheme, with options
for handling benefits they have already earned;
¢ the Cabinet Office Statement of Practice which sets out how staff compulsorily
transferred should be treated;
* — Retention of Employment in the NHS recognises the specific needs of the
NHS. Staff who fall under this agreement remain employed by the NHS and
are then seconded to the new service provider; and
the Best Value code of practice, which came into effect from March 2003 across
England. It applies to all new staff employed on PFI, PPP and outsourcing
contracts that are covered by Best Value. The code ensures new employees terms
and conditions that are “overall, no less favourable” than their transferred
colleagues, and requires that employers proved a pension to a given standard.
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1.24 Going forward, the Government is also committed to monitoring the implementation
and performance of measures taken to avoid new joiners to PFI workforces receiving worse
terms and conditions than do transfered staff, as this will be key to establishing future best
practice. It is important that the principles behind the code, workforce protection and
adequate flexibility to deliver high quality public services, are achieved.
1.25 To ensure that the value for money delivered by PFI does not come at the expense of
employees’ terms and conditions, Departments have the option of not transferring soft
services staff in a PFI project, where they believe their transfer is not essential for achieving
the overall benefits of improved standard of service delivery specified by the procurer, and
where not transferring staff is consistent with delivering the Prime Minister's commitment to
flexibility in public services provision.
ASSESSING VALUE FOR MONEY
1.26 The Government's commitment to PFI rests on its ability to deliver value for money in
public investment that is not at the cost of the terms and conditions of employees. The
Government's procurement decisions must be based first on its approach to considering
where particular procurement options are appropriate and second on an unbiased and
rigorous assessment of which of the available options represents the best value for money. It
is therefore vitally important that the process of assessing value for money is robust — that it
takes place at key stages of the procurement process and that there is the budgetary flexibility
to pursue alternative procurement routes if PFI does not prove value for money. This is in
order to ensure that there is no inherent bias between procurement routes. Chapter 7 sets out
the Government's approach to assessing value for money and outlines measures to ensure its
effective use in the procurement process.
1.27 In order to better ensure that investment is always procured through the best value for
money option, the Government will be consulting on reforms to the appraisal process
including the Public Sector Comparator (PSC), an important tool used in assessing the value
for money of PFI projects. The result will be a value for money appraisal process that adopts
a comprehensive and analytically rigorous assessment of all the costs and benefits of PFI and
builds in the option to pursue alternative procurement routes at any stage if they offer better
value for money. The changes proposed are:
¢ instituting a new test of the potential value for money of procurement options
when overall investment decisions are made, to ensure PFI is used only in
those sectors where it is appropriate and has a good value for money case;
*¢ reforming the Public Sector Comparator into an early rigorous economic
appraisal of an individual project at the stage an outline business case is
produced, prior to the procurement of the project, to allow projects to
proceed down alternative procurement routes where they offer better value
for money; and
* instituting a final test at the procurement stage of a project that would
evaluate the competitive interest in a project and the capacity of the market to
deliver it effectively.
1.28 In sectors where the evidence and analysis now suggests that PFI procurement does
not offer the benefits that had been expected, specifically in the IT sector, and in individually
procured projects with small capital values, the Government is reassessing the use of PFI. The
evidence on deals with a low capital value, presented in Chapter 7, suggests that they can offer
poor value for money because of high pre-contract transaction costs relative to their overall
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value. Where small individual projects are bundled together, however, value for money can be
secured through increased efficiences in procurement. In the IT sector, structural
characteristics have proven to be at odds with the principal benefits of PFI, and PFI has not
been able to deliver the step-change in performance the public sector requires as outlined in
paragraph 7.39. The research showed that in those IT projects which were more successful,
contracts had been negotiated to accomodate improved structures, susggesting a move in
practice away from a PFI model. The Government will therefore consult with Departments on
a level of capital expenditure below which alternative means of procurement will be pursued.
The Government will replace PFI in IT with a range of procurement models, better able to
deliver, on which it will consult.
1.29 Where PFI has proven and continues to prove to be value for money the Government
will use PFI procurement for new investment, for example in delivering vital new
infrastructure for schools and hospitals. The Government will also investigate with
departments and other stakeholders potential new areas where PFI investment could offer
value for money. If there is evidence that these new areas exhibit potential for benefiting from
PFI procurement, investigation and consultation would be followed up with a pilot stage to
provide further evidence to judge performance in practice. Areas under consideration include
moving in the prisons sector from the construction and management of new build prisons to
management of the existing prisons estate, urban regeneration, waste management and
social housing.
1.30 The Government is committed to transparency in monitoring and reporting on the
progress of the PFI investment programme. Since 1997, the Government has increased the
information disclosed in the Financial Statement and Budget Report to include:
* — arecord of future payments contracted for by each PFI scheme; and
© the capital value of contracts signed to date and in procurement.
131 The Government plans to build on this by publishing, on an annual basis, a
comprehensive statement on the progress of the PFI programme. This will include a complete
record of transactions committed to in the previous year, a record of projects that have been
completed in the year in question and their performance against expectations, and a
statement on potential future transactions by sector.
IMPROVING DELIVERY
1.32 Assessing where PFI could offer value for money is only part of the process in ensuring
there is the delivery of quality public services. It is important that the public sector is able to
manage the procurement process efficiently, intelligently and in a timely manner in order to
maximise the benefits of PFI and other sorts of public procurement, and to be consistent with
the need to secure value for money. A lasting step-change in the quality of public services in
the UK can only be achieved if the public sector has the skill set necessary to translate
increased public investment and facilities fit for modern public services.
133 The Government is therefore introducing measures that will help the public sector
become a better client and harness the benefits that can be achieved by helping to coordinate
public sector activity and be treated as an important client. These measures are detailed in
Chapter 8.
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1.34 The process of standardising PFI contracts helps spread best practice, improving PFI
procurements across the public sector, and reduces the length and cost of PFI procurement.
Atthe same time, the standard contracts maintain flexibility for an individual project to set its
needs and requirements, while providing standard terms for those elements of PFI that are
common to all procurement processes. To maximise these benefits, a new approach will be
taken on the enforcement of standardised contracts by the Project Review Group and by HM
Treasury in the future. To help with this process, HM Treasury has agreed with Partnerships
UK that it will increase the resources it will make available to support the adoption of
standardised contracts.
135 Alongside increasing procurement skills within the public sector, it is important to
ensure that public sector managers have access to high quality advice. The Government is
therefore proposing to put in place over the next 12 months a single information resource,
accrediting specialist advisers who have demonstrated their expertise and the quality of their
advice in PFI projects in fields such as law, commercial structuring and finance. By
implementing this information resource and promoting its use by procuring authorities, the
Government will be able to:
¢ ensure that the public sector is able to act like a single, important client for
advice in PFI;
¢ benchmark the price and quality of advisers, based on evidence of their past
expertise and performance, to help authorities secure the best advice and
value for money from their advisers; and
° provide positive incentives for advisers to ensure that they give the best advice
to Government, utilising their most skilled personnel and full resources, as the
accreditation system will provide an effective means for the public sector to
reward excellence.
136 The Government is also introducing new models of PFI delivery that should provide
procurement expertise and support to the public sector in its own assessment and delivery of
local public service investment needs. Bundling projects together offers the benefit of
increasing the involvement of PFI experts in the procurement process from the earliest stages
through to the operational phase of projects and ensures that the timing of projects
maximises market interest. Another route is the establishment of public sector procurement
bodies specialising in structuring and delivery of PFI projects, which work with local public
sector managers to procure projects, to increase the quality of specifications and reduce
delays in the process and the procurement burden on local managers. Chapter 8 gives a
number of examples of where these models are now being pursued in practice.
1.37 Chapter 8 also outlines where the Government intends to carry out further research on
the public sector's ability to identify and secure value for money in practice. In particular, the
Government intends to examine the way in which PFI bids are evaluated, and the public
sector's record in managing PFI contracts to ensure their flexibility in delivering the
requirements of public services in practice.
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PRIVATE FINANCE
138 The involvement of private finance in taking on performance risk is crucial to the
benefits offered by PFI, incentivising projects to be completed on time and on budget, and to
take into account the whole of life costs of an asset in design and construction. Private finance
in PFI, particularly third-party finance, takes the risks in a project and allocates them to the
party best able to manage them. The lenders to a PFI project, as they have significant capital
at risk, have a powerful incentive to identify, allocate and ensure the effective management of
all the risks the private sector assumes in a project. Private finance therefore plays an
important part in PFI's ability to deliver value for money benefits, and will continue to be
integral to its success. Paragraphs 3.54 to 3.64 outlines the role of private finance in PFI.
1.39 By involving private finance in PFI, the Government seeks to ensure that it receives the
best value for money in securing the benefits it brings, and that its involvement is on a
sustainable basis. To facilitate this, as outlined in Chapter 9, the Government intends to:
¢ maintain a variety of sources of funding for PFI projects to ensure competitive
tension, a sustainable spread of investment programme risks across different
funders, and a minimal Government exposure to systemic market risks;
° explore the provision of framework funding, particularly in bundled small PFI
schemes, to provide a faster, cheaper funding solution for these kinds of
schemes; and
¢ explore through pilot projects the potential role of a form of credit guarantee
finance as an additional means of funding PFI projects. This means of
financing would retain the private sector lender's risk premium and its
benefical role as risk-taker and risk-allocator, but improve overall value for
money by utilising the Government's ability to secure funds more cost-
effectively.
1.40 The Government also seeks to ensure that the involvement of private finance does not
lead to unnecessary inflexibility in privately financed projects. In a standard PFI contract, the
public sector has built-in safeguards to ensure it retains the same levels of flexibility as in a
conventionally procured project, including the ability to hold competitions for work to
implement changes. However, in the extreme case where, because of a wholesale change in
public sector requirements, a PFI contract needs to be terminated by the authority, the
Government will explore further measures to ensure that termination costs do not limit this
flexibility. The measures under consideration are outlined in paragraphs 9.24 to 9.37.
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KEY MEASURES
Box 1.3: Summary of key measures from Chapters 7 to 9
To improve the assessment of value for money, and provide for greater transparency, the
Government will:
* embed value for money appraisal at three key stages of the procurement process;
© reform the Public Sector Comparator as the second stage of that process;
© reassess the role of PFI, given the evidence, in projects with small capital values
and in the IT sector;
© investigate potential new areas where PFI could offer value for money — such as the
management of the existing prisons estate, urban regeneration, waste
management and new application in social housing; and
* confirm that to ensure that value for money in PFI does not come at the expense
of employees’ terms and conditions, Departments have the option of not
transferring soft services staff in a PFI project, where they believe their transfer is
not essential.
To improve delivery in PFI and other procurement routes, the Government will:
° rigorously enforce contract standardisation to reduce bid costs;
* enhance the role of the Project Review Group in monitoring PFI procurement by
local authorities;
© set up a system of accreditation of public sector advisers and introduce an
information resource accessible to all public authorities to ensure quality in
external advisers;
* create vehicles to coordinate procurement in particular areas to put in place,
support and share best practice; and
® research the public sector’s record in bid evaluation and securing contract
flexibility, to ascertain whether and what steps may be required.
To ensure value for money and flexi
will:
lity in privately financed projects, the Government
© explore the provision of framework funding, to make available a faster, cheaper
funding solution for bundled small schemes;
© pilot an additional means of funding PFI projects that combines the benefits of
private sector risk-taking with the Government’s comparative advantage in
securing funds; and
© help ensure that the involvement of private finance does not lead to unnecessary
inflexibility by consulting on the role of the Spens clause in the termination of
bond-funded PFI projects and the continuing value in the private sector hedging
interest rate risk.
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PFI — MEETING THE INVESTMENT
CHALLENGE
The detailed information presented in this chapter on the current place of PFI investment
in Government expenditure demonstrates how private finance is contributing to the
modernisation of public infrastructure.
The main points are:
© PFI currently plays a limited but important part in public sector
capital investment. Investment under PFI is projected to make up II per cent
of total investment in public services in 2003-04. The majority - over 85 per cent
- of public investment is still carried out through conventional forms of
procurement;
* investment in public services has increased significantly since 1997,
and the PFI programme has expanded in proportion. Both the number
and the total capital value of PFI projects has increased, from nine projects with a
total value of £667 million in 1995 to 65 projects with a total value of £7.6 billion
in 2002. Over the same period, public sector gross investment rose from £17.3
billion in 1997-98 to an expected total of £33.4 billion in 2003-04. However, the
proportion of investment made up by PFI has remained steady at between 10 and
15 per cent over this period;
° this investment programme is delivering extensive new and
modernised infrastructure to public services. A total of 451 PFI projects
have now completed construction across a broad range of sectors, delivering over
600 new public facilities including 34 hospitals and 119 other health schemes, and
239 new and refurbished schools; and
° the decision to use PFI is taken on value for money grounds alone, and
whether it is on or off balance sheet is not relevant. Almost 60 per cent
of PFI projects by value are reported on Departmental balance sheets and fully
reflected in the Government’s national accounts. The Government publishes a
complete statement of the costs of PFI facilities, which are fully covered by annual
unitary payments, in the Budget document.
BACKGROUND
2.1 This section focuses on the scale of the Government's investment plans for public
services, and on the size and scope of the PFI programme within that in particular. It
illustrates the significant increases in the flow of public investment to the UK’s public
services, and the historical growth of the PFI market and of private investment in public
infrastructure, in line with that increased investment. In reporting the PFI programme, it
excludes investment by the private sector in public services not undertaken under PFI-type
contracts. It therefore does not include investment by private sector businesses like London
and Continental Railways (CTRL) or under Public Private Partnerships (PPPs) like the
National Air Traffic Services (NATS), where the Government owns an equity stake in a
business. (See Annex B for technical details of the reporting of PFI and PPPs.)
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PRIORITISING PUBLIC INVESTMENT
2.2. The UK's public services have suffered from a legacy of under-investment. A repairs and
maintenance backlog built up on existing assets, and plans for new investment projects were
subject to flaws in the budgeting system which encouraged short termism and a bias against
capital spending. Public Sector Net Investment fell by an average of more than 15 per cent
each year between 1991-92 and 1996-97, and represented 0.6 per cent of GDP in that year —
the lowest level for over a decade.
2.3. This fall in public sector investment translated into a marked decline in general
government capital spend, in both central and local government, since the start of the 1990s.
Chart 2.1 sets out gross fixed capital formation, the acquisition less disposal of fixed assets, by
government sector. These figures show the decline in public corporation and local
government capital spend caused by the shrinkage of the public sector over the 1970s and
1980s, and also the downturn in capital investment between 1990 and 1997.
Chart 2.1: Gross domestic fixed capital formation in real terms
60
£ billion, 2002-03 prices
50
40 <<
30
» — ~~ %.
SN
10 =
——
1969 1971 1973 1975 1977 1979 1981 1983 1985 1987 1989 1991 1993 1995 1997
—— Public sector —— General Government Local Government
Public corporations —— Central Government
Source: HM Treasury
2.4 This record of under-investment in assets produced a damaging backlog of repairs and
maintenance that has hampered the ability of public servants to deliver high quality services
to taxpayers:
*® in 1997 the backlog of repairs in schools was estimated at around §7 billion;
e the backlog of maintenance in NHS buildings in 1997 was over £3 billion; and
¢ the transport sector had suffered from consistent neglect, and a highly
damaging lack of investment in infrastructure.
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2.5 In order to secure the long-term future of the public services, the Government has
significantly increased the total investment flowing into them. By the end of 2005-06, Public
Sector Net Investment will be 2.1 per cent of GDP, more than trebling since 1997 as a
proportion of GDP and funding sustained investment in the infrastructure of public services.
2.6 To ensure that this increased investment translates into the maximum improvement in
public service delivery, it has been matched by reform of the budgeting framework to protect
capital investment programmes and to give new incentives for managing the public sector
asset base more effectively. PFI represents one option for infrastructure and facilities
investment in particular that, in some circumstances, enables the Government to secure
value for money for the extra investment it is undertaking.
PFI’S PLACE IN PUBLIC EXPENDITURE
2.7 The Government only uses PFI where it is appropriate, and where it will deliver value for
money. Not all investment will be suitable for PFI. This is why PFI accounts for a limited
proportion of the Government's capital spending, as illustrated in Chart 2.2. The majority —
over 85 per cent — of public investment is still carried out through conventional forms of
procurement.
Chart 2.2: Total investment in public services
60
50
E 40
2
5
= 30
i
=
10
0
a a a a a a a a aid
F ial oot w oS on Ss ag 2 »
SESS es Ee SESS SERBS
[Bi psnt [7] Depreciation [J] Asset sales [lj PrI/PPP
in the yeor that investment tokes place
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2.8 Total investment in public services will rise to over £48 billion in 2005-06, compared
with £23 billion in 1997-98, a 7 per cent average annual increase after inflation. Total UK
investment in public services includes: Public Sector Net Investment, reflecting conventional
capital spending undertaken within departmental budgets; recycled proceeds from asset
sales which are re-invested in capital on top of the budgets already available to departments;
depreciation, to reflect the ongoing capital investment in existing assets to repair buildings
and carry out maintenance; and investment carried out by the private sector on public
service assets under PFI (including maintenance).
2.9 The vast majority of this increased investment is conventionally procured public
investment, with the proportion of government investment represented by estimated private
sector investment in public services through PFI remaining relatively constant between 1998-
99 and 2003-04, at between 10 and 13.5 per cent of total investment. PFI is expected to
account for an estimated £4.6 billion this year, or 11 per cent of total investment, as shown in
Chart 2.3.
Chart 2.3: PFI investment as a proportion of total investment
in 2003-04
Projected total investment in public services in 2003-04 = £41.7bn
PFI/PPP
11% i Psnt
[BB Depreciation
Asset sales [Dl Asset sales
% I PFI/PPP
PSNI
45%
Depreciation
35%
Source: Budget 2003. PFI gues are fer deals signed to date ond report capital investment expected under signed contracts
in the year thot ivestment takes p
2.10 PFI remains a limited proportion of government investment within any particular
sector. Chart 2.4 shows PFI investment compared with total capital investment undertaken
within departmental budgets for key spending departments (excluding investment funded by
asset sales), and for the devolved administrations. In no case does PFI represent more than
around a quarter of investment being undertaken in a sector.
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Chart 2.4: PFI investment by Department as a proportion of
total investment within Departmental Expenditure Limits (DEL)
Transport
Health
Home
Office
Devolved
Admin.
t
3 4 5 6 7
Annual capital value (£bn)
HEPFI investment [J Total Investment in DEL
Source: Budget 2003. PFI figures for deats signed to date. “Total Investment within DEL’ includes Capital DEL and
copital grants to the private sector within Resource DEL. Plans at Budget 2003 — final figures are subject to
departmental decisions about the allocation of capital grants, and decisions by the Devolved Administrations about the
allocation across their Resource and Capital budgets.
2.11 The same is true for investment undertaken through local government. Investment
through PFI in local government is expected to be £1.9 billion in 2003-04, compared with
capital spending on local government supported through departmental capital budgets
expected at £10 billion. PFI investment in schools, which is undertaken by local education
authorities, is included in this local government figure.
PFI — MEETING THE INVESTMENT CHALLENGE
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Box 2.1: PFI in local authorities
procurement.
Much of the PFI programme is delivered by local authorities, largely with revenue support
provided by sponsoring departments. So far, 119 local authority projects have been signed,
97 of which are now operational, and a further 119 schemes are in various stages of
The chart below, which shows all the local authority PFI projects, signed and unsigned, by
sector, illustrates how PFI is helping authorities meet local priorities.
Number of projects supported by departments
IB ies - schools'
[BB oppM - fire, housing, regeneration
[Bh ort - transport
Hl Home Office — police
[BB DoH — social services
[BB DEFRA - waste management
Bh Le — court services
Hl DCMS — leisure services
BB Joint projects
Source: HM Teasuy,
1. PFI schools projects, sponsored by DfES, typicaly cover a group of schools with a single project.
Completed Infrastructure
2.12. 451 PFI projects have now completed construction and are in operation. These projects
have delivered new facilities including:
4 34 hospitals, and 119 other health schemes;
* 239 new and refurbished schools;
e 23 new transport projects;
¢ 34 new fire and police stations;
. 13 new prisons and secure training centres;
. 12 waste and water projects; and
. 167 other projects in sectors including: defence, leisure, culture, housing and
IT.
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THE DEVELOPMENT OF PFI
2.13 Total government investment has increased significantly since 1997, and the
development of the PFI programme has gathered pace in line with it. Government investment
is planned to continue to grow in the future, and PFI is expected to grow in proportion. Chart
2.5 illustrates the capital value of PFI projects signed in each calendar year since the
programme's inception.
Aggregate
number and Chart 2.5: Number and value of PFI projects by year
value of PFI 20 120
projects by year
+100
5 ww
= +80 »
: a
3 04 L603
g +40 2
5
+20
0- +0
1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004
[Bi capital value (bn) [] London Underground contracts. —i No. of deals
Source: HM Treasury
2.14 A total of 563 PFI transactions reached financial close by 4 April 2003, with a total capital
value of £35.5 billion. Over £32.1 billion of the total has been signed since 1997. Chart 2.5 also
provides projected figures for the capital value of PFI investment under projects signed or
expected to be signed in 2003 and 2004. (A more detailed breakdown of planning for future
PFI projects can be found in Chapter 7, paragraph 7.21 onwards.)
2.15. The number and total capital value of PFI projects has increased in recent years. In 1995,
projects amounting to £666.8 million were signed, whereas PFI investment from 1997 to 2001
has averaged £2.6 billion a year. With the London Underground contract signed in December
2002, the capital value of PFI contracts in 2002 is more than double the comparable figure for
1997 - comparable growth to that in PSNI. As detailed in paragraph 2.9, PFI has remained a
relatively constant proportion of increasing total investment since 1997, at between 10 and
13.5 per cent. The PFI contracts with the Tubelines and Metronet consortia to modernise
London Underground, signed in 2002 and 2003 represent the most significant PFI contracts
signed to date by capital value, and consequently a very high proportion of the market of PFI
contracts in those years. Nevertheless, even if the London Underground contracts are set
aside, the total value of PFI projects due to close in 2003 is, at over £5.5 billion, expected to be
the highest to date.
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2.16 The construction and investment undertaken through these PFI projects has already
delivered, through the 451 completed projects, over 600 operational facilities, as Chart 2.6
illustrates. These are the public facilities which have opened and are in use. More are under
construction or in procurement. The increase in the pace of government investment since
1997 is reflected in the acceleration in the delivery of operational PFI facilities around 2000,
as the construction phase of these projects is completed.
PFI’s
contribution to Chart 2.6: Number of operational PFI facilities
public infra-
structure 700 5
600
1997 1998 1999 2000 2001 2002 2003
[Bij Education [_] Accommodation & LA admin I] Other HB Waste
[Heath —_ [I Emergency Services [El Law & Order JI Housing
[_] ttitetecoms I Urban Regeneration J Utilities im] Defence
Source: HM Treasury.
2.17 Of course, although there are now a large number of PFI projects operational, they are
all in an early stage in their operation of what are typically 20 to 30 year contracts. The
operational performance of PFI contracts, and in particular their ability to maintain a
consistent quality of service over the long term, will need to be assessed in later years.
Breakdown of Projects
2.18 PFI investment has been used across the range of sectors. PFI transactions have been
signed in over 20 different sectors, and by over a hundred different departments and local
authorities. Chart 2.7 shows the largest users of mainstream PFI by value have been:
¢ the Department for Transport, which accounts for 22 per cent of projects by
capital value. Large capital investment projects such as the M6 Toll Road (£485
million) account for the high value in this sector;
¢ the Department of Health, which has seen a total capital investment of £3.2
billion with 117 PFI projects signed to date;
20
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¢ the Department for Education and Skills, with a total of 96 transactions worth
a total capital value of £2 billion; and
e the Ministry of Defence, with 46 projects and a total value of £2.5 billion.
Total number and
capital value Chart 2.7: Total capital value of projects by department
of projects by
sector
16%
2%
2%
3%
16%
5%
6%
10%
HH DoH = [_] Other (7) MoD [Hj DfES [I Home Office Hj ODPM
[i perrA Mi pwe HiR [i Dev. Admin. [ij Transport
Source: HM Treasury
Other Departments
exclude LUL contracts
th signed projects are: FCO, LCD, DCMS, Customs, DTI, OWP GCHQ, HMI, IR, and the OGC. Figures
Geographical Breakdown
2.19 Chart 2.8 shows signed PFI projects broken down by region. All the regions of the United
Kingdom have signed at least 20 PFI projects. Every region will receive capital investment
under PFI signed projects worth at least £400 million. Information about the extent of
PFI investment being undertaken in each English region is available in HM Treasury's
regional map publications. Information about these publications is available at
www. treasury.gov.uk.
21
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22
Chart 2.8: Capital value of projects by region
Capital Value (£bn)
East Midlands
East of England
London
North East
North West
Scotland
South East
South West
Wales
West Midlands
Yorkshire &
The Humber
National/More
Than One
Northern Ireland
Gi Capital Value [] London Underground contracts
Source: HM Treasury.
2.20 As Chart 2.8 shows, the Devolved Administrations are also seeing significant
investments in public services through PFI, with 143 projects signed worth a total capital
value of £3.3 billion between Scotland, Northern Ireland and Wales.
* Scotland has a total of 84 signed projects amounting to a total capital value of
£2.3 billion. Signed projects include schools and healthcare projects.
¢ — Northern Ireland has signed a total of 29 PFI projects with a total capital value
of £416 million. This involves projects in areas such as schools and health.
© Wales has a total capital value of £615 million from 30 PFI projects signed.
Energy management, healthcare and road projects are typical examples of
projects procured.
FINANCIAL REPORTING OF PFI CONTRACTS
2.21 The Government only uses PFI where it offers value for money, considered over the long
term. Its approach to the use of PFI is detailed in Chapter 3. The financial reporting and
balance sheet treatment of projects are subsequent and irrelevant to the decision whether to
use PFI, but the monitoring and reporting of financial commitments made under PFI is an
important part of managing the public finances.
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2.22 The Government publishes its estimates of the unitary charge payments — single annual
payments made by the procuring authority to the private sector which cover all the costs,
both capital and service, of PFI projects — to be made under all signed PFI contracts in the
Financial Statement and Budget Report. These payments represent the full price of the
specified facility being made available and cover all costs over the life of the contract. These
Departmental commitments of future revenue are monitored by Government, included in
consideration of future budgets, and therefore taken into account by Departments in
deciding how much PFI investment to undertake.
2.23. PFI unitary charges include payments to cover the cost of capital expenditure (money to
repay the debt and interest charges, including hedging costs, incurred in building a large
capital asset), the services needed to run and repair that asset, like maintenance work and
supporting soft services like catering, cleaning and hospital portering. In a typical PFI
hospital, payments for services make up 40-50 per cent of the unitary charge. For a typical PFI
schools project, around 30 per cent of the unitary charge goes toward caretaking,
maintenance and other services. If a project is built using conventional procurement, these
future costs for services are not automatically covered, monitored or disclosed. Reporting
estimated payments under PFI contracts therefore provides a fuller picture of future
commitments than would be possible under conventional procurement, and provides better
information for the management of future budgets.
2.24 These annual payments under PFI unitary charges make up a very small proportion —
just over 2 per cent — of total annual resource budgets, as illustrated in Chart 2.9.
Consequently, they represent very little threat to the flexibility of the Government's budgets,
and a small commitment of future revenue.
Chart 2.9: PFI unitary charge payments in 2003-04 as a
proportion of Departmental and locally financed annual
resource expenditure (£bn)
Ii PFI Unitary Change
5.4 I [ij Other Resource DEL
and Locally Financed
Expenditure
Source: Budget 2003
23
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PFI — MEETING THE INVESTMENT CHALLENGE
2.25 This conclusion, that PFI presents little threat to overall budgetary flexibility, remains
true into the future. Because the cost of PFI unitary charges in the future is clear, and
transparently reported, the Government is able to take it fully into account in future
budgeting. In fact, as illustrated in Chart 2.10, the estimated payments under signed PFI
contracts begin to fall after 2007-08. These figures obviously do not take into account unitary
charge payments under future PFI contracts, however, if PFI investment remains the limited
proportion of total investment it currently is, there is no reason to believe that these
payments represent a long-term threat to overall budgetary flexibility.
Chart 2.10: Estimated payments in real terms under signed
PFI contracts
Ss
Payments (£bn)
NWR A Nw ©
0
03-04 05-06 07-08 09-10 M412 1344 15-16 17-18 19-20 21-22 23-24 25-26 27-28 29-30
Source: Budget 2003. These figures represent the estimated payments that the pubic sector expects to make to
the private sector for services delivered under PFI. The payment mechanisms of PFI contracts contain provision for
perforrnance deduction — which reduce payments ifthe service is unavailable or to a poor standard to incentivise
contractor perfomance — and may therefore be flower than these figures. These figures include estimates of the
first 15 years of LUL PFI contracts, as these contracts are reviewed periodically and payment levels may change.
These payments also include tax payable by the private sector in respect of profits earned on the PFI scheme,
Accounting 2.26 The accounting treatment of a PFI project on a Departmental balance sheet, and its
treatment of PFI reflection as an asset in the national accounts, is not material to the Government's decisions
about when to use PFI. These are based on value for money alone. In fact, the majority —
57 per cent - of PFI projects by capital value are reported on Departmental balance sheets, as
illustrated in Chart 2.11. Accounting and reporting treatment follows rules set by a series of
independent national and international organisations, and is decided by independent
auditors. (See Annex B for details.)
24
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Chart 2.1I: Balance sheet treatment of PFI projects by value
[i On-batance
Bl off-balance
2.27 It is important to note that, simply because a PFI asset is reported on Departmental or
Authority balance sheets, that does not mean that there has been no effective sharing of risks
with the private sector, or that the PFI project has secured value for money gains by doing so.
As outlined in Chapter 3, the appropriate sharing of risks in a PFI project, leading to their
better management, is an important source of its value for money benefits. However, the
accounting treatment of PFI assets depends only on a subset of the risks involved in a project,
in particular the risks of ownership. For example, accounting treatment does not take into
account whether a party bears the risks involved with building a property — a very important
subset of risk in major capital projects.
25
26
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THE GOVERNMENT’S APPROACH
To PFI
The Government is committed to securing, over the long term, the most cost effective
infrastructure for the public services. To achieve this, it seeks to ensure that investment
uses the appropriate procurement option which can offer the best value for money, and
that there is no inherent bias between procurement options. Consequently, its approach
to PFI is based on an objective assessment of where it can offer value for money, where it
can meet the Government’s requirements of efficiency, equity and accountability, and
where the value for money it offers is not at the cost of the terms and conditions of staff.
The Government continues to work closely with employers and trade unions to ensure
that the rights, conditions and pensions of employees in PFI are properly safeguarded.
The Government’s analysis of where the PFI model is likely to be applicable, based on
evidence of its delivery in practice, suggests that it is most likely to offer value for money
in major capital projects where there are significant ongoing maintenance requirements,
where the structure of the service allows the public sector to appropriately define its needs
as service outputs, and where the nature of the assets to be procured allows them to
benefit significantly from whole-of-life costing. It is less likely to represent value for money
where very fast-paced change makes a long-term contract structure inappropriate; or
where the costs of pursuing PFI procurement are disproportionate to the benefits it
brings.
Private sector expertise and experience has always been utilised in public sector
procurement, but, where in traditional procurement private companies built and then
walked away, PFI seeks to ensure that the private sector takes responsibility for the quality
of design and construction it undertakes, and for long-term maintenance on an asset, so
that value for money is achieved. PFI projects can capture the benefits of having the
private sector incentivised to perform by having its own capital at risk, while safeguarding
and advancing the public interest in the best public services for all.
In effective PFI procurement:
© the public sector specifies the outputs it requires and a private sector
consortium then contracts to meet those requirements;
© the risk involved in the project is shared between the parties, with
each party managing the risks they are best able to. This approach to risk-
sharing provides powerful incentives for the private sector to perform, and ensures
value for money for the public sector; and
© the public sector ensures the quality and continued effective delivery
of public services is maintained, with the ability to make deductions for poor
performance, the flexibility to make necessary changes in future, provisions for the
consortium or funders to replace poor service providers, and ultimately the right
to terminate the contract.
27
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THE GoveRNMENT’s APPROACH TO PFI
BACKGROUND
3.1 The Government uses PFI where it is appropriate and where it expects it to deliver value
for money. In assessing when PFI is appropriate, the Government's approach is based on its
commitment to efficiency, equity and accountability and on the Prime Minister's principles
of public service reform. The Government seeks to ensure that there is no inherent bias in
favour of one procurement route or another. It explains the benefits PFI can offer when used
appropriately and certain key aspects of the PFI programme, such as the Government's
approach to partnership, risk sharing, flexibility and the public sector safeguards
incorporated in PFI contracts to ensure that key services continue to be delivered even when
PFI contractors fall into financial difficulty.
MODERNISING PUBLIC SERVICES
3.2 As outlined in Chapter 2, the Government has significantly increased total investment in
public services. To ensure that this increase in investment will have maximum impact on the
public services delivered to users, it must be accompanied by reform, and delivered in a way
that provides value for money.
The Prime 3.3. The Prime Minister has set out the Government's four principles of public service
ister's reform’:
Principles of
Public Service
Reform
© national standards, which means working with hospitals, schools, police
forces, and local government to agree tough targets, with performance
independently monitored so that people can see how their local services
compare;
¢ devolution, whereby central government has to give successful frontline
professionals the freedom to deliver;
© flexibility, which means removing artificial bureaucratic barriers which
prevent staff improving local services; and
° choice, acknowledging that customers should increasingly be given the kind
of options that they take for granted in other walks of life.
THE ROLE OF PFI
3.4 There are a number of ways the Government is delivering increased investment. When
comes to procurement, Office of Government Commerce (OGC) and HM Treasury set out
in May 2000 three recommended approaches for improving delivery:
¢ prime contracting, where a single party acts as the sole point of responsibility
between the public sector client and the supply chain, bringing together all of
the parties necessary to meet public sector requirements effectively;
¢ design and build, where a supplier is responsible for both the design and
construction of a facility to meet the public sector's output specifications; and
¢ PFI, where the public sector contracts to purchase quality services, with
defined outputs, from the private sector on a long-term basis, and including
maintaining or constructing the necessary infrastructure so as to take
advantage of private sector management skills incentivised by having private
finance at risk.
‘Reforming our Public Services, March 2002.
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THE GovERNMENT’S APPROACH TO PFI
3.5. For each project or programme of new investment, the Government seeks to identify
which of these options will deliver the best value for money. Specifically, in modernising the
infrastructure needed for public services such as hospitals, schools and other facilities the
Government seeks to avoid the weaknesses of past procurement (see Box 3.1) and ensure its
procurement choice will deliver:
¢ buildings of high quality, maintained to a high standard throughout their life;
© effectively-managed services for the public, while protecting staff; and
Ls new investment which is completed on time and within budget, so that
facilities are available when the public sector needs them, and for the
expected price.
3.6 Each of the procurement options set out in paragraph 3.4 have been designed to
improve value for money and avoid past difficulties with conventional procurement. Each
will offer best value for money in different circumstances. The key for public sector
procurement professionals is to judge which project suits which procurement option.
3.7 PFI is characterised by a long-term, whole-of-life commitment by the private sector to
deliver and maintain new public infrastructure. This approach will only be suitable for certain
types of investment, naturally limiting the use of PFI as laid out below. These constraints have
limited the use of PFI to around 11 per cent, or £4.6 billion, of total investment in public
services this year (see paragraph 2.9). Historically PFI has not exceeded 15 per cent of total
investment for any year since 1997.
3.8 The analysis set out in Chapter 4 of this report suggests that PFI can offer significant
advantages for certain major capital projects — such as the construction and maintenance of
hospitals or schools, or the provision of major capital assets for defence or transport
infrastructure — but has not offered the same advantages in information technology (IT) or for
small capital projects. (See paragraphs 4.3 to 4.12 and 4.27 to 4.56.)
3.9 The PFI model is only likely to be applicable where:
¢ the private sector has the expertise to deliver and there is good reason to think
it will offer value for money;
¢ the structure of the service is appropriate, allowing the public sector to define
its needs as service outputs that can be adequately contracted for in a way that
ensures effective, equitable and accountable delivery of public services into
the long term;
¢ it can be demonstrated that PFI offers greater value for money for the public
sector compared with other forms of procurement; and
¢ the nature of the assets and services identified as part of the PFI scheme are
capable of being costed on a whole of life, long-term basis. Investment with a
time horizon of 5-10 years is unlikely to benefit from the PFI approach.
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30
3.10 For example, the use of PFI would be inappropriate where:
© the pre-conditions of equity and accountability in public service delivery
could not be met, as in most forms of frontline service delivery;
¢ the transaction costs of pursuing PFI were disproportionate compared to the
value of the investment a project was delivering, impairing its value for money
(see paragraphs 4.27 to 4.40); or
¢ the fast pace of technological change in a particular sector made it too difficult
to establish requirements in the long term, or high levels of integration make
enforcing systems risk allocation difficult (see paragraphs 4.41 to 4.56).
PFI and Value for Money
Overview 3.1 The Government's approach is to use PFI only where it can offer the best value for
money. Public procurement cannot choose the short-term, least-cost option, but must
instead concentrate on the true value and whole-of-life costs of capital expenditure to secure
the long-term quality of the public services. The public sector needs the skills, at all levels, to
identify the true benefits of good design and quality construction and maintenance, and take
into account all the costs associated with major investment projects. Value for money benefits
in PFI should not come at the expense of employees’ terms and conditions.
3.12. The Government defines value for money as follows: “the optimum combination of
whole-life cost and quality (or fitness for purpose) to meet the user requirement”, In seeking
value for money for PFI, the Government seeks to ensure that:
¢ the evaluation of which procurement option to use is undertaken with no
inherent preference for one option over another. There should be no
dogmatism in this choice. Decisions should be made on the best evidence
available;
¢ value for money is not taken to be least cost. There is a need to ensure that
quality standards are maintained, for example in the design of public
infrastructure, and the long-term viability of the PFI contractor is assured;
¢ the commitment to value for money should not be at the expense of the terms
and conditions of employees transferred or subsequently employed by a PFI
contractor; and
© a full evaluation of the costs and benefits on a whole-life basis is always
undertaken, including an assessment of risk. (See paragraphs 7.2 to 7.20 for
further details of the appraisal process and proposed reforms.)
3.13. The Government in the Green Book’ and guidance on Public Sector Comparators
(PSCs)' has set out extensive guidelines on how to assess value for money in PFI. Paragraphs
7.2 to 7.20 of this document set out further proposals to improve the procurement and
appraisal process. Although assessing value for money will always involve a significant
quantitative analysis of the merits of different procurement approaches, the emphasis on
optimum whole-of-life cost and quality requires that objective professional judgement based
on the best available evidence be brought to bear in determining the best procurement
option.
? Government Accounting.
2 The Green Book: Appraisal and Evaluation in Central Government, 2003.
“Treasury Task Force Technical Note 5 ~ How to Construct a Public Sector Comparator.
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Box 3.1 Addressing the weaknesses of past public procurement.
The historical record of Government procurement shows that too often new assets have
been delivered late and over budget. Furthermore, where projects experienced difficulties,
the financial costs have been borne by the taxpayer. For example:
© the initial cost estimate of Guy’s and St Thomas’ Hospital rose by £124 million to
£160 million and the completion date slipped by over three years;
© the cost of the Trident submarine shiplift and berth at Faslane rose from an
estimate of £100 million to a final cost of £314 million, and was delivered two and
a half years late;
* the London Underground Jubilee Line extension was delivered two years late and
cost £1.4 billion more than original estimates; and
© the top twenty five equipment projects in the MOD experienced cost overruns
amounting to £2.8 billion with average delays of three and a half years.
A 1999 NAO study found that only 30 per cent of non-PFI major construction projects
were delivered on time and only 27 per cent were within budget, whereas the NAO's
report on PFI construction performance showed that over 70 per cent of PFI projects were
delivered on time, and no construction cost overruns were borne by the public sector.
This record reflects a number of weaknesses that have beset public procurement in the
past. In particular, the full costs of projects have not been calculated accurately
beforehand, risk management procedures have not been implemented, and there have
been insufficient incentives, for management or organisation-wide, to ensure that projects
are driven forward successfully.
These factors have helped establish PFI as an effective public procurement mechanism
where it can be properly and effectively employed. The NAO’s 2002 report into PFI’s
construction performance found that 76 per cent of PFI projects were delivered on time
or early and Treasury research ona larger sample found 88 per cent on time or early. Both
the NAO’s construction survey and HM Treasury’s research reported in Chapter 4 found
that 78 per cent of PFI projects were within public sector budgets — and in each case, price
changes were driven by changes in public sector requirements, not construction cost
overruns. This result demonstrates that construction risk transfer has been effective, as
cost overruns were not borne by the taxpayer. (See Chapter 4 for more detailed results of
HM Treasury research.)
The Government, through the OGC and other initiatives, is taking steps to ensure
improvements in all types of procurement, luding both conventional procurement and
PFI. The OGC expects to deliver £3 billion worth of value for money gains in civil
procurement through better public sector skills, value for money testing and other
efficiency savings, by 2005-06.
The Benefits 3.14 Where PFI is effectively utilised, it offers a number of advantages in delivering public
of PFI sector infrastructure. These advantages stem from the sharing of risk in public projects within
astructure in which the private sector puts its own capital at risk to delivery and performance.
In the right circumstances, PFI can help ensure:
¢ desired service standards are maintained. Since under PFI the private sector's
capital, not just its profit, is at risk depending on private sector performance,
there is a very strong incentive for the private sector to maintain high and
reliable service standards throughout the life of the contract;
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¢ new services are more likely to start on time, since the private sector
contractor does not get paid until it delivers. The record of conventional
procurement is poor in this respect, with frequent delays before public assets
become operational;
* more efficient use of public money. In the past, some conventional public
procurements have gone heavily over budget, consuming funds which could
otherwise have been invested in other public services (see Box 3.1). Under PFI,
the public sector only pays for the service it has contracted for, at the price it
has contracted for, and only when that service is available. Under
conventional procurement the public sector is forced to fund cost overruns,
and pays out whether or not the service it needs is actually available; and
* contractors are incentivised to deliver the required service over the whole
life of the asset. The private sector partner only gets paid if it maintains
standards throughout the length of the contract (for example 25 years in the
case of new PFI hospitals). This means that in designing, building and
maintaining a PFI hospital or school the private sector has a strong incentive
to ensure high standards are built in and maintained across the building's
whole life, as it would be forced to remedy defects and make repairs in the
future.
3.15 Furthermore, when used properly, PFI offers other advantages to the public sector, over
and above providing high quality, well-maintained assets over the life of the contract. In
particular PFI helps the public sector by providing:
* — abetter understanding of the total costs of providing the required service. In
PFI procurement, the public sector client can clearly define at the start the
service it requires, and the private sector partner gives a price for the total cost
of that service — covering both the up front cost of new investment but also
ongoing recurrent costs such as maintenance. This helps to avoid short-
termism by focusing on the long-term needs of the public sector; and
* new ways of working, and new approaches to the delivery of the service. The
public sector defines the service to be delivered, but it is for the private sector
partner to decide how to deliver it, drawing on its own innovation and
experience. This provides the private sector with an incentive to develop
innovative ways to meet requirements, and allows the public sector to harness
the efficiency that can come from contestability, helping improve standards
across the public sector. To bring out these benefits from innovation, it is
important that the public sector has available the skills to act as an effective
client in PFI procurement. Chapter 7 details Government measures designed
to spread effective procurement expertise across procuring authorities, and so
improve the value for money it can secure through PFI.
3.16 Where it can be effectively utilised, PFI helps to ensure that money invested flows
through into improved public services. Chapter 4 lays out the findings of recent HM Treasury
research designed to help evaluate how far PFI has delivered the benefits expected of it in
major capital projects, and also examines two specific areas — projects with a small capital
value and information technology (IT) projects — where further research was conducted.
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HOW PFI WORKS
Overview 3.22 In PFI, the public and private sectors enter a contract which shares between them the
risk of undertaking an investment project, typically to provide a major capital asset for the
public services such as a school or a hospital and related support services like repairs and
maintenance. The public sector retains some of the risks it would bear in a conventionally
procured project, like demand risk or the risk that it has not adequately assessed its
requirements, but transfers the remainder to the private sector. Furthermore, the public
sector underwrites the public service, but not the private sector service provider, ensuring
that safeguards are in place in event of failures in the private sector. The private sector takes
on those risks it is best able to manage, like design, construction and maintenance risks, so
that it is better incentivised to perform. The financial cap to the risk assumed by the private
sector is the full value of the debt and equity it provides to a project.
PFI Contracts
Specification 3.23 The centre of any PFI project is a concession contract within which the public sector
of Outputs specifies the outputs it requires from a public service facility, and the basis for payment for
those outputs. The level of outputs required by the public sector is typically drawn up in close
consultation with the public sector workers — doctors, teachers, firemen or policemen — who
will be using the asset and support services provided through the PFI contract. This contract
is the key document that sets out the risk-sharing arrangements between public and private
sectors in a PFI project and is the subject of extensive guidance.
3.24 Public service requirements would normally be framed not as precise input
specifications and designs for a particular asset, but as an output specification defining the
service required; for example, supported hospital beds for a certain number of patients, or
prison accommodation for a specific category of inmates. This approach helps utilise the
private sector's ability to provide innovative solutions to meet these requirements. Once the
public sector has determined the level of outputs it requires to run the public services, the
private sector is then invited to submit proposals which meet the desired output objectives
using best private sector expertise and know-how to deliver the service.
3.25 When the private sector has submitted bids to fulfil the public sector's requirements, the
public sector evaluates these proposals, selecting the option which represents the best value
for money. In making this evaluation the public sector should take advantage of the empirical
evidence available, both qualitative and quantitative, and exercise objective judgement in
selecting the best option, using appraisal and evaluation criteria, and a PSC to determine
whether the PFI option offers better value than conventional procurement. It is vital that the
public sector is equipped with the skills to do so. Chapter 5 discusses steps the Government
has taken to ensure these skills are in place, and Chapter 8 lays out further measures to
improve the quality and effectiveness of public sector clients. Chapter 7 discusses reform of
the appraisal process to further ensure that all the relevant benefits and disbenefits of PFI
procurement are taken into account at the earliest appropriate stage and throughout a
procurement.
Performance 3.26 Also contained within the PFI contract is a payment mechanism and performance
Regimes regime which outlines how service delivery levels against the public sector's desired outputs
— supported hospital beds, pupil places or prison accommodation - is measured. The public
sector undertakes to make a unitary charge payment, covering both the availability of the
asset and the support services provided along with it. Deductions are then made from this
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34
unitary charge to penalise poor performance by the private sector or lack of availability.
While Chapter 4 contains some preliminary indications of the operational performance of
PFI projects in practice, it is not possible to assess PFI's operational performance as a whole
at this early stage in the life of projects.
3.27 This process of setting performance measurement and penalty mechanisms in the PFI
contract ensures that the private sector delivers the specific outputs the public sector intends
to purchase. It also means the public sector only pays if those services are delivered. For
example:
¢ if an operating theatre in a PFI hospital were unavailable, a deduction would
be made from the unitary charge paid to the private sector until that theatre
was again in full working order;
¢ if the pipes in a school burst, flooding it and causing damage to its fabric, the
private sector would be responsible for fixing the pipes and returning the
school to its proper condition, and in the meantime it would not be paid
unitary charges for those parts of the school that were unavailable; or
co) if there is an electrical fault in an office's lighting, and the conditions in the
office therefore fail to meet the project's output requirements, then the private
sector — and in this case typically a specialised facilities management firm that
was a part of the private sector consortium — would have a set time period to
remedy the fault. If it failed to do so, it would incur a financial penalty until the
fault was remedied.
3.28 Once public service requirements have been set, the contract goes out to tender and
companies in the private sector compete to fulfil those requirements. In order to produce the
most competitive bid, the private sector must:
* build a consortium which is best qualified to meet the specified requirements.
This would typically involve an experienced construction contractor forming
a joint venture with a facilities management company capable of running and
maintaining the asset and with other contractors best qualified to deliver
other outputs to be specified in the contract. Increasingly, the consortium
would also include specialised investors, who ensure appropriate sub-
contract structures and perform a ‘due diligence’ role, evaluating the project's
assumptions and exploring its risks; and
*® produce a bid which takes into account the whole-of-life cost of the asset,
incorporates the proper level of repairs and maintenance, and reflects the cost
of the services provided and the cost of third party finance. Competitive
tension between bidding consortia helps ensure value for money, while
consortia would also have no incentive to place artificially cheap bids. Such
bids, which compromised on design or construction quality, or
underestimated required maintenance, would seriously damage the
profitability of the consortium and place its equity at risk because any failure
to deliver in the future would mean unitary charge performance deductions.
Equally, the third-party lenders to the consortium would eliminate any such
optimism bias in the bids to ensure the safety of their investment.
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Risk Sharing
3.29 The appropriate sharing of risks is the key to ensuring value for money benefits in PFI
projects are realised. The benefits described above all flow from ensuring that the many
different types of risks inherent in a major investment programme, for example construction
risk or the risk associated with the design of the building and its appropriateness for
providing the required service, are borne by the party who is best placed to manage them.
This section goes on to outline how risks are typically allocated within a PFI project between
the public and private sectors, and within the private sector between the various parties
involved.
Approach to Risk 3.30 The Government's approach to risk in PFI projects does not seek to transfer risks to the
private sector as an end in itself. Where risks are transferred, it is to create the correct
disciplines and incentives on the private sector to achieve a better outcome. The general
principles behind the Government's approach to risk-sharing in PFI are:
@ the Government underwrites the continuity of public services, and the
availability of the assets essential to their delivery; but
¢ that the private sector contractor is responsible, and at risk, for its ability to
meet the service requirements it has signed up to. Where it proves unable to
do so, there are a number of safeguards for the public sector and the smooth
delivery of public services in place, but the contractor is at risk to the full value
of the debt and equity in the project; and
¢ the full value of that debt incurred by the project, and the equity provided by
contractors and third parties, is the cap on the risk assumed by the private
sector.
3.31 Successful PFI projects should therefore achieve an optimal apportionment of risk
between the public and private sectors. This will not mean that all types of risks should be
transferred to the private sector. Indeed, there are certain risks that are best managed by the
Government; to seek to transfer these risks would not offer value for money for the public
sector.
Retained risks 3.32 The key risks that the Government does not seek to transfer in entering a PFI scheme,
and which it retains in the same way in conventional procurement, are usually:
© the need for the facility on the date given and the adequacy of its overall size
to meet public service needs. So for example, if an NHS trust underestimates
the number of beds required to meet demand, it must pay the costs of
expanding the available facilities just as it would had it built a conventional
hospital;
¢ the possibility of a change in public sector requirements in the future. If the
needs of public services change, the Government retains the responsibility to
make alterations in both conventionally built and PFI facilities. Provisions for
flexibility to cover changing requirements in PFI are covered in more detail
below;
¢ whether the standards of delivery set by the public sector sufficiently meet
public needs. The public sector retains the risk involved in planning the
provision of public services, and specifying a procurement of facilities that
meets those requirements, in both PFI and conventional procurement;
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¢ inmost cases, the extent to which the facility is used or not over the contract's
life. For example, if the demand for school places in an area drops
significantly, the Government would continue to pay unitary charges for a PFI
school, in the same way as it would continue to own and maintain a
conventionally procured school. In some cases, where it is value for money,
this risk is passed to the private sector, so in some office accommodation,
should the Government decide it no longer needs full usage of the building,
the private sector would take on the risk that it could let the remainder of the
floor space; and
general inflation risk. Unitary charges are typically linked to inflation, and so
are subject to the same inflation risk as future maintenance or other costs in a
conventional procurement.
Transferred risks 3.33 In a PFI, the risks which the Government usually seeks to transfer by contract to the
private sector over the term of the contract, typically 15-30 years, are specifically identified
and limited. In a typical PFI, these would involve the following:
© meeting required standards of delivery. So if, for example, the project's design
was unable to provide the required service needs, the private sector would
need to pay the cost of rectifying the design to meet those requirements and
receive payments;
© cost overrun risk during construction. If, for example, ground conditions are
discovered to be unstable after construction begins, and the building requires
considerably more extensive foundations, the private sector would need to
cover those extra costs in order to complete the building to the required
standard. There would be no increase in the Government's unitary charge
payments. In conventional procurement, the Government would be forced to
cover these costs;
¢ timely completion of the facility. If, in the example of unstable ground
conditions cited above, the facility was completed and delivered late to the
public sector, no payments would be made to the private sector until it was
available. Chapter 4 details research demonstrating the impact of this risk
transferral on construction performance;
¢ underlying costs to the operator of service delivery, and the future costs
associated with the asset. For example, where the private sector takes on an
existing building in a PFI project, it takes the risk of any latent defects in the
building requiring remedy. The private sector would need to make these
remedies, and cover the cost of them, to continue to receive payments for the
building's availability;
¢ risk of industrial action or physical damage to the asset; and
° — in limited cases, certain market risks associated with the scheme (for
example, in some road schemes, the actual traffic which uses the road).
Risk Sharing 3.34 With most PFls the risks transferred by the public sector to the private sector are then
within a PFI reallocated between the different private sector parties participating in the PFI project, using
consortium a central consortium company with subcontracts as a means of distributing these risks
amongst the private sector participants.
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3.35. The consortium company is owned by one or more equity investors. Some of these
shareholders may also be contractors to the central consortium company, who undertake to
carry out construction, design or facilities management work in the project for a fee from the
central consortium company. Others may be financial investors. The consortium will also
raise debt finance, in the form of bank debt or bonds, to pay for the construction and
operation of the project. It is at risk if the consortium is unable to meet its debt service
obligations. Chart 3.1 illustrates the typical commercial structure of a PFI project.
Chart 3.1: The consortium company joint venture model
Government Operation i Finance
customer H I
' ' Construction
' ! investor
I Services Equity I
Procuring I delivered in and sub I Aor
Authority, "return for debt Facilities mgmt
and ongoing I annua! charge Special finance (FM) investor
users of ' Purpose '
public " Unitary charge I Vehicle '
services I payment 5
i ' 3rd party equityI
' Carried out Debt I I investor
I under contract finance I I
I I Construction Facilities mgmt I ‘+ it use m
I I contractor (FM) operator I I
3.36 Within this structure, the private sector reallocates risk to the most appropriate parties.
Typically:
° the construction contractor, under a subcontract with the consortium
company, takes the design, construction and completion risk;
© the service provider, under a subcontract with the consortium company, takes
the risk of timely and cost effective service provision;
° insurers provide protection for risks of damage and business interruption; and
¢ the consortium company, its lenders and investors are therefore left with a
series of residual risks, some of which are credit risks on the subcontractors’
performance.
3.37 The benefits of this consortium joint venture structure are that it permits different
parties to become involved in the PFI scheme and share the risks effectively. It also permits
the involvement of third party funders who must assess the strength of the contractual
arrangements and the level of support offered as they rely on these when it comes to
repayment of their loans.
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Flexibility
3.38 It is important for the public sector to retain flexibility in delivering services. For
example, if there is new technology which could improve service delivery, a desire to change
the service configuration of the facility such as a shift from in-patient to out-patient care or
an expectation that the volume of support services required may change, the public sector
needs to retain the flexibility to manage such changes efficiently.
3.39 There will always be constraints on the public sector in facilitating such changes
whichever procurement method is employed in delivering new infrastructure. Once
complete, a new building inevitably presents a degree of inherent inflexibility by its very
design. Similarly, it may be difficult to change service delivery quickly given the management
and personnel arrangements put in place at the outset. Any change is also likely to require
new funds to finance any new construction work needed, so affordability could also
constrain.
3.40 With PFI, the contract entered into at the outset recognises that there will be a need for
changes over the 15-30 year life of the contract. The key flexibility rights given to the public
sector are:
© the public sector has a right to change any aspect of the building or service
provision, subject to agreement with the PFI contractor on cost;
* to ensure that value for money is maintained, for changes over £100,000 in
value the public sector can require a competitive tender for any works; and
© where there is a requirement to change service configuration, there is a similar
right for the public sector to change any aspect of service provision, subject to
agreement on costs, with the ability to require a competition as set out above.
This is in addition to their rights to re-tender service provision regularly
throughout the contract's life.
3.41 When the public sector wishes to make changes to the PFI building or services it bears
the cost as it would in conventional procurement.
3.42 Ifa dispute arises concerning this process, there is a dispute resolution procedure which
is binding, involving an independent expert agreed by both parties. However, if the public
sector remains dissatisfied, or the scale of change required goes beyond what can be
accommodated by the change mechanisms set out in the contract, the public sector can
voluntarily terminate the full contract, as distinct from termination due to private sector
default. Futher detail on voluntary termination by the public sector can be found in
paragraph 9.27.
3.43 Evidence to date suggests that the flexibility provided by the PFI contract has already
been used by the public sector during the construction period in early PFI transactions. The
research set out in Chapter 4 identifies 22 per cent of PFI contracts during the construction
period being adjusted to facilitate changes in scope required by the public sector. Given that
most operating PFI contracts have only been in operation for a short period, evidence on how
well the change mechanism works in practice for any changes which the public sector
requires in respect of service delivery is not extensive.
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3.44 The Government will continue to monitor whether PFI in practice delivers the flexibility
which PFI contracts offer and which public services will need, whilst preserving value for
money. Chapter 8 sets out proposals for monitoring the public sector's management of these
change mechanisms in practice. The Government is also concerned to reduce the costs of
voluntary termination where it is required to meet a public sector need to terminate in the
rare cases where changes cannot otherwise be achieved, and has set out proposals to achieve
this in Chapter 9.
Public Sector Safeguards
3.45 Ultimately, the Government reserves the right to protect the ongoing delivery of public
services. For those services provided through PFI, the contract entered into with the private
sector provides major protections to the public sector should the private sector fail to meet
requirements, ranging from payment deductions to termination for default.
Deductions 3.46 In the first instance, if a PFI contractor fails to deliver the project on schedule or the
for poor services provided fall below the standard originally specified, deductions and penalties will
performance be withheld from payments made by the public sector.
3.47 The loss of revenue resulting from deductions and penalties provides a powerful
incentive for the PFI contractor to remedy any shortcomings in service delivery. Shareholders
will see a decline in their returns, third party credit providers will be concerned that this loss
of revenue will increase risk that the PFI contractor will be unable to meet its debt service
obligations. In these circumstances credit providers have contractual rights over the other
private sector participants in the project, which can enable them to enforce performance
against contractual obligations. Credit providers can replace the private sector participants in
the PFI with other companies better able to deliver to the required standard.
3.48 Furthermore, even in circumstances where there is not default, under a PFI contract the
Government retains the right to step in to take over the operation of the services being
provided by the PFI contractor:
¢ ifthe Government determines that there is a serious risk to the health or safety
of the public;
° ifthe Government determines that there is a serious risk to the environment;
© where the Government is required to exercise its statutory responsibilities; or
e if the Government determines that the project may have implications for
national security.
Default and 3.49 Where a PFI contractor consistently fails to deliver the services to the standard originally
Termination specified and the private sector has failed to remedy this deficiency, the PFI contract will fall
into default, giving the public sector the right to terminate the contract and step in to ensure
continuity of service delivery. In these circumstances:
¢ — with rare exceptions, projects will revert to public ownership, including the
assets and staff necessary to continue to deliver the service;
* compensation is only due to the private sector for the true value of assets
taken over by the public sector less any rectification costs. In extreme
circumstances this could result in no payment; and
¢ the public sector is then able to take ownership of the project itself or re-
tender the opportunity to take over the project to other private sector
contractors.
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3.50 Given the 564 PFI projects signed to date and the long term nature of the PFI contracts
it is likely that a small proportion of the PFI projects will fall so far short of their contractual
requirements that they will be terminated by the public sector.
3.5 Itis impossible to predict with accuracy the percentage of PFI projects which may fail,
but it is important to understand that in these extreme circumstances of failure, after all
reasonable attempts have been made by all parties to resolve any difficulties which may
emerge, the Government will be prepared to terminate such contracts in accordance with its
legal rights, even if at a loss to financial participants in the scheme. Where this happens, it will
also act within its legal right to ensure that public services will be maintained.
Public sector 3.52 It is important for the public sector to regularly monitor the performance of PFI
monitoring projects, and ensure they have the access to the professional skills they will need to take
advantage of these public sector safeguards if necessary. Chapter 5 and Chapter 8 discuss
steps already taken or planned to ensure the public sector has this expertise in place.
Contract expiry 3.53 Upon expiry of a standard PFI contract, with rare exceptions the key assets needed to
continue to deliver public services revert to the public sector free of charge.
The Role of Private Finance
3.54 The providers of private finance to a PFI project, both providers of equity and debt play
a series of important roles in the overall success of the project.
Equity 3.55 The shareholders in a PFI project provide it with equity capital, by investing in ordinary
shares or subscribing for long term subordinated debt. Typically this investment will
comprise approximately 10 per cent of the project's up-front costs and is the element of the
financing most at risk to loss. This equity capital is usually provided by those providing
services to the PFI project, whether they be the construction contractor or long term facilities
manager and increasingly, specialised financial institutions.
3.56 An equity investor only benefits from its investment in a PFI project after it is complete
and successfully in operation as unitary charges are only paid once an asset becomes
available. Also, the value of the project to the investor is determined by the expected
performance of the project over its whole life. This incentive to create a public asset with long-
term value enables construction contractors to take a long-term interest in the project, even
after they have completed their construction task. This also enables the various contractors
to the PFI project and investors to work together with a common interest in creating an
optimum, whole-of-life, cost-effective project and provides the right incentives to seek the
best performance in the form of the performance regime set out in the PFI contract and
actively remedy deficiencies.
Senior Debt 3.57 Typically, third party credit providers are more risk-averse than equity providers and
provide the majority of the funding. The PFI approach and process thus leads banks and other
financial institutions who lend to PFI projects to play a important role in ensuring that proper
due diligence is performed, all important risks are identified and properly addressed and
allocated to the appropriate parties. They will seek to have robust and rigorous contractual
undertakings from private sector participants in the PFI scheme and this
the PFI process delivers projects to time and to budget.
is one of the reasons
3.58 Private financiers usually provide a significant component of the project funding for a
PFI project. It is recognised that the funders who provide this finance play an important role
in developing the project scheme, and provide many of the benefits outlined in paragraphs
3.14 to 3.16 above. Typically, areas where funders perform key roles are:
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© due diligence. When funders consider financing a project, they will carry out
extensive due diligence work, aided by independent advisers, on all aspects of
the project plan including its technical, insurance, legal and financial aspects.
This due diligence is intended to ensure that the plan is robust based on the
project assumptions and to eliminate any identifiable ‘optimism bias’ in the
consortium's plans. Funders are incentivised to ensure as far as is possible that
all potential project risks are taken into account;
e risk allocation. Funders ensure that all the risk identified in a project is
allocated to the party best able to manage it. As funders are potentially
exposed to all of the debt provided to the project, they ensure that the project's
contractual structure properly incentivises and apportions risk to the
appropriate parties to the contract. Ultimately funders remain exposed and
will assess the residual risks of, for example, not achieving a watertight
contract structure, or the inherent risk that a failing or failed project will not
have sufficient funds to repay its debt;
* contract enforcement. Where a project has experienced problems, the private
sector funders ensure that the contract structure they have created through
the due diligence and risk allocation process is properly enforced, and that
parties who have assumed risks are accountable. This enforcement role helps
ensure that projects are nevertheless completed so that the public sector
client can enjoy their benefit and the private sector receive whatever
payments follow; and
¢ taking overall project risk. Although the credit providers ensure that the great
majority of project risk rests with the consortium and its sub-contractors, they
hold the overall risk that their debt is not repayed. To manage this risk, they
hold step-in rights to take over failing projects and bring in new contractors
who can meet public sector requirements.
3.59 The involvement of private finance in a project therefore brings with it many benefits,
over and above taking on the risk of the project to the value of debt and equity provided.
Annex C contains the results of a study conducted into the cost of private finance in PFI
projects.
Comparing Costs of Finance
3.60 Discussion of the role of private finance in PFI projects must take into account the
benefits which it brings to PFI projects, outlined above, and it should also ensure that the
costs of securing finance from both public and private sources are assessed on a consistent
basis. A balanced approach to consideration of the costs and benefits of private finance is
essential for developing future policy.
3.61 The cost of private sector finance in PFI is often cited as greater than the cost of funds
available through public finance. A simple comparison of the combined returns on debt and
equity earned by the private sector with the non-risk rate on gilts would show that the cost of
public debt was lower, but this single cost comparison does not adequately capture the
different methods of costing for risk in the public and private sector, nor does it reflect the
value for money benefits which whole-life costing and appropriate risk-sharing in PFI bring
to projects. There is a cost to the Government's use of private finance, involving the extra cost
of the private sector securing funds in the market, but a great part of the difference between
the cost of public and private finance is caused by a different approach to evaluating risk.
4
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The price of risk 3.62 Typically, the private sector takes account of risk by discounting future cash flow at a
— private sector higher rate. A risk premium is therefore made explicit in the private sector cost of capital, and
the level of return on capital is competitively determined according to the risks assessed in
the project. In PFI, the project discount rate, or expected rate of return for the private sector,
takes into account the costs associated with procuring private capital and also seeks to price
the wider risks associated with lending to the project.
3.63 The gilt rate, on the other hand, does not make any attempt to calculate risks. This does
not mean that the Government is able to borrow and spend money free of risk. Instead it
means that, with publicly financed procurement, the taxpayer underwrites the associated
risk, and this is reflected in a lower price of capital to the public sector. The taxpayer takes on
the risk attached to the project, and where it materialises, bears the cost as a result. It is
therefore inappropriate to compare a “risk free” cost of gilts with the cost of private finance:
PFI projects provide value for money through the private sector taking on, pricing, and
managing more effectively these project risks.
The price of risk 3.64 Instead of reflecting risk in a risk premium on capital, Government investment
— public sector decisions reflect risk by calculating the present value capital sum it regards as the necessary
contingency for the risks inherent in a project. For example, when deciding between
procurement options, project managers calculate an expected value of all risks for each
option, and consider how exposed each option is to future uncertainty. They then discount
the cost of these options in future years at 3.5 per cent per year to a present value, which
purely reflects society's preference for consumption now over consumption in the future,
rather than discounting the value of project cash flows at a higher rate to make a
compensation for risk. (A further explanation of this process is contained in the Green Book.)
Risks are therefore priced individually, for each project option. The discounted costs of these
risk-adjusted options can then be compared with each other, or with the cost of a PFI project,
in a PSC, to determine which procurement option represents best value for money taking
account of risk and uncertainty. This approach is consistent with the fact that in conventional
procurement the public sector pays for risk not in its borrowing — which for the public sector
is at non-risk rates —- but when risks crystallise and must be covered in publicly funded
projects.
*The Green Book: Appraisal and Evaluation in Central Government.
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The Government is determined to ensure that a sound evidence base informs the rigorous
investigation of where PFI is delivering better facilities and value for money benefits in
practice. The PFI programme has progressed to a point where, with 451 projects
operational, sufficient evidence is available to assess many aspects of the early
performance of the programme. This section summarises the findings of new HM Treasury
research into completed major capital PFI projects. It also presents the findings of research
into two particular areas of the PFI programme: projects with a small capital value, and
information technology (IT) projects.
The main findings of this new research are:
© PFI projects are being delivered on time and on budget. HM Treasury
research into completed PFI projects showed 88 per cent coming in on time or
early, and with no cost overruns on construction borne by the public sector.
Previous research has shown that 70 per cent of non-PFI projects were delivered
late and 73 per cent ran over budget;
© there is scope to reduce procurement times, although there is evidence
that new initiatives to tackle this problem are having an impact.
Procurement times averaged 22 months, but the first scheme signed under the
NHS LIFT lative, a new form of PFI joint venture designed to bring procurement
expertise directly into primary healthcare projects, closed in just 14 months; and
© the operational performance of PFI has met with approval from public
sector clients. Over three quarters of clients surveyed reported their PFI
Projects performing as expected or better. Further research into operational
performance is required, to assess projects once they have had longer periods in
operation. Moreover, it is still early for the expected long-term operational
benefits of PFI procurement, in terms of whole-of-life costing and locked-in
standards, to have become apparent.
Two previous independent reports by the NAO into aspects of the PFI programme further
support many of these findings, providing evidence of improved construction performance
over non-PFI projects and of public sector client satisfaction.'
In HM Treasury’s research focused on PFI projects with capital values below £20 million,
the main findings were:
* construction and operational performance were good, in line with
larger projects. Over 80 per cent of projects were delivered on time or early,
and over 90 per cent met with client expectations; and
© the procurement process for small projects was of comparable length
to that of major capital schemes. This indicates that, in relation to the level
of capital investment undertaken by the schemes, procurement times are
disproportionately long, and procurement costs disproportionately high.
For IT projects, the main findings of research were that:
© IT PFI projects were moderately successful, but the majority of more successful
Projects renegotiated their contracts after signature to achieve ongoing flexibility,
moving away from the mainstream PFI focus on contractually defining outputs; and
© this finding was in line with qualitative research on IT PFI, which identified a
number of important differences with PFI in other sectors, including a greater
need for project flexibility, a higher level of integration with public sector business
systems, and little or no market for third party finance.
The policy implications of these findings are explored in Chapter 7.
' PFI: Construction Performance, NAO, 2003; and Modernising Construction, NAO, 2001
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BACKGROUND
4.1 With 451 projects now operational, it is possible to take stock of the performance of the
PFI programme to date. This chapter outlines new research carried out by HM Treasury on the
track record of PFI in major capital projects, which tests its performance particularly against
its expected benefits of on time and on budget delivery. It also reports on research into two
particular areas of the PFI programme, small capital value projects and IT projects, to
examine the value for money that PFI is actually delivering in these sectors.
4.2 By concentrating on operational projects, this research gauges how PFI has performed
in practice, both in construction and the early years of operation. However, such projects
were inevitably commissioned in the early years of the PFI programme, before a number of
initiatives designed to establish and spread best practice had been implemented. The
dynamic nature of the PFI programme, and the Government's commitment to further
improving PFI’s application, means continuing appraisal in the future is essential. In
particular, it is important to monitor the effectiveness in practice of PFI's operational benefits
and contractual protections, including contract flexibility, the ability of authorities to manage
contracts, and the maintenance of quality standards into the medium and long-term. Areas
for further investigation are laid out in more detail in Chapter 7.
PFI DELIVERY SO FAR: PUBLIC SECTOR RESEARCH
Sources
Researching PFI: 4.3 In September 2002, HM Treasury conducted research to investigate whether PFI had
substantial delivered the benefits expected from it in completed procurements. Specifically, the research
capital assets project examined information held on individual projects by procuring authorities and asked
that additional data be sought from project managers across a range of sectors. Chart 4.1 sets
out the project sample used to provide a picture of:
*® construction performance;
© — delivery against budgets;
- bidder selection;
© procurement times; and
© operational performance.
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The project
sample / Chart 4.1: PFI delivery project sample
Health
10 Hospitals; I In-patients centre;
I Acute Psychiatric centre
a I Old Peoples’ Home
Justice/Custodial
9 Prisons ~~
2 Police Stations
I Magistrate Court
Schools
Transport __ 6 Grouped Schools
7 Roads Projects covering
2 Major Bridges 56 Schools
4 Light Rail/Trams
Defence
8 New Build, 2 Refurbished
Accommodation
6 Equipment and I Helicopter
Training Suite
Source: HM Treasury.
4.4 The scope of the research was restricted to the use of PFI as a procurement tool for
substantial capital assets that were currently operational. IT or smaller projects, both the
subject of separate research programmes were excluded from the sample.
4.5 Nine of the 70 projects in the sample were found to fall outside the scope of the
research, leaving a sample of 61 operational projects covering a wide range of service areas.
This sample represents about 10 per cent of all completed PFI projects. This information
combined both objective data on the procurement process itself as well as more qualitative
aspects concerning how far the schemes were matching up to the expectations of the public
sector clients. The research will be published on the HM Treasury website in the Autumn.
Research Outcomes
Overview 4.6 The research into completed PFI projects provided good evidence of PFI’s successful
performance in major capital projects. It showed PFI delivering new assets on time, within
budget and meeting the expectations of public sector clients. The strength of current PFI
performance in major capital projects provides a solid base for the continuing use of PFI to
provide substantial capital investment in public services where it is appropriate to do so.
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Delivering New Assets: Construction Performance in PFI
Delivering on 4.7 Akey focus of the research was to assess how far PFI delivered new assets on time. The
time sample suggested that PFI was delivering new assets on time across the public sector.
88 per cent of projects were built on time or early. This strong track record of PFI is borne out
by a comparison of the HM Treasury findings with those of the National Audit Office (NAO).
A recent NAO report' found that of a sample of 37 projects, only 8 per cent of PFI schemes
were delayed by more than two months.
Chart 4.2: Delivering on time
100 5
HMT PFI Research NAO PFI Research Previous, non-
PFI Experience
BH On Time or Early Hi Late
Source: HM Treasury: NAO: PFI Construction Performance 2002 HC 371, Session February 2002-03; NAO: Modemising
Construction, 2001, HC 87, Session 2000-01
4.8 The track record of conventional Government construction projects has been
considerably worse in this respect. Other research into previous non-PFI construction
performance has shown that around 70 per cent of conventional construction projects came
in late’.
"PFI: Construction Performance, NAO, 2003.
+ Modernising Construction, NAO, 2001.
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Chart 4.3: Construction performance by sector
100
90
Hy on time [ij early [Fj tate
Source: HM Treasury; NAO PFt: Construction Performance 2002, HC 371, Session February 2002-03.
4.9 Chart 4.3 shows PFI construction performance by sector. For school, hospital and
defence projects (of which a high proportion were accommodation projects), very few
schemes experienced delays. No prison and road projects surveyed were delivered late. In
some sectors, such as light railways, the planning difficulties in densely populated urban
areas and inherent infle: ities in the schemes mean that PFI has been less successful in
meeting initial delivery timetables. However, unlike conventional procurement, the direct
financial costs associated with these delays were not borne by the public sector and payment
only began to flow to the private contractor once the asset was complete and the service was
underway.
Delivering to Budget
4.10 HM Treasury research assessed how far PFI was delivering new assets within the
budgets originally agreed with the contractor. Under PFI, the public sector only begins to pay
for an asset once it is built and the flow of services associated with it begins. As discussed in
Chapter 3 from paragraph 3.22, this means that the costs involved in developing and
operating an asset are at risk to the private sector.
4.11 In order to determine whether there were budget overruns on projects in the public
sector, HIM Treasury therefore sought to assess whether the unitary charge payment the pubic
sector makes had changed following contract award. Construction cost overruns borne by the
private sector would not, of course, be reflected in these data. There are situations where the
unitary charge payment could increase during construction, not due to project cost overruns,
but due to the public sector altering the specific requirements it wanted, and the private
sector varying its price to reflect that. In fact, all cases in the research sample where the cost
to the public sector increased were due, not to construction overruns, but to changes in
public sector requirements.
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PFI is delivering 4.12 Overall both HM Treasury research and the earlier NAO sample suggest that PFI
new assets provides high levels of price certainty for the public sector, particularly in comparison to the
within budgets budget overruns experienced in traditional procurement, demonstrating that construction
risk had been effectively transferred to the private sector:
¢ in the HM Treasury sample, changes to the unitary charge were experienced
in only one fifth of projects, and all were driven by changes in the
requirements of the public sector client; and
© inthe NAO sample, 21 per cent of projects surveyed involved a change in price
for the public sector after contract award? - and all were driven by a change in
requirements by the public sector client.
PFI is therefore delivering very high levels of price certainty for the public sector for
construction and operation, although of course at an early stage of the contract's life.
Chart 4.4: Delivering to budget — price uncertainty in public
procurement
805
70
60
50
€
S 49
&
30
20
105
7 Treasury sample — PFI NAO sample — PFI Previous Government
experience — non PFI
Source: HM Treasury: NAO: Mocerising Construction, 2001, HC 87, Sesson 2000-01; NAO: PF Constuction Fefamance 2002
HC 371, Sesson February 2002-03.
Level of Competition
Competition 4.13 PFI allows the public sector to harness the efficency that can come from contestability
in public procurement. It is important then that the PFI market retains the capacity to deliver
healthy competitive tension.
4.14 Data on PFI competitions from the HM Treasury research showed that deals averaged
four bidders each. This figure was relatively consistent across sectors. Four bidders represents
strong competition for these contracts, and any significantly greater number of serious bids
would probably be difficult to manage effectively enough to drive competition any further.
415 Although this research provides some evidence of healthy competition, the
Government intends to continue to take steps to improve public sector procurement skills,
give greater certainty for deal flow and so, as well as improving value for money in the public
sector, ensure a healthy market of PFI in the private sector. Measures intended to strengthen
public sector procurement and encourage private sector bidders are detailed in Chapter 8.
> PFI : Construction performance, NAO, 2003.
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Bidder Selection
4.16 The HM Treasury research also sought to identify what project managers presented as
the primary factors underpinning their selection of bidders. Project managers were asked to
list those factors that were particularly important in awarding contracts (Chart 4.5). Overall,
procurers said that price followed by design had been the dominant factors affecting their
bidder selection.
4.17 The Government is clear that value for money should not be equated with the lowest
cost option, but should instead identify the optimum combination of whole life cost and
quality. Chapter 8, paragraphs 8.42 to 8.44 outline the Government's plans to investigate
further bidder selection in PFI. Box 8.1 outlines the Government's approach to encouraging
good design in public procurement.
Chart 4.5: Bidder selection in PFI
19%
[BB Bidder Track Record
[Bh Reputation
Ell Design
[Bh Wider Organisational
13% [i Other
19%
Source: HM Treasury.
Procurement Times
4.18 Procuring through PFI can be complex and can involve lengthy negotiations before
contracts are signed, although after signature construction periods tend to be shorter than in
conventional procurement and delays are significantly reduced as the private sector's own
capital is at risk and payments from Government do not start until the service is available. The
Government is concerned that investment be delivered to public services as quickly as
possible, while ensuring the necessary safeguards and due diligence are in place to prevent
public money being wasted. Futhermore, procurement delays and associated costs incurred
by the private sector can damage competition and value for money in PFI. Chapter 5 outlines
private sector concerns regarding the procurement process, and measures already in place
to improve the efficiency of procurement. As a result, reducing procurement delays in PFI
prior to contract signature, without compromising on achieving value for money, is a
Government priority. Further steps to improve procurement in the public sector in PFI are
outlined in Chapter 8.
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419 Table 4.1 sets out the procurement times for the operational projects examined by HM
Treasury from the point where first invitation to tender is published in the Official Journal of
the European Communities (OJEC). Average procurement times were about 22 months,
although average times were greater in the health sector. It is hard to compare this figure with
non-PFI procurement times as aggregate information for the public sector is not presently
available. However, this is a long lead time which may in part reflect early difficulties
experienced at the outset of the PFI programme, such as unfamiliarity with the process, the
absence of standard form contracts and uncertainty regarding the legal powers of public
sector clients.
4.20 Long lead times are a result of a number of factors, some common to all procurement,
and some associated with PFI. Furthermore, some of this time is taken performing tasks that
are highly beneficial to the overall project, but in some areas progress to reduce procurement
times is possible. Extended procurements have broadly been the result of:
¢ the increased complexity associated with procuring a PFI project, including
securing the necessary technical, legal and financial advice and conducting
contract negotiations;
the need for the public sector to carefully specify its actual service
requirements from a procurement, rather than provide a prescriptive design
specification. The scope for improving the quality of public service outputs,
which this rigorous procurement process provides, make this a very beneficial
factor and one that should be present in all procurement; and
* legal issues surrounding the right of NHS Trusts to enter into PFI contracts in
the early stages of the Department of Health's PFI programme. This problem
has now been overcome and procurement times in the Health sector have
fallen as a result.
4.21 The Government has taken a series of practical steps to overcome these difficulties,
detailed in Chapter 5, which have met with success. For example, the first scheme under the
NHS LIFT initiative, which uses a joint venture structure to inject procurement expertise into
the public sector client, reached financial close in just 14 months. Improving the public sector
client's general skills, and particularly its capacity to specify public service requirements and
properly manage a PFI procurement process, continues to be a major concentration of the
Government. Chapter 8 sets out measures to streamline the procurement process and boost
public sector client capacity in more detail.
Table 4.1: Procurement times in early PFI
Procurement Dates OJEC to Financial Close Upper/Lower bounds
(OJEC issued) (months) (months)
Health December 1994— 40 22-60
December 1998
Schools March 1997— 2B 15-25
December 1999
Defence November 1994— 23 18-32
September 1999
Custodial/Prisons March 1997— 214 14-25
November 1999
Road March 1986~ 18 15-20
November 1995
‘Tram/Light rail March 1986~ 223 13.30
November 1995
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Operational Performance
4.22 _Itis difficult to assess the operational performance of PFI projects at this stage. The fact
that all operational schemes are in the early years of long-term agreements of up to thirty
years means that it is too early to draw far-reaching conclusions on this point.
4.23 Research by HM Treasury, and also by the NAO, has sought to gain some initial
indication of operational project performance by surveying the opinions of public sector
managers. HM Treasury asked respondents to indicate how far “overall performance of the
private sector partner” was “matching up to expectations at the time of contract close’.
4.24 Of the project sample:
© over three quarters of public sector clients described the performance of the
project as ‘as expected’ or ‘better’ and one quarter of respondents said the
project was ‘far surpassing’ their expectations; and
© 24 per cent of respondents reported performance as less than expected.
Further research is being conducted into projects viewed as poorly
performing to ascertain the factors involved and determine remedies.
Chart 4.6: How far is the private sector partner meeting up to
initial expectations?
6%
i Far Surpassing
Ti Surpassing
DD As expected
BB Less than expected
i Much less than expected
35%
Source: HM Treasury
4.25 These findings are in line with a November 2001 survey of 98 projects by the NAO,
which focused more specifically on the Public Authorities’ perception of value for money. Of
those sampled, 81 per cent of public bodies involved in PFI projects believed that they are
achieving satisfactory or better value for money from their PFI contracts. Only 4 per cent
described value for money as ‘poor’.
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Project 4.26 PFI involves long-term contracts in which private sector contractors are bound to
evaluation in the deliver a clear level of service at a fixed price over the whole life of the asset. A primary
future motivation behind this structure is to ensure value for money over the long term. As the
experience of service delivery under PFI increases, and particularly as the assets procured
under PFI begin to age, the Government will seek to evaluate how far the long-term benefits
of PFI are realised, and establish and pass on best practice in the public sector's management
of these contracts. Future steps to be taken in this area are contained in Chapter 8.
PROJECT PERFORMANCE IN LOW CAPITAL VALUE SCHEMES
Background 4.27 One important area where research has recently been conducted to determine
whether PFI is delivering in practice, and providing value for money overall, is in individually
procured PFI projects with a low capital value, which, for the purpose of this research, was
defined as less than £20 million. Historically, the number of small PFI projects has been high,
as illustrated in Chart 4.7.
Chart 4.7: Number of projects grouped by Capital Value
300
250—
Number of Projects
SS
se F & Pid ra ral ra s
Capital Value (£m)
Source: HM Treasury
4.28 Because of a recognition that the development and transaction costs involved in PFI
could be disproportionately high if it was utilised in those projects with small capital values,
the Government sought to assess the performance of PFI in these projects and the value for
money represented by its benefits. HM Treasury therefore commissioned Partnerships UK to
survey projects which:
© were operational;
* involved the provision of a new capital asset under £20 million; and
° — were identifiable as PFI, involving unitary charge payments for both the
availability of an asset and services associated with it, so as to eliminate from
the sample other common forms of procurement in small projects such as
outsourcing.
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4.29 A sample of 35 projects was selected. Of these, ten were the subject of additional, in-
depth interviews.
Overview of 4.30 The performance of PFI in small projects has been good, with the proportion of
Results projects completed on time and on budget, and operating to client expectations, in line with
the results for larger projects. However, average procurement times were similar — at around
two to two and a half years — meaning that times were disproportionately long for the projects
with a small capital value. Small schemes also typically faced similar transaction and bid costs
as major capital schemes, again indicating that these were disproportionately high.
Construction 4,3] Partnerships UK's research showed that projects with a lower capital value do deliver
performance in new assets on time and to budget. Of the sample of 35 projects, 83 per cent were delivered on
smaller projects time or early. Of the 17 per cent delivered late, the longest delay was four months.
Operational 4.32 The projects sampled also suggested that subsequent operations are satisfactory and
performance in jn line with the public sector clients’ expectations:
smaller projects
*® 32 projects delivered met initial expectations or surpassed them;
¢ for one project, performance was ‘as expected’ but with certain elements
‘below expectations’; and
¢ for two projects, performance was ‘below expectations’ in terms of facilities
management services, but ‘above expectations’ in terms of build quality.
4.33 This record of satisfactory performance, with over 90 per cent of projects fully meeting
client expectations, even surpasses that of larger PFI projects, where the figure was 75 per
cent.
Procurement 4.34 For the 35 projects sampled, procurement times ranged from 14 months to five years,
times in smaller with an average duration of two and half years. Subsequent interviews with ten project
projects managers found that the duration of the procurement for all ten projects was longer than
expected and, in many cases, considerably so. The periods ranged from just two months
longer to a delay of four years in one case.
4.35 The two most prevalent reasons for delay, certainly once the PFI procurement had
started, were: first, issues related to the availability of the appropriate sites (for example,
acquisition, title, town planning); and second, protracted contractual negotiations once the
preferred PFI partner had been selected.
4.36 Whilst PFI’s record of performance has been similarly good for major schemes and for
projects with a capital value of less than £20 million, there is however also evidence that
smaller projects face a number of difficulties that need to be addressed to ensure that this
success is not obtained at disproportionate cost.
Costs of third- 4.37 All PFI schemes face the cost of using third-party finance and small schemes typically
party finance face the same level of legal and technical documentation, complex due diligence
requirements and financial modelling that lenders require for much larger projects. As a
result, the costs of private finance are relatively higher for small schemes.
Bid costs in small 4.38 Similarly, in addition to their own internal costs, bidders must typically meet the costs
schemes of technical, financial, design and legal advisors. These costs do not necessarily fall in
proportion to the size of the project, and so drive up the relative cost of small PFI schemes.
For example, one private sector contractor has suggested that their bid costs, as a proportion
of a project's capital value, are 33 per cent lower for a £50 million project compared to a
project costing £20 million.
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Procurement 4.39 Procurement costs for the public sector are not included in the Public Sector
costs and the Comparator (PSC) under the current guidelines, and so the evaluative comparison made on
PSC small projects in the past would not have captured these external value for money factors. To
address this issue, proposals for a reform of the PSC are outlined in Chapter 7, which will
enable value for money appraisal to take into account both the procurement costs associated
with a PFI project, and the strength of market interest it is likely to generate.
Policy Implications
4.40 The overall implication of this research into individually procured small PFI projects is
that, although PFI continues to perform well in these small schemes, its transaction and
development costs and procurement times are disproportionately large. These factors make
it difficult for small PFI schemes to consistently obtain value for money unless projects can
be bundled together, a process outlined in paragraphs 8.26 to 8.40. Chapter 7 outlines policy
measures designed to take account of this.
PERFORMANCE OF PFI IN IT
Overview 4.41 The Government is committed to improving the delivery of IT projects it procures to
ii
plement public services. The use of PFI in IT has been one method employed to achieve
this. In particular, one objective was to introduce third-party finance into IT projects to effect
risk transfer, impose further commercial discipline and ensure risk mitigation in the delivery
of IT contracts.
4.42 HM Treasury along with Partnerships UK have recently reviewed the operation and
performance of PFI in IT to determine how far PFI has been successful in achieving an
appropriate sharing of risk in IT and so improved public service delivery. It also sought to
investigate important differences between PFI in IT and PFI in other sectors. The evidence
collected suggested that, in the majority of successful IT procurements, contracts were
renegotiated to move away from the mainstream PFI model based around specified outputs,
to adopt a different approach.
Principles of PFI 4.43 Overall, this research indicated that because of the significant differences between IT
and IT PFI and PFI in other sectors, and the attendant difficulty of ensuring an appropriate sharing
Procurement of risk through PFI, IT PFI may not be able to consistently offer value for money benefits. In
particular many aspects central to IT procurement do not fit well with the central
requirements of PFI, laid out in Chapter 3, particularly:
¢ the fast pace of change in the sector make it difficult for the public sector to
effectively define the outputs it requires in a long-term contract;
¢ the high level of integration of IT infrastructure into the other business
systems of the procurer makes it difficult to clearly delineate areas of
responsibility to the client and the contractor, and so makes an appropriate
sharing of risk more difficult to both discern and enforce;
¢ the lack of a market for third-party finance in IT PFI removes a powerful driver
ensuring appropriate and effective risk allocation in a project. This detracts
from PFI's ability to secure value for money for the public sector;
¢ the nature of the capital investment, with costs in IT dominated not by large
up-front investment but by running costs; and
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© the duration and phasing of investment, where IT projects have a short life,
and include significant asset refresh, makes defining and enforcing long-term
service needs more problematic.
These points are outlined in more detail below. The policy implications of these findings are
detailed in Chapter 7.
Differences between IT PFI and PFI in other sectors
4.44 The successful implementation of IT procurement has always been difficult, for both
the public and the private sector, no matter what method is used. The Standish Group's
report’ on IT projects from the United States suggested that only 16 per cent of software
projects are completed on time and on budget throughout IT procurement. The report went
further, stating that “even when these projects are completed, many are no more than a mere
shadow of their original specification requirements. Projects completed by the largest
American companies have only approximately 42 per cent of the originally proposed features
and functions. Smaller companies do much better. A total of 78.4 per cent of their software
projects will get deployed with at least 74.2 per cent of their original features and functions”.
4.45 It was hoped that the use of PFI in IT, by achieving an appropriate sharing of risks
between the procurer and the IT contractor, could drive improvement in sectoral
performance. However, because of the particular characteristics of IT procurement, outlined
below, achieving an appropriate level of risk transfer has been difficult.
Difficulty of 4.46 The close links between IT infrastructure and organisational operational needs,
specifying combined with the rapid pace of technological change, frequently make it difficult to codify
requirements long-term IT requirements into an effective contract, especially over the time periods that PFI
agreements typically cover. Generally, the service requirement in an IT project is likely to
change frequently during the course of a contract.
Difficulty of 4.47 A consequence of the structure of IT PFI projects, the intricate nature of IT service
substituting provision, and the difficulty of integrating proprietary technologies is that it is very difficult
suppliers and sometimes impossible to substitute in a timely manner a second IT service provider in
the event of contractor failing to meet its obligations under the contract. This means that
when an adequate service is not delivered, departments are often at a disadvantage in
negotiating with their existing vendors. This problem has not occurred in the vast majority of
the 440 other operational PFI projects.
Lack of third- 4.48 IT PFI very rarely involves genuine third-party finance, whereas most non-IT PFI
party finance projects do. When PFI was introduced in the IT sector, it was hoped that a market for third-
party finance of IT projects might emerge; however, for a variety of reasons including the
general downturn in the IT sector, this has not occurred. As explained in Chapter 3
paragraphs 3.54 to 3.59, third-party finance provides a series of important benefits to PFI
projects in other sectors
4.49. This lack of third-party finance in IT has had a number of consequences:
¢ it imposes constraints on the ability of the private sector to finance long up-
front development costs, and often requires these costs to be met from
corporate borrowing. This is especially significant in the context of large
software development projects, in which IT service providers are often
expected to finance months or years of development before receiving any
revenues;
“The Chaos Report, The Standish Group, 1995.
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) it removes a valuable source of due diligence, which has been shown to reduce
optimism bias and tighten contract terms in non-IT PFI, as outlined in
paragraph 3.54 to 3.59. This makes it more difficult to assure effective risk
allocation in IT PFI; and
sal it makes it difficult for small and medium-sized IT providers to bid for many
projects, especially considering the large size of some projects and the
requirement in many PFI contracts for the private sector to finance
development costs up-front. This has weakened competition for projects.
Nature of capital 4.50 Although both IT PFI projects and other PFI projects involve the provision of capital
investment assets (whether buildings or IT applications, systems or networks), the costs of delivering IT
projects are dominated by the annual running costs associated with delivering the service
requirement, rather than by the up-front costs of investment in the project assets. In a typical
IT project, project assets often account for less than a third of the present value of projects; in
anon-IT PFI project, this fraction is usually considerably higher.
Duration and 4.5! The life of IT PFI contracts is typically shorter than that of PFI projects in other sectors,
phasing of with IT projects typically lasting ten years, and other PFI projects lasting 15 to 30 years. The
investment expected life of an IT project's assets is typically even shorter than the contract duration, with
the consequence that the contractor is expected to undertake significant asset refresh during
the course of the project. For example, in a desktop outsourcing IT PFI project, the outsourcer
will typically replace a procuring authority's PCs and servers more than once over a ten-year
contract. In non-IT PFI projects, most assets typically will be useful for the whole life of the
contract.
The Performance of PFI in IT
Overview of 4.52 The track record of performance in IT has reflected these qualitative differences.
research findings Although performance has been good in comparison to the IT sector as a whole, the best
performing projects were those that renegotiated their contracts after signature to obtain
greater ongoing flexibility and looser output specifications, moving away from the PFI model.
Although it is encouraging that user expectations were generally met or exceeded, the results
suggest that there is still room for significant improvement in the procurement of IT, and that
PFI has not delivered the step-change in performance that the Government originally
intended, and still requires.
4.53 HMTreasury, with the assistance of Partnerships UK, sought views from managers and
users of a sample of 16 operational public sector IT projects. This research was intended to be
indicative, rather than comprehensive, and as such was more limited in scope than other
surveys of PFI projects carried out by HM Treasury and reported in this document. The
sample used was a representative one, including projects by a variety of departments and
authorities and of a variety of size. 11 projects responded in full.
Project 4.54 Most (75 per cent) of these projects were regarded as fulfilling or exceeding user
Performance expectations. However, only 22 per cent of projects were, according to managers, delivering
80 to 100 per cent of defined programme benefits (see Chart 4.8). This is in line with the result
obtained in the Standish Group's survey of IT outsourcing.
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Chart 4.8: Client experience of IT PFI projects
Project managers’ appraisal —
percentage delivery of defined benefits User satisfaction ratings
. Exceeded
Did not meet i
80-100% expectations expectations
60-80%
Source: HM Treasuy.
Details of 4.55 However, the majority (54 per cent) of the more successful IT projects surveyed were
research those where the public sector had sought and obtained greater flexibility by renegotiating
terms after the contract was signed — moving away from the PFI model.
Chart 4.9: Successful IT PFI/PPPs renegotiating contract after
signing
Did not
Most successful IT
PFI/PPPs
renegotiated their
joving away
from the PFI model
Source: HM Treasury.
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58
Policy Implications
4.56 The Government, like any customer, needs IT projects delivered to time, cost and full
performance. The concern raised by this research is that expectations in the IT industry and
among public sector procurers are set too low. But more importantly it demonstrates that the
qualitative differences between PFI in IT and PFI in other sectors have a significant impact on
the way that IT PFI has been delivering. The difficulties with achieving appropriate risk
transfer in IT PFI, because of the need for significantly greater flexibility than in other sector,
the high degree of integration into the other business operations of the procuring authority,
and the lack of third party finance, mean that it may not be the appropriate value for money
procurement route for IT. Policy measures to reflect this are laid out in Chapter 7.
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It is a priority of the Government to ensure that it has the right skills and support
mechanisms in place for the public sector to deliver on the reform and renewal of public
services.
The Government recognises the need to improve procurement skills and ensure that
procuring authorities have the capacity and support to pursue both conventional
procurement and PFI effectively. By improving in its role as public sector client, the
Government helps:
© enable authorities to focus more effectively on securing overall value
for money, taking in whole-of-life costs, allowing scope for innovative design and
using discretion and good judgment in evaluating procurement options;
° increase the speed with which investment is delivered to the public by
reducing time spent in procurement;
© reduce the cost to the public sector of procuring PFI projects, improving
their value for money; and
© by being a better client, encourage the private sector to bid for PFI
projects, strengthening competition and innovation in PFI.
Future steps to improve the capacity of the public sector client in PFI will help address the
remaining concerns of the private sector over the costs of bidding for PFI projects and the
potential for delay in the PFI procurement process.
BACKGROUND
5.1 The Government places great importance in ensuring that the public sector develops
strong delivery and procurement skills for both conventional procurement and, as
particularly addressed in this chapter, for PFI. The Prime Minister's four principles of public
sector reform, the Cabinet Office Civil Service reform programme and the OGC’s programme
of skills development in central civil government are all aimed at securing excellence across
Government and in the delivery of vital public services.
5.2 Delivery skills in general, and procurement skills in particular, have historically been
insufficiently valued and undersupplied in the public sector. Particular problems have been
experienced with ensuring that these skills are consistently in place where they are needed:
® procurement has not been sufficiently valued in the public sector as a career
choice, meaning that high calibre staff often pursued other options and did
not develop these important skill sets;
® some procurement professionals were attracted away from the public sector;
and
® procurement expertise, where it was built up, was often dissipated after a
single procurement as project teams disbanded, rather than being applied to
whole investment programmes.
5.3 In markets where the Government is a major procurer of goods and services, its own
actions may impact upon competition and hence the long-term value for money it can
secure. The Competition Commission last year made a number of recommendations to
improve competition in procurement, following which the Government announced that the
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Office for Government Commerce (OGC) would consider steps to increase competition and
to encourage better long-term capacity planning in markets where the Government
possesses significant purchasing power.
5.4 The Government recognises that procurement skills are at a particular premium in PFI
procurement, because of its complexity, and the necessity therefore for high levels of
expertise. Better procurement skills lead to lower transaction costs, better value for money in
projects procured, and faster delivery of investment to public services. In PFI in particular,
improved procurement skills:
¢ enable the public sector to maximise the benefits available in the
procurement process by effectively conducting the long-term options
appraisal necessary both to determine whether the PFI route is value for
money, and to secure best value from PFI bidders;
* improve value for money, by reducing delays and lowering procurement
costs for the public sector and actively managing the specialist advisers, such
as technical, financial and legal advisers necessary for PFI;
¢ secure value for money from contract negotiations by achieving the
Government's aims in risk-sharing, and ensuring a smooth and timely
procurement process; and
* create an environment that encourages the private sector to bid for PFI
projects, improving competition and delivering a stronger PFI market.
5.5 The Government has already taken significant steps to improve its ability to procure
PFI projects, in the context of a wide-ranging programme to increase the public sector's
delivery skills more generally. This chapter sets out these measures taken to increase
Departments’ and local authorities’ ability to negotiate effective PFI projects quickly and with
reduced cost to themselves and to the private sector.
PROGRESS TO DATE
5.6 The present Government took a number of immediate measures to improve the public
sector's PFI procurement capabilities:
¢ it ended universal testing of all investment projects for the potential
application of PFI in 1997, allowing departments to dedicate skilled resources
to those areas most likely to give rise to effective PFI projects and to prioritise
the most promising PFI opportunities;
* it instituted the Bates Review to suggest improvements to the delivery of PFI
projects. The resulting report, published in 1997, led to a number of further
measures, including the creation of the Treasury Taskforce on PFI and the
establishment of standardised contract terms;
in April 1999, Peter Gershon undertook a review of civil procurement in
central government. One outcome of this review was establishment of the
Office of Government Commerce, incorporating several existing government
agencies. The OGC vision is to work with central civil government as a catalsyt
to achieve best value for money in commercial activities. Among other policy
measures, the OGC initiated the creation of standardised PFI contracts (see
paragraph 5.23 to 5.26); and
* since 1997, public sector bodies have also significantly increased their internal
PFI expertise. The Department of Health, HM Prison Service, the Highways
Agency and other bodies have developed specialised private finance units to
provide advice on the most effective use of PFI to achieve departmental
investment targets.
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Treasury 5.7 The Treasury Taskforce, formed in 1997, provided departments with highly skilled
Taskforce procurement and project management advice, reducing procurement delays and helping to
design robust projects. Following the advice of the second Bates Review in 1999 the
Government re-established the Treasury Taskforce as Partnerships UK, a public private
partnership with a public interest mission to make the public sector a more effective client in
public private partnership and PFI transactions.
Gateway reviews 5.8 In 2001, OGC introduced the Gateway process, a performance management tool to
allow the public sector to track and assess the effectiveness of projects, including PFI
schemes, throughout their procurement process. Gateways are designed to ensure that any
potential problems are addressed early on in any tender process. The process for each stage
is outlined in Box 5.1 below.
5.9 All new central civil government procurement and NHS projects must undergo
Gateway reviews, which are conducted on a confidential basis for the benefit of the senior
official and ownership of the report rests with them. The senior official is then accountable for
implementation of recommendations. Typically, the review team agrees an overall project
assessment of red, amber or green for the inclusion in the Gateway report.
5.10 From April 2003, the Gateway process is being piloted in local government sector PFI
projects by the Public Private Partnerships Programme (4Ps) (see paragraph 5.14), as
recommended by the Byatt review.
Box 5.1: The Gateway process
Gate 0 Strategic Assessment: The evaluation is applied at the start of a project or
programme and is designed to consider the strategic assessment of the business need.
Gate I Business Justification: This evaluation occurs once there is an outline business
case in place. Its aim is to confirm that the business case is robust and make
recommendations for improvements where necessary.
Gate 2 Procurement Strategy: Prior to the invitation for tender, this gate considers
the project’s potential for success and its ability to proceed.
Gate 3 Investment Decision: This gate is intended to establish whether the
recommended investment decision is appropriate prior to the contract being awarded. It
also examines the processes in place to select the supplier.
Gate 4 Readiness for Service: the purpose of this gate is to examine how the
organisation will implement business change associated with delivery and how robust the
solution is. It should also assess whether there is a basis for evaluating the projects ongoing
performance.
Gate 5 Benefits Evaluation: The focus here is ensuring the delivery of benefits and
value for money as set out in the initial business case.
The CABE Report 5.11 The Commission for Architecture and the Built Environment (CABE) was established
to promote high standards in the design of public buildings. It aims to help public bodies
towards improved performance as a client, so that public buildings are known for their design
quality. Creative design is an essential ingredient in delivering value for money; and through
the working life of a building, design excellence can make service delivery more efficient, and
enhance the working environment for all those that use public buildings.
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5.12. To ensure the public sector receives a high quality of design from public procurement
in PFI projects, OGC published ‘Improving the Standards of Design in the Procurement of
Public Buildings’ in conjunction with CABE in October 2002. The report highlighted the
importance of ensuring the public procurement process produced buildings that facilitated
the delivery of high quality services and which provided optimal value to the taxpayer. The
report set out 11 recommendations to ensure the implementation of good design. An
example of how some of the CABE recommendations are being applied in practice is the DfES
plans for exemplar school design, described in further detail in Box 8.1.
PFI and Local Authorities
5.13 It is important that sufficient support is available at the local authority level to enable
local authorities to procure PFI projects effectively, particularly where authorities are
engaging in “one-off” procurements. The Government has taken a number of specific
measures to support local authorities engaging in PFI.
4Ps 5.14 The Public Private Partnership Programme (4Ps) has been created to provide a
supporting role to local authorities involved in PFI procurement and plays a significant role
on the Project Review Group, which reviews the quality and value for money of local authority
PFI. 4Ps has also created procurement packs providing information on street-lighting and
leisure PFI schemes, as well as case studies and guidance notes on PFI projects, and is
working with the Government to increase standardisation of local government PFI contracts.
The role of the 5.15 IThe Government established the Project Review Group (PRG) as an interdepartmental
Project Review body to test the quality of local authority PFI projects prior to entering their procurement
Group stage, acting as final gatekeeper for the delivery of PFI credit funding to local authorities. No
PFI project can be submitted to the PRG before the relevant government department has
agreed that it meets policy objectives, is likely to provide value for money and is suitable for
a PFI approach.
5.16 Once departments have accepted that a scheme should be prioritised for
development, the PRG then reviews the business case to assess the extent to which the project
matches the 12 key criteria (shown in Box 5.2).
Box 5.2: Checking project deliverability - the role of the Project Review
Group
Key criteria for the PRG in assessing the viability of projects are:
© affordability;
* output specification;
© design quality;
° risk allocation;
° key terms and conditions;
© bankability;
© use of appropriate comparators;
° indicative timetable;
© project team;
° suitability of advisors;
* commitment of sponsors/users; and
© statutory process.
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5.17 By evaluating proposed local authority PFI schemes, the PRG provides:
© a review of the commercial deliverability of schemes before they go into
procurement, and therefore provide reassurance to local authorities that PFI
is the right value for money approach, or indicate whether alternative options
should be pursued; and
* — aprocedure to review the progress of local authority projects so that a pipeline
of deliverable deals is established and maintained, and so that lessons learnt
from preceding projects are used to inform the development of new projects.
The Role of Partnerships UK
5.18 Partnerships UK was established in June 2000 as a public private partnership,
incorporated as a private sector company, with 51 per cent of its shares owned by private
sector institutions with the remaining 49 per cent held by HM Treasury and Scottish
Ministers. It was created out of the Treasury Taskforce to ensure continued access to
procurement expertise for the public sector. Partnerships UK's Board consists of three
Executive Directors and six Non-Executive Directors, two of which are Treasury nominees.
Partnerships UK is limited to working for the public sector in the UK and overseas. To preserve
and assist in this mission of supporting the public sector, an Advisory Council consisting of
twenty members and chaired by Sir Andrew Turnbull, the Cabinet Secretary, meets twice a
year to review Partnerships UK’s activities.
Partnerships 5.19 Partnerships UK's primary objective is to be available to support all parts of the public
UK’s objectives sector, including local authorities and devolved administrations in implementing their PFI
and PPP programmes and projects. By creating Partnerships UK, the Government has put in
place a central resource of professionals, drawn from both private and public sector, with
procurement expertise relevant to PFI and other PPPs. Partnerships UK’s primary aim,
therefore, is to provide the public sector with an improved client capability. An example of
this working in practice is set out in Box 5.3.
Box 5.3: Aquatrine
Partnerships UK entered a Development Partnership Agreement with MOD Defence
Estates, in 2001, for the procurement of the Aquatrine project — a major PFI for the water
and waste water treatment facilities of MOD sites across Great Britain.
As co-sponsor of this procurement, Partnerships UK joined the project board and has
played a full and active role in assisting Defence Estates achieve not only improved value
for money from the PFI but also increased efficiency and reduced timescales for the
Procurement process itself.
Since joining the procurement, Partnerships UK has played a leading role in achieving:
* areduction of 15 months in procurement timescale; and
© acorresponding £6 million reduction in the cost of delivering the project.
The project is divided into three packages, the first of which — for sites in Wales and South
West England - was awarded to the Brey consortium in April 2003. The remaining
packages are due to be awarded in March 2004.
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Partnerships UK 5.20 In understanding Partnerships UK’s role, it is important to emphasise that it does not
provides PFI replace the need for the appointment of financial or legal advisers to assist the public sector,
procurement nor act in some way as the Government's “investment bank”. Most of its staff are procurement
expertise to the specialists, not City professionals. Also, as a private sector company, it does not determine
public sector nor can it enforce PFI or PPP policy, which remains a matter for the Government. The
responsibility for the implementation of individual PFI projects rests with procuring
authorities and for overall PFI policy with HM Treasury. Instead, Partnerships UK acts in
partnership with the public sector by providing an effective bridge between public and
private sectors, and provides access to expertise for the public sector .
5.21 Partnerships UK achieves its objectives in a number of different ways:
* advising public sector clients;
* creating procurement joint ventures with the public sector for specific
programmes, such as LIFT and Partnerships for Schools (see Chapter 8); and
* entering into development agreements with the public sector to jointly
procure PFI projects.
Partnerships 5.22 Because of Partnerships UK's active presence across the public sector in implementing
UK’s role as a_ projects, it can often act as a “bridge” between public and private sectors. It is called upon by
bridge procuring authorities to identify and seek to remove roadblocks to the successful and timely
implementation of particular projects, whether they arise from the public or private sectors.
Partnerships UK is also an important source of market intelligence in formulating PFI policy.
For this reason, it can be tasked to more formally act as such a “bridge” between public and
private sectors, as it was recently in implementing revisions to standardised contracts on
behalf of the Government. The Government believes that it is important for Partnerships UK
to retain and develop this role of a “bridge” between public and private sectors.
Standard Contracts
5.23 One of the key tools in the Government's approach to procurement of PFI projects has
been the development of standardised commercial contracts. In July 1999 the first edition of
Standardisation of PFI Contracts was published. In July 2002, the Government launched a
revised version of the standardised contracts. This revised guidance built on the experience
and best practice gained in the application of the earlier PFI standardised contracts across a
wide range of projects and reflected the results of a widespread consultation with both the
public and private sectors.
5.24 The three main objectives of the Government's guidance on standardised contracts
are:
© to reduce the period and costs of negotiation;
*® to promote a common understanding of the main risks encountered in a
standard PFI project; and
* to allow a consistency of approach and pricing across a range of similar
projects without detracting from their ability to cater for specific needs.
5.25 This generic guidance has then been used as the basis for sector specific guidance in
health, education, and defence.
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5.26 The revised standardised contract is now being used widely across PFI projects. It has
already helped to reduce the scope and time of negotiations. Partnerships UK operate a help
desk for the Government, which provides support to both the public and private sectors on
the implementation of standardised contracts.
PFI and the Private Sector
5.27 The successful delivery of the Government’ PFI investment programme requires an
effective partnership between the public and private sectors. It is central to this partnership
to ensure that the PFI procurement process runs smoothly, that there is sufficient capacity in
the public sector to act as an effective client and a matching capacity in the private sector to
deliver what is required of it and confidence on both sides that the partnership rests on a
sustainable base.
5.28 For the private sector, the drive to improve capacity in the public sector means:
© amore certain market in PFI, which runs without delay;
* smoother deal flow, and so the confidence that the market is sustainable; and
° reduced transaction costs on PFI, improving their ability to bid for projects,
and so improving competition and value for money for the public sector as
well.
Private sector 5.29 Private sector experience and views of the PFI process and the strength of the market
concerns remain of importance to the Government. HM Treasury conducted research into private
sector participants’ experience of PFI over 2002 in order to assess areas where private sector
concerns might be impacting on the effectiveness of the PFI programme. Opinion was
positive about PFI. In particular:
* all firms involved expressed pride and satisfaction in the facilities they have
provided to the public sector through PFI. All believed they had contributed to
an outcome which would not have been possible under conventional
procurement and that this represented good value for money for the public
sector;
© most were content that the risk sharing approach of Government set out in
standardised contracts was a reasonable allocation of risks. Most also
provided examples of where risks had materialised in practice, reducing their
returns due to increasing costs which they had borne, and demonstrating that
risk transfer has been effective; and
= most were content that the future flow of PFI projects was sustainable. All
contractors sampled were happy there was sufficient funding liquidity
available for projects, as were the funding sources surveyed.
5.30 Where the private sector raised concerns, these centred on:
* high bid costs, particularly after recent changes introduced by the Accounting
Standards Board in the accounting treatment of such costs and for some, the
length of time taken by some departments and authorities in procuring PFI
projects; and
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© some were concerned that the Government may pursue an approach to risk
transfer that was unsustainable, seeking to transfer too much risk to the
private sector. As outlined in Chapter 3, the Government's approach to risk
sharing in PFI is to seek to transfer only those risks that the private sector can
more effectively manage. It does not seek to maximise risk transfer, as this
would offer poor value for money.
Bid costs and 5.31 Undoubtedly, high bid costs and long procurement times can represent a concern for
procurement both the public and private sector, can impair delivery and value for money for the public
timescales sector and limit companies’ capacity to bid for projects. Several companies have found that
new technical guidance published by the Accounting Standards Board on how to account for
pre-contract costs increased the impact of up-front costs. The guidance required some
bidders to recognise as costs in the year incurred the expense associated with PFI bids, which
previously they had been able to capitalise, and has increased the sensitivity of some
companies to bid costs.
5.32 The Government recognises that bid costs and procurement timescales for PFI
transactions will always be somewhat longer than for conventional procurement. Unlike
other forms of procurement, PFI projects benefit from whole-life costing over 30 years,
involving both construction and service delivery, and a full competition for design with
extensive involvement of users in deciding upon the preferred solution. Bidders must invest
time and money in planning bids in some detail and persuading others to fund their
proposed scheme. The Government believes this process leads to a greater degree of up-front
due diligence by both public and private sectors and detailed analysis and negotiation of the
risk aspects of a project. The evidence in Chapter 4 suggests this greater effort at an early stage
of a project's development has significantly improved project outturns to the benefit of the
public sector.
5.33 The cost of bidding for PFI projects will always place some constraints on the private
sector in its ability to bid for large number of PFI projects. HM Treasury's research into PFI
companies suggests that the cost of bidding for PFI projects can be a consideration as
important as the funding of an investor's equity and subordinated debt investments. In
funding such costs, a key consideration for the private sector is its success rate in winning
bids. Irrespective of success, however, the aggregate level of bid costs expensed in a year does
limit the number of bids a company can undertake in that year, usually determined by the
overall financial capability of the contractor.
5.34 The Government does reimburse bid costs in certain very limited circumstances,
where it is deemed that the increased competitive tension created by assuring bidders that
costs will be covered provides value for money in the procurement, but the Government does
not believe that this is a potential general solution, for the following reasons:
* to the extent that high bid costs represent wasted or duplicated work, the
Government's aim should be to reduce these costs, rather than allow them to
persist by funding them;
* to reimburse the bid costs of losing bidders will in effect subsidise less
successful PFI companies or artificially discourage them from redeploying
resources to other PFI opportunities where this could be more successful; and
* it will reduce the competitiveness of bids by limiting the downside faced by
losing bidders. The Government wishes to maintain competitive tension
throughout a procurement.
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5.35 The Government's drive to improve public sector capacity is the best, most sustainable
solution to problems associated with bid costs and delays in procurement. To this end, the
Government's approach which is set out in more detail in Chapter 8 will be to:
* improve the enforcement of standardisation;
*¢ develop new procurement models and reinforce procurement expertise to the
public sector, to ensure all departments operate as best practice clients;
© improve the transparency of the future PFI programme to encourage private
sector investment; and
* continue to encourage new entrants into the PFI market, including firms
currently active outside the UK.
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PFI has the potential to bring improved value for money in public services with greater
quality and innovation, but the Government has always made clear that this should not be
achieved at the expense of staff terms and conditions. Throughout the 1980s and early
1990s, workers transferred from public to private sectors were extended only the limited
protection offered by the 1981 TUPE regulations. Over the past six years, the Government
has pursued a strategy for enhancing worker protections and ensuring their fair and
reasonable treatment in PFI projects, based on the following principles:
© being open with staff by providing greater transparency about workers’ rights
and through involving staff and their representatives in the contracting out process
and its outcome through mechanisms such as the Statement of Practice on Staff
‘Transfers in the Public Sector;
© protecting terms and conditions for both transferees and new joiners
to PFI workforces through the Retention of Employment model and soft services
testing in the NHS and the Best Value Code of Practice on workforce issues, which
applies to staff in Best Value local authority PFI projects;
© protecting staff pensions through the Fair Deal for Staff Pensions which
addressed one of the principal gaps in TUPE regulations covering public and
private transfers; and
© retaining flexibility in public service delivery, including through PFI, to
ensure efficient workforce management and encourage innovation in service
delivery. The first stage of the Review of Efficiency in Public Services will be
completed later this month. It has examined new ways of providing Departments,
their agencies and other parts of the public sector with incentives to exploit
efficiency savings, and so release more resources for front line delivery. The Review
will lay the basis for a continuing programme of work to improve efficiency, as part
of the Government’s ongoing commitment to improve the value for money and
quality of public services without a reduction in the level of terms and conditions
for the workforce.
COMMITMENT TO WORKFORCE PROTECTION
6.1 PFI has allowed for considerable innovation in workforce practices, but the value for
money that PFI can deliver should not be achieved at the expense of staff terms and
conditions. The Government has taken a range of steps to strengthen worker protection and
ensure the fair and reasonable treatment of those working under PFI contracts.
6.2 Prior to 1997, there were limited safeguards in place to protect the terms and
conditions of public sector workers transferred to the private sector as a result of PFI
contracts. Each project was treated independently and the attitude of private sector
employers bidding for contracts was a major input into the standard of staff treatment, which
resulted in practices varying widely from project to project and contract to contract with no
clear pattern across Departments or over time.
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63 The main form of protection then available for transferees was the Transfer of
Undertakings (Protection of Employment) Regulations 1981 (TUPE). In broad terms, TUPE
protects employees’ terms and conditions of employment when the business in which they
work is transferred from one employer to another. The TUPE Regulations were designed to
safeguard employees’ rights when compulsorily transferred between firms. TUPE:
© guarantees transferees “no less favourable” terms and conditions at the time
they transfer from one employer to another.
* applies to second-, third- and fourth-generation transfers as well as to the
initial shift from the public to private sectors.
¢ is augmented by a Cabinet Office Statement Of Practice, see Box 6.1, which
requires that transferees from the public to the private sector be given
“broadly comparable” occupational pension rights as well.
6.4 Public sector employers were guided by advice that there was some risk of legal
challenge if transferred staff suffered a material detriment to general terms and conditions as
a result of the transfer. This resulted in court cases to establish that TUPE applied, not only to
transfers within the public sector, but also to transfers from the public to the private sector. It
is therefore accepted today that the measure applies to the public sector workers
compulsorily transferred under PFI contracts.
6.5 However, contract terms relating to membership of occupational pension schemes
were not required to be novated when staff transferred. Frequently, staff were denied any
option to transfer their accrued service, and in some cases the pension scheme made
available by the new employer was materially inferior to the scheme from which the staff were
transferring. The treatment of pensions showed little consistency. In a few projects primary
legislation was used to give special protection to pension scheme membership for the
transferred workforce, far in excess of any protection enjoyed by other workforces in the
private sector, or any workforce remaining in the public sector. At the other extreme,
sometimes staff who had transferred from the public sector where they were members of a
good quality defined benefit pension scheme were given no pension plan at all by their new
employer.
Principles for 6.6 Since 1997 the Government has been, and continues to be, determined to extend the
extending protection of the terms and conditions for staff transferring to the private sector, to address
workforce uncertainty and anxiety caused to public sector staff in relation to a PFI, as well as the
protection potential disparity between the terms and conditions of new joiners and transferred staff.
6.7 Over the past six years, the Government has pursued a strategy based on the following
principles:
© being open with staff;
® protecting terms and conditions for both transferees and new joiners;
* extending protection to staff pensions; and
* retaining flexibility in the delivery of public services.
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6.8 In 1997, the Government made it a priority to review their position and set out a
common standard for treatment of workforces to which public sector employers would be
pledged, which would create a partnership between employers and trade unions. This was
intended to reassure public sector staff that, if transferred to the private sector, not only would
their legal rights be respected in all cases, but beyond that, they would be reassured that they
would always be treated according to a published standard of good employment practice with
a right of appeal before any transfer if they felt that this standard was not being met.
6.9 In 1998 the Cabinet Office published guidance on “Better Quality Services” which
reinforced the requirement for fair and reasonable treatment of staff, drew particular
attention to the importance of ensuring that the new employer provided access to a good
quality pension scheme, and which suggested that the availability of an agreement for staff to.
transfer past service into the new scheme should be a factor in evaluating bids. It was
recognised that this left uncertainty in a number of areas about how staff would actually be
treated in practice.
Treasury 6.10 Toimprove transparency and encourage greater consultation with staff during transfer,
Taskforce the Government published in 1998 Treasury Taskforce statement 4, which requires full and
guidance continuous communication where there are staff transfers, to ensure unions and staff are
fully engaged throughout the process. This document was welcomed by both the TUC and the
CBI.
Increased protection for staff pensions
The Fair Deal 6.11 To further enhance the protection of transferees’ pension rights in PFI, the
Government announced the Fair Deal for Staff Pensions in June 1999. The Fair Deal applied
to all projects directly controlled by Ministers - central Government departments and their
agencies — and it was set forward as good practice, which the Government expected other
public sector employers to follow. It covers all transferees from central Government
departments and agencies, including those transferred as part of PFI projects, and is
recommended for use by other parts of the public sector. In addition the Fair Deal applies to
all subsequent transfers. It states that:
¢ _ staff who transfer from the public sector should continue to have access to a
good quality occupational pension scheme, under which they can continue to
earn pension benefits for future service; and
* staff should be given options for the handling of the accrued benefits that they
have already earned.
6.12 A good quality occupational pension scheme is defined as one that is broadly
comparable to the public sector pension scheme. The new pension scheme does not have to
be identical to the scheme available before transfer, but must overall be materially at least as
good as it. The Fair Deal also requires, going forward, that all PFI bids include a bulk transfer
agreement, which details how the full value of transferees’ past service pension rights will be
credited.
6.13 For the first time the definition of “broad comparability” was published which
actuaries would be expected to apply, ensuring complete transparency to staff and unions.
The Fair Deal also:
*® required there to be a nominated minister for each project involving a
compulsory transfer of staff to the private sector;
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) pledged that in each case staff and trades unions would have the details of
how the pensions protection was to be delivered, explained openly well in
advance of the transfer; and
* required that no transfer would be conducted until there had been a
reasonable time for the details to be studied and for questions to be asked and
answered.
6.14 The Fair Deal sought to improve the transparency of the contracting-out process by
setting out the principles that the Government will apply in its role as a contracting authority.
These principles are:
° to treat staff fairly;
* to do so openly and transparently;
* to involve staff and their representatives fully in consultation about the
process and its results; and
*® to have clear accountability within the Government for the results.
6.15 In its 2000 document “Public Private Partnerships — The Government's Approach’, the
Government recognised the importance of protecting and valuing staff, setting out the
importance of transparency and consultation, and required:
* “full effective and continuous communication where such transfer could take
place in order that staff and recognised trade unions can be engaged
throughout the process”; and
¢ “transparency during and after the procurement process, with commercial
confidentiality only being accepted as justification for non disclosure where
this would cause real harm to the legitimate commercial or legal interests of
suppliers, contractors, the public sector client or any other party.”
Cabinet Office 6.16 Building on this the Government issued a Statement of Practice on Staff Transfers in
Statement of the Public Sector as a guarantee of staff terms and conditions in January 2001 (see Box 6.1).
Practice 200! This applies directly to PFI and PPPs in central government, as well as to other situations
involving staff transfers, such as outsourcing. It is also intended to apply to the rest of the
public sector, including local government. The Statement of Practice requires that the public
sector should follow TUPE regulations, and that if, as a matter of law, TUPE does not apply,
steps should be taken to ensure equivalent protection for workers’ terms and conditions.
6.17 These measures mean in practice that workers transferring from the public to the
private sector as a result of PFI will receive the same terms and conditions that they did before
their transfer, along with a comparable pension — extending Fair Deal beyond central
government.
New entrants 6.18 The Fair Deal and the extension of TUPE provided enhanced protection to the
pensions, pay and conditions of transferees, but it is important that PFI does not begin to
result in a diminution in the terms and conditions of new entrants and the creation of a two-
tier workforce in PFI projects, in which new joiners to PFI workforces receive worse terms and
conditions than do transferred staff. At the same time, the Government believes that
workforces in PFI projects must be allowed the flexibility necessary to deliver innovative and
high quality public services.
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Box 6.1: Cabinet Office Statement of Practice
The 2001 Cabinet Office Statement of Practice extended the themes of the Fair Deal
across the public sector. It sets out that:
* contracting-out exercises with the private sector and voluntary organisations and
transfers between different parts of the public sector will be conducted on the
basis that staff will transfer and TUPE should apply, unless there are genuinely
exceptional reasons not to do so;
* this includes second and subsequent round contracts that result in a new
contractor and where a function is brought back into a public sector organisation
where, in both cases, when the contract was first awarded staff transferred from
the public sector;
© in circumstances where TUPE does not apply in strict legal terms to certain types
of transfer between different parts of the public sector, the principles of TUPE
should be followed (where possible using legislation to effect the transfer) and the
staff involved should be treated no less favourably than had the Regulations
applied; and
© there should be appropriate arrangements to protect occupational pensions,
redundancy and severance terms of staff in all these types of transfer.
The Statement of Practice covers the following types of situation that may involve
transfers of staff:
° Public Private Partnerships (e.g. following Better Quality Service reviews). This
includes contracting-out; market testing; PFI; privatisation and other outsourcing
and contracting exercises;
© second and subsequent generation contracting where, when the contract was first
awarded, staff transferred from the public sector;
° reorganisations and transfers from one part of the public sector to another; and
° reorganisations and transfers within the civil service (where TUPE cannot apply
because there is no change in employer but TUPE principles should be followed).
NHS 6.19 The Government recognises that protection for new entrants to the workforce is also
important. In the NHS two measures were introduced to address this with the specific
workforce needs of the NHS in mind. These were the Retention of Employment model, and
value for money testing for soft services. They recognise that the NHS workforce constitutes
a distinctive “family”, and that allowing employees in PFI hospitals to maintain a link to this
family will help these projects operate successfully.
6.20 When a PFI hospital is planned, the department has the option to retain in-house soft
services should their transfer prove not to be essential to service delivery, and does not
enhance the value for money of the project. This reinforces the Government's commitment to
deliver quality public services, but not at the expense of the workforce.
Retention of 6.21 Retention of Employment applies to support staff in five areas: catering, portering,
Employment security, domestics and laundry. The model will be used in all major hospital PFIs in the
advanced stages of procurement. Three pilots of Retention of Employment have been
initiated, at Stoke Mandeville, Havering and Roehampton hospitals. The contract for the
Walsgrave hospital PFI, which includes Retention of Employment, has now been signed.
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6.22. Staff covered by Retention of Employment remain employed by the NHS, and benefit
from NHS terms and conditions and pension entitlements. Under the scope of the contract,
they are then seconded to the private sector joint venture. New joiners also become NHS
employees, seconded to the joint venture. Typically, this means that around 80 per cent of a
PFI hospital's staff will remain NHS employees. In order to ensure the effective management
of PFI hospitals, risk-bearing supervisory staff are not covered by Retention of Employment,
and are employed by the private sector.
Best Value Code 6.23 The Government's Best Value review in 2002 has led to the publication of the Best Value
of Practice Code of Practice, which came into practice in March this year, and is currently being rolled
out across England for all new contracts. The Best Value Code of Practice applies to new
joiners to workforces employed by contractors in areas covered by Best Value. These include
local authority projects in a wide variety of areas, such as transport, education, police and fire
services, waste management, and housing.
6.24 The Code of Practice protects both term and conditions of employment and pensions.
It requires that new joiners be offered terms and conditions that are “fair and reasonable” and
“overall, no less favourable” than those available to transferees. The deal is designed to protect
workers while maintaining the flexibility for employers to deliver quality public services. It
does not prevent firms in tight labour markets from offering packages superior to those
afforded by the public sector.
6.25 The terms and conditions should “offer reasonable pension arrangements’, defined as
either:
© membership of the local government scheme;
© membership of a “good-quality” employer pension scheme (if it is defined-
contribution, the employer must match employee contributions up to six per
cent); or
*¢ astakeholder pension (with the same matching requirement).
The government has since announced that this standard should also be written into new
TUPE regulations to apply to all compulsory transfers of staff in the economy. It will remain
open to any employer to set out a standard for protection of transferees which exceeds this
minimum standard: and the government remains committed to maintaining its own
standard of pension protection where TUPE applies.
6.26 The Government is monitoring the performance of these new measures to assess their
effectiveness in preventing the emergence of the two-tier issue, whilst maintaining flexibility
to support the delivery of high quality public services. Going forward, the Office of the Deputy
Prime Minister have recently welcomed a proposal from the LGA, the Employers’
Organisation for Local Government, the TUC and the CBI on an alternative dispute resolution
procedure as part of the Code of Practice, although the detail is yet to be finalised.
Next steps 6.27 The Government will continue to monitor the performance of the measures now in
place, to ensure that:
© PFI workforces are adequately protected;
¢ the measures are being effectively implemented in PFI projects;
¢ the measures do not undermine the flexibility or quality of delivery of public
services; and
¢ any disputes that may arise are quickly and equitably resolved.
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6.28 To ensure that the value of money delivered by PFI does not come at the expense of
employees’ terms and conditions, Departments have the option of not transferring soft
services staff in a PFI project, where they believe their transfer is not essential for achieving
the overall benefits of improved standards of service delivery specified by the procurer, and
where not transferring staff is consistent with delivering the Prime Minister's commitment to
flexibility in public service provision.
75
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The Government’s commitment to the PFI option rests on its ability to deliver value for
money in public investment that is not at the cost of the terms and conditions of employees.
The Government believes that procurement decisions must first be based on its approach
to where different procurement methods can be appropriate. This approach, set out in
Chapter 3, depends on the evidence about the characteristics of PFI projects which have
delivered good value for money. Secondly, decisions must be based on a rigorous assessment
of which of the available options represents the best value for money. The process must be
‘one such that there is no inherent bias in favour of one option over another.
Appraising value for money is therefore a central process in procurement. The
Government will:
© institute a new assessment of the potential value for money of
procurement options when overall investment decisions are made, to
ensure that PFI is used in those sectors where it is appropriate in accordance with
the Government's approach and understanding of the evidence;
© reform the Public Sector Comparator (PSC) to ensure an economically rigorous
appraisal of a project’s outline business case prior to its procurement, to allow an
alternative route to be chosen at this stage if it offers better value for money; and
* set up a final assessment of competitive interest in a project, and the
market’s capacity to deliver, at the procurement stage.
The Government will be consulting procurement practitioners, contractors and other
stakeholders on the detailed issues to be considered under each of these three consecutive
steps. These reforms will have no effect on projects already in procurement, and the
Government will continue to use PFI to invest in areas where the evidence shows
value for money has been strongest: a further £8.9 billion in schools, hospitals,
housing and defence projects by 2005 alone. Among other facilities, this is expected to
build 53 new hospitals and healthcare facilities and 323 new and refurbished schools.
To ensure that the value for money delivered by PFI does not come at the expense
of employees’ terms and conditions, Departments have the option of not
transferring soft services staff in a PFI project, where they believe that their
transfer is not essential for achieving the overall benefits of improved standards of service
delivery specified by the procurer, and where not transferring staff is consistent with the
Prime Mi ity in public service provision.
ister’s commitment to flexil
The evidence of PFI value for money delivery discussed in Chapter 4 suggests a need to
reassess the role of PFI in projects with small capital values and in the IT
sector. The Government will therefore:
* consult on an appropriate minimum level of capital expenditure below which
alternative means of procurement will be pursued; and
© replace PFI in IT with a range of procurement models which are better able to
deliver, on which it will consult.
Equally, the Government will investigate potential new areas where PFI
investment could offer value for money. Areas under consideration include the
management of the existing prisons estate, urban regeneration, waste management and
new applications in social housing. Initial indications on the basis of evidence from previous
similar sorts of projects would be followed with a pilot stage to provide more solid evidence
to judge performance in practice.
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OVERVIEW
7.1 The Government's approach to the choice of procurement option is determined by a
comprehensive testing of both the potential benefits of their application, their likely value for
money in particular projects, and the evidence of previous procurements. Chapter 3
explained this approach in more detail, and Chapter 4 described the evidence which backs it
up. This chapter:
¢ explains the emphasis the Government is putting on the rigour of an unbiased.
value for money test, and the reforms to it proposed;
*® confirms that the appraisal approach proposed taken together with the
evidence collected means that PFI is expected to continue to be an important
tool in key areas of the Government's investment programme;
© draws the policy conclusions from the evidence presented in Chapter 4 about
the need to reassess the role of PFI in individually procured small deals and
information technology (IT) projects; and
© explores the possibility that the approach laid out and the evidence about the
characteristics of successful areas for PFI could lead to pilots of new
applications in some limited areas.
PROCUREMENT APPRAISAL BASED ON VALUE FOR MONEY
7.2 The Government's aim in procurement decision-making is to secure the maximum
improvement in public services from investment through maintaining an unbiased stance on
which procurement route will offer value for money in each case. The value for money
appraisal process is therefore key to decision-making. The research set out in Chapter 4
showed that PFI works well for certain types of investment, but that conventional
procurement may be better value for money for others, and therefore that evidence of
delivery of value for money in practice for each sort of investment should be factored into
initial decisions. Box 7.1 below suggests the characteristics of successful PFI that would shape
this assessment. A robust appraisal of all the costs and benefits, including transaction costs,
involved in pursuing a procurement route is needed, and paragraphs 7.8 to 7.12 describe the
present PSC, and propose some reforms to it. Procurement authorities also need to have built
in budgetary and procedural flexibilities to ensure that the best value for money option can
be selected.
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Box 7.1: Characteristics of successful PFI
The benefits which PFI can offer, outlined in Chapter 3, and backed by the evidence of its
Performance in practice presented in Chapter 4, indicate that there is a case for
considering PFI where:
© there is major capital investment programme, requiring effective management of
risks associated with construction and delivery;
© the private sector has the expertise to deliver and there is good reason to think it
will offer value for money;
© the structure of the service is appropriate, allowing the public sector to define its
needs as service outputs that can be adequately contracted for in a way that
ensures effective, equitable and accountable delivery of public services into the
long term, and where risk allocation between public and private sectors can be
clearly made and enforced;
* the nature of the assets and services identified as part of the PFI scheme are
capable of being costed on a whole-of-life, long-term basis;
© the value of the project is sufficiently large to ensure that procurement costs are
not disproportionate;
* the technology and other aspects of the sector are stable, and not susceptible to
fast-paced change; and
© planning horizons are long-term, with assets intended to be used over long periods
into the future.
7.3 To date, PFI investment projects have been assessed for value for money at the project
level, using the methodology set out in the Green Book and drawing on the guidance on
constructing a PSC to compare the costs of a PFI procurement with a public sector option.
7.4 Taking the above analysis into account, the Government proposes to move to a three
stage procedure:
¢ instituting a new assessment of the potential value for money of procurement
options when overall investment decisions are being made in the context of
the Spending Review, to ensure PFI is only used when it is the best option and
has a good prospect of offering value for money;
¢ reforming the Public Sector Comparator (PSC) into an early, rigorous
economic appraisal of an individual project at the outline business case stage
prior to involving the private sector, to allow projects to proceed down
alternative procurement routes where they offer value for money; and
° setting up a final assessment of competitive interest in a project, and the
market's capacity to deliver, at the procurement stage.
7.5. Given that the proposals set out in this chapter are a broad framework, the
Government will be consulting on the details of how these stages will be implemented, and in
particular on the reformed PSC (see paragraphs 7.8 to 7.12 below). They will not affect or hold
up projects already in procurement.
The Investment Programme Assessment
7.6 The Government proposes, in reforming the value for money appraisal process, to
establish an investment programme assessment of the appropriate procurement option for
those areas where PFI may offer best value for money. In this first stage, Departments will
make both an assessment of the best choice of procurement route, and the appropriateness
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of PFI for these particular sectors. Departments will have to justify their assessment of the
appropriate procurement route in the Spending Review context, demonstrating how the
benefits of PFI outweigh the known costs, on the basis of:
the Government's approach to where PFI investment can be appropriately
used as laid out in Chapter 3, taking into account equity, efficiency and
accountability;
© the general characteristics apparent from the evidence so far which seem
necessary for PFI to be successfully applied as summarised in Box 7.1,
including the ability to specify requirements in the long term, and effectively
allocate risks; and
i) the available evidence on where PFI and conventional procurement have
proven successful at providing overall value for money in the past in similar
investment projects. This evidence will be made available in new guidance,
laying out what the objective benefits and costs of each procurement option
are, benchmarked against the relative success of other PFI and conventional
procurement programmes.
7.7 By making a value for money assessment of all procurement options at an early stage,
as investment programmes are being considered, this new initial stage will allow maximum
flexibility in the choice of procurement options in these areas. This early value for money
assessment will be used, for example, to evaluate some potential new areas where PFI may be
applicable, outlined below.
The Public Sector Comparator
7.8 The PSCisseenas a key tool for evaluating the value for money of PFI projects. The PSC
provides a quantitative analysis to support a qualitative judgement of the best procurement
option, taking into account the risks of each procurement approach as a means of informing
a wider value for money assessment. However, the PSC at present is focused only on the
narrower benefits and disbenefits of the future project options and is often done at a stage
where it is not possible to take sufficient account of the wider factors around pursuing a PFI
procurement programme, such as pre-contract costs.
7.9 Recent NAO reports' have highlighted a number of issues relating to the use of the PSC
as an effective appraisal tool, specifically noting that in some instances procuring authorities
had treated the PSC as a single pass/fail test to justify the choice of a PFI procurement route,
and potentially striven for spurious accuracy. The NAO has put considerable emphasis on the
fact that financial appraisal is just one part of an overall assessment of a project's value for
money, suggesting that public sector managers should in future ensure that value for money
decisions are not based on one-dimensional comparisons of single figures.
7.10 The Government believes that a rigorous economic assessment is important to ensure
that the right procurement option is chosen on the basis of value for money. The Government
agrees with the NAO, however, about the dangers of putting disproportionate emphasis on a
single figure comparison. It therefore believes that the PSC continues to have an important
role but as the second stage in a three stage process, and needs some reform in itself.
The Green Book 7.Il The first step in reforming investment appraisal has already been taken, with the
publication of the revised Green Book in January 2003. This set out a rigorous approach to
project appraisal for all investment undertaken by the public sector, whether procured
conventionally or through PFI. The approach was designed to encourage a more thorough,
‘For example, “Ministry of Defence Redevelopment of MOD Main Building’ April 2002.
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long-term and analytically robust approach to appraisal and investment evaluation.
Measures of particular relevance to PFI are:
© anew discount rate of 3.5 per cent, based solely on social time preference,
should be used to assess the present value of any investment proposal;
*® separate adjustments should now be applied to appraisal calculations for
optimism bias and tax;
© the recommendation that appraisals should be conducted with the rigour
appropriate to the scale of the expenditure involved, and the decision-making
stage that has been reached;
¢ that more weight should be placed on valuing the benefits of proposals, and that
more steps should be taken to ensure that benefits are realised as projects unfold;
¢ that greater consideration should be given to the wider impact of proposals
across society.
The reformed 7.12 The existing PSC will be reformed into a comprehensive project appraisal carried out
PSC at the outline business case stage, i.e. prior to procurement and the role of the private sector
with the quantitative aspect remaining part of a broader qualitative approach to the
assessment. At this stage the procurement team should be in a position to look in greater
detail at the specific characteristics of the project. It should be able to make an informed
judgment as to whether the original choice of PFI or conventional procurement, made on the
basis of the investment programme assessment, is confirmed. Should the specific
characteristics of the project suggest that value for money would best be achieved through
alternative procurement options, there should be sufficient flexibility within internal budgets
for investment to ensure that the best value for money options are taken forward. At this point
appraisers should also be preparing for the third stage, considering the project in the light of
the potential strength of market interest. Annex A describes the proposed criteria to be used
in the reformed PSC in more detail.
The Final Procurement Assessment
7.13 The final stage focuses, prior to going out to tender, on the potential market capacity
to deliver the project, and then on the quality of the competitive interest in it. This stage
should inform the way the project is taken to market, and the timing of that competition. In
the very few cases where it is not possible to achieve suitable competitive tension for a
project, prudent investment planning by Departments should ensure that it will still be
possible to procure the project conventionally. Given the previous assessments, the
probability of changing procurement routes at this stage should be very small.
Competition 7.14 Market feedback and quality of competition are both key factors in delivering the
expected benefits of PFI, and the final procurement test is designed to take them into
account. The Government also considers that incorporating assessment of the market and
competition in the appraisal of value for money will continue to encourage procuring
authorities to adopt a forward looking approach to maximise competitive pressure during the
tendering process. In extreme cases of market failure where the competitive process fails it is
also important for public sector managers to have available alternatives.
Next Steps in Implementing the New Appraisal Process
7.15 An early and comprehensive appraisal of both the financial and non-financial factors
of each procurement option should lead to a low probability of projects not proceeding as
expected by procuring authorities close to contract close. But investment programmes will
need to be actively managed to ensure sufficient budgetary flexibility to alter the
procurement route in the event that this proves necessary so that the best value for money
procurement option can always be pursued. The process is shown schematically in Box 7.2.
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82
Box 7.2: Three stages in VfM appraisal
Appraisal: Which is VfM Option?
PFI Option Conventional Option
Investment Programme Assessment:
Government’s approach
Key characteristics of
PFlis VM —/successful PFI i.e. Evidence
onisector PFI not appropriate / Good VIM
A Proposed PFI Project: Conventional Procurement
Outline Business Case Option
\ Project stage PSC
Assessment:
Costs/benefits
Optimism bias, tax,
PFLis VIM Risk adjusted PFI not VIM
(Start Final Procurement
Assessment)
Invitation to Bid Conventional Procurement
Option
I
Final Business case
Final Procurement Assessment:
Quality of competition
Market capacity
PFlis a Rig vim
Contract Award Conventional Procurement
Option
By applying this appraisal process throughout the competitive process, public
sector clients will safeguard value for money by:
* ensuring there is no inherent preference for a particular procurement option;
* making the quality of the competition an explicit part of evaluation;
* encouraging intelligent management of market capacity as part of procurement
and pre-tender dialogue;
© feeding information back into projects and programmes in earlier stages of
procurement. This will be supported going forward by the improved signed deals
list and the adviser database; and
* providing an early warning of when competitive tension may be reducing, and how
this can be remedied.
PFI procurement will only be pursued if these assessments show that it will
deliver value for money.
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7.16 HM Treasury will consult on the guidance for the new value for money appraisal
framework with Departments, particularly in terms of the timing and application of the tests to
ensure that they represent best practice and fit in with existing processes for allocating and
managing investment (including the next Spending Review). The development and
implementation of the new framework will not be allowed to disrupt programmes or individual
projects which are already underway. More detail on the scope and application of the new value
for money appraisal framework can be found in Annex A. The Annex covers in more detail:
*¢ the factors to be considered at each of the three stages of assessment:
investment test, project test and final procurement test; and
© the elements included in the economic analysis undertaken at each stage.
Value for Money in Soft Services
7.17 The Government's commitment to PFI is based on its ability to deliver value for money
in public investment, while protecting the terms and conditions of employees. Therefore — as
the Government has always made clear — value for money should not be achieved at the
expense of staff terms and conditions.
7.18 The Government believes that PFI procurement does not involve maximising the
transfer of employees to the private sector and that the value for money benefits it can offer,
outlined in Chapters 3 and 4, are not obtained at the expense of workers’ terms and
conditions.
7.19 To ensure that the value of money delivered by PFI does not come at the expense of
employees’ terms and conditions, Departments have the option of not transferring soft
services staff in a PFI project, where they believe their transfer is not essential for achieving
the overall benefits of improved standard of service delivery specified by the procurer, and
where not transferring staff is consistent with delivery the Prime Minister's commitment to
flexibility in public service provision.
7.20 Where staff transfers do occur, the Government will continue to protect the terms and
conditions of transferred staff.
FUTURE OF EXISTING PFI
Overview 7.21 Where PFI has demonstrated that it can deliver value for money based on a rigorous
and even-handed appraisal process, it should be used as one important tool to deliver the
Government's significant increases in public investment. The Government's analysis suggests
that PFI has been successful in delivering high quality facilities for public services, with the
benefit of on time and on budget delivery in certain key sectors of public investment. These
sectors ~ particularly health and education, but also defence and transport - display certain
common factors which mean that the continued use of PFI has a sound value for money
basis. Consequently, the Government plans to continue to use PFI to deliver part of its plans
for rapidly increasing investment in these sectors.
7.22. Consequently, the Government expects a significant number of major new capital
investment projects to continue to be procured using PFI in 2003 and 2004, as in Chart 7.1
below. Chart 7.1 shows the projected capital value of PFI projects by key Departments that are
currently in the procurement process and expected to reach financial close by 2004, alongside
the expected total capital value of signed and unsigned projects expected to close in 2003, and
the actual capital value of deals signed in 2002. Even with these increases, the speed of
conventional capital spending growth is projected to be such that PFI will remain broadly at
the same small but important proportion of total investment as it is today.
83
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Chart 7.1: Future projected capital value of projects signed or
expected to be signed by key departments by calendar year
3000
_ 2500
—E
2
g 2000
=
3 (1500
o
S 1000
500 I
0 T T Fi
Health Office of the Deputy Education Defence
Prime Minister
Department
HH 2002 [2003 fi 2004
Source: HM Treasuy.
7.23 The Department of Health are expecting to see both the number and capital value of
deals signed rise significantly over the next two to three years. The projected number of deals
for health is 55, amounting to a total capital value of £6.5 billion by the end of the 2005
calendar year. The projected capital value for Ministry of Defence PFI projects is also
expected to rise with an estimated 14 deals totalling £5.7 billion over the same period.
Chart 7.2: Public assets to be procured through future PFI projects,
2003-05
Projected Number of Projected Number of
PFI projects — Health PFI projects - Schools
New Build New
" Redevelopment
45
2
Mental
Heath
2
carnal Redevelopment/
Relocation Refurbishment
3 2718
Capital Value (£m)
[Bij Housing [Jj schoots [FF] Hospitals
Source: HM Treasury.
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7.24 This investment is expected to deliver significant new public infrastructure over the
next few years. As shown in Chart 7.2 above, the PFI investment programme in health projects
is expected to deliver 11 new hospitals or other health facilities, and redevelop or consolidate
to a central site 44 more. In education, £1.5 billion in planned investment will redevelop or
refurbish 278 schools and deliver 45 new schools. In housing, 28 PFI projects will deliver
capital investment estimated at over £800 million, even without the potential new
applications of PFI in social housing discussed at paragraph 7.53 below.
7.25 Furthermore, in secondary schools, the Building Schools for the Future initiative has
recently outlined an extensive investment programme that will involve the use of PFI and
conventional procurement. It is expected that the initiative will lead to sustained investment
in secondary schools worth £2.2 billion in 2005-06.
Investment 7.26 In some sectors, like schools and primary care trust facilities, although the capital
through new value of individual projects is small, meaning that transaction costs for PFI would be
methods disproportionately high, the Government is using new procurement methods to deliver
investment more effectively. These procurement vehicles (outlined in more detail in
paragraphs 8.26 to 8.40) will improve the speed and reduce the cost of PFI procurement,
improving value for money, and allow PFI to be used to provide:
© up to £1 billion of investment through the Local Improvement Finance Trust
(LIFT) initiative in new areas of health where it had previously been
impractial, such as primary care facilities; and
© over £1.5 billion worth of investment in schools over the next ten years, to
schools like those in the Church of England Schools estate (through the
Partnerships for Church of England Schools programme).
INDIVIDUALLY PROCURED LOW CAPITAL VALUE PROJECTS
Overview 7.27 Because the Government's commitment to the use of PFI rests only on its analysis of
where it may be applicable and the evidence of its delivery of value for money in practice, it
is necessary to examine continually particular aspects of the programme to determine
whether PFI is the appropriate procurement route. Where PFI procurement does not
represent the best value for money option, the Government is committed to pursuing
alternative options that offer better value overall. One area where the Government's analysis
of PFI suggests that a reassessment of the overall value for money of PFI is necessary is in
individually procured low capital value projects, due to disproportionately significant
procurement costs and times.
Analysis 7.28 The research set out in Chapter 4 demonstrated that PFI had performed well in some
important respects in projects with small capital values, achieving levels of on-time and on-
budget delivery and performance satisfaction in line with the results of PFI in major capital
projects and delivering the kinds of benefits that drive PFI’s value for money in large projects.
7.29 However, delivering these advantages involves considerable time and resources
invested by both public sector clients and private sector bidders alike. The evidence
presented in paragraphs 4.34 to 4.38 demonstrated that procurement costs and times in small
projects did not decrease in proportion to their size, but remained at roughly the same level
as for much larger projects. It outlined that:
* small projects face the same costs of using third-party finance, employing
legal and technical advisors, and conducting due diligence financial
modelling in the same as for much larger schemes. As a result, these costs are
relatively higher for small projects individually procured;
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) similarly, bidders in small PFI schemes must typically meet the costs of
technical, financial, design and legal advisors. These bidders’ costs also do not
necessarily fall in proportion to the size of the project, and so the
disproportionate costs reduce interest and competitive tension in small PFI
schemes; and
* public sector clients tend to develop their own specialised PFI procurement
skills far more when they are engaged in a range of projects on a sufficiently
large scale. Small, one-off PFI projects raise questions about whether the
public sector has the capacity and expertise to secure the best deal.
7.30 The threat that these potentially disproportionate transaction costs pose to a project's
value for money was not adequately reflected in the original PSC, which failed to capture
consistently the costs, and did not take into account the disbenefits associated with delayed
delivery of investment to the public services. There was therefore the potential that some
small projects would pursue PFI on the basis of a value for money assessment which did not
take into account the wider disbenefits in terms of transaction costs and extended
procurement times.
Measures 7.31 In recognition of these disproportionate costs at the lower end of the scale, the average
capital value of PFI schemes has risen in recent years, partly thanks to a trend towards
bundling small projects together (new initiatives in this area are discussed in Chapter 8). For
example, the average capital value of PFI schemes sponsored by Local Authorities has risen
steadily in recent years and stood at £37 million in 2002. Further action to improve general
procurement skills and drive through standardised contracts across the public sector,
detailed in Chapter 8 can also improve the value for money achieved in PFI. However, there
are strong grounds for a new approach which builds on the trend toward larger capital value
projects and helps ensure decisions between procurement options are always made on a
value for money basis by:
¢ reforming the process of PFI procurement to include consideration of the
transaction costs associated with PFI at an early stage in the process, and
identifying alternative procurement options where those costs mean a project
does not offer overall value for money, as outlined above; and
© making a general presumption against PFI being used for small schemes,
below a level on which the Government will consult (see paragraph 7.34
below).
Process 7.32 These reforms will be introduced in a way that maximises flexibility for the public
sector to manage the transition, ensuring that both allocations of PFI credits to Departments
and investment plans by Local Authorities are not disrupted, and that current projects can
continue to be delivered according to plan. Both reform of the PSC process and of the
minimum value for PFI projects in each sector will take place in the context of the Spending
Review. Specifically:
¢ HM Treasury will begin consultation with Departments and other
stakeholders on where robust, minimum values should be set in each case to
promote those projects where the public benefit is greatest; and
° on the basis of these discussions, new minimum values for PFI projects that
receive Government funding will be rolled-out in the context of the next
Spending Review.
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7.33 At present, the great majority of small PFI schemes are sponsored by local authorities
and funded through PFI credits allocated to central government Departments to pass on to
local authorities as part of the Spending Review process. Any change in minimum values
must respect the credit allocations to Departments made in the 2002 Spending Review and
avoid any disruption to both current public investment plans and projects which are already
in development.
7.34. While the appropriate minimum value of projects will vary from sector to sector,
experience to date suggests that these values are likely to be above £20 million. For schemes
below this level which do not benefit from initiatives which increase value for money by
aggregating projects and streamline the procurement process (such as NHS LIFT), a range of
other procurement routes are likely to be more appropriate.
7.35 The Government's policy is to use PFI only where it represents the best procurement
option and as shown above, this is unlikely to be the case for projects with a small capital
value. It is important then that local authorities have the flexibility to develop such projects
through a wide range of procurement routes, choosing the most appropriate option that
delivers the best value for the project. This flexibility is part of a wider commitment to devolve
responsibility to local councils to meet local priorities, increase local choice and improve
performance by removing unnecessary controls that stifle local innovation.
7.36 The Government is currently reviewing how it allocates support for capital expenditure
to local authorities. A consultation document outlining the options for future capital support
to Local Authorities will be issued shortly. This will focus on support for traditional (non-PFI)
capital expenditure. Give the desire to improve efficiency and flexibility and recent
developments in the PFI market, this review will provide the context for the Government to
consider the PFI credit regime and how best to support the principle that there should be no
bias in favour of particular procurement options and a genuine range of procurement choices
available to Local Authorities.
IT PROJECTS - IMPROVING PROCUREMENT
Overview 7.37 The Government's analysis of the characteristics of successful PFI projects, and the
evidence collected to examine how these characteristics related to the performance of PFI in
practice, suggested IT was also an area where an approach that took into account all the
potential benefits and disbenefits of PFI would mean a strong presumption against PFI.
Analysis 7.38 The review of PFI IT procurement in Chapter 4 suggested that, even though the
majority of projects had been delivered to the satisfaction of public sector users, there was
still room for significant improvement. There are significant differences between the IT sector
and other sectors whose characteristics are more aligned with those outlined above, in
Box 7.1 and so fit better with PFI. In particular:
¢ the fast pace of change in the sector makes it difficult for the public sector to
effectively define the outputs it requires in a long-term contract;
¢ the high level of integration of IT infrastructure into the other business
systems of the client makes it difficult to delineate clearly areas of
responsibility to the client and the contractor, and so make effective risk
transfer considerably more difficult; and
¢ the lack of a market for third party finance in IT PFI removes a powerful driver
ensuring appropriate and effective risk allocation in a project. This detracts
from PFI’s ability to secure value for money for the public sector.
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7.39 The findings of the research suggest that better performance can be achieved in the
procurement of IT if the public sector uses procurement models that better reflect the unique
needs of IT projects. The research showed that in those IT PFI projects going particularly well,
contracts had in fact been renegotiated to accommodate improved structures and better,
more flexible outputs — suggesting that in practice a move away from a PFI model brought
operational benefits by allowing for better risk allocation, better response to changing
business requirements, and more effective incentive structures.
Measures 7.40 This experience and the underlying differences between IT projects and other
infrastructure procurement suggest that it is appropriate to look again at the methods used to
procure IT. This will involve ensuring that the forms of contract and financing used contribute
to overall delivery success. As a result, the Government will now adopt a presumption against
the use of PFI in future IT projects.
7.41 PFI in the IT sector will be replaced by a set of procurement options appropriate for
different types of IT project. Over the course of summer 2003, OGC and HM Treasury will lead
a project to draw up guidance on a range of models for government IT partnering projects,
which will allow for joint consideration by customer and supplier of objectives plans, risk and
problem resolution. This guidance will replace existing IT PFI guidance but will draw
extensively on the innovations and improvements obtained as existing IT PFI contracts have
been renegotiated.
Process 7.42 The non-PFI procurement options to be set out in the guidance will:
° offer a level of flexibility appropriate to the specific type of IT project being
procured;
© ensure an optimal level of risk transfer to achieve value for money for the
public sector given the lack of available third-party finance;
¢ tackle specifically the handling of IT integration risk;
*¢ address the questions of when it is appropriate for the public sector to own IT
assets and what appropriate levels of contract termination costs; and
® take into account the capital and operational constraints of the private sector.
7.43 This reform should ensure that more IT suppliers are encouraged to bid for
Government business. By encouraging greater market access, the Government aims to create
the conditions for more competitive choice, thereby delivering good value for money in
procurement.
7.44 The consequence of these proposed changes will be to provide forms of contracting
and financing that can be used as part of the Government's overall agenda for tackling the
weaknesses in IT-embedded programmes and projects, and ensuring successful delivery
through the use of Best Practice.
7.45 The process of drawing up the new guidance will involve consultation with both the
public and private sectors to ensure the new models are robust and satisfactory. Once the
guidance is issued, it will be applied by OGC as part of its wider remit for improving the
effectiveness of government IT. HM Treasury will remain responsible for advising
Departments on any financial dimensions of IT projects.
Improving IT 7.46 The Government is aware that, as part of this reform of IT procurement to improve
procurement outcomes and the deliver of value for money, it is vital to improve the public sector's ability to
ability procure and manage complex IT projects. The OGC is currently working to address
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Departments’ IT delivery capabilities, for example through the creation of Centres of
Excellence in Programme and Project Management.
7.41 Action is in hand by OGC on a range of improvements. First, OGC is developing the
Programme and Project Management specialism to help Departments define and acquire the
skills they need for all projects, including IT. This will involve professional development of
existing staff and a recruitment drive to bring in additional talent. Secondly, Centres of
Excellence in Programme and Project Management have been set up in all Government
Departments with the aim of overseeing their project portfolios and ensuring that
appropriate approaches are being adopted. Senior Responsible Owners have been appointed
for all major projects and robust Business Cases are now required. Departments should not
adopt a big-bang approach to IT, but must seek a modular or incremental approach. The
Gateway process ensures that projects not adopting an appropriate approach in all these
areas are identified at an early stage.
7.48 OGC have issued revised guidance on evaluating suppliers’ proposals on the basis of
true life-cycle value for money, giving due weight to the deliverability and quality of proposals
as well as the price tendered. Guidance has been provided to Departments on how to
prioritise their projects to help ensure that they operate within their delivery capabilities. And
OGC has put in place arrangements to ensure that appropriate training in delivery skills is
available to all those involved in the process. All OGC guidance is now available through one
Successful Delivery Toolkit at its website www.oge.gov.uk.
CONSIDERING NEW APPLICATIONS FOR PFI - ANALYSIS
AND PILOTS
Overview 7.49 The Government is committed to securing value for money for all of its investment
programmes. The appraisal and decision-making process outlined in this chapter supports
that commitment by putting in place an assessment process focused on the real merits of
different procurement options, building in the ability to select alternative routes at each
stage. As part of this process, the Government intends to consider potential new areas for
piloting PFI investment whose characteristics suggest that they could benefit in value for
money terms, and so allow that investment to go further toward improving public services.
7.50 This section examines the characteristics of sectors which could benefit from PFI
investment, and outlines the process of investigation and consultation, value for money
testing and piloting the Government will pursue in these areas as part of the process of
continual assessment of the scope of the PFI programme laid out above, specifically
providing a basis for assessing an investment programme test in these areas in the context of
the next Spending Review.
Regeneration 7.51 The Deputy Prime Minister's Sustainable Communities Plan, published in February
2003, sets out an action programme for building successful, thriving and inclusive
communities, including through substantial development in four growth areas in the South-
East and East, and renewal of areas of housing market weakness in the Midlands and North.
There is a case for looking at the scope for PFI, and other public-private partnership
approaches to contribute to this programme. PFI could have a part to play, for example:
¢ in the procurement of major capital assets, where the risks attached to
conventional procurement, and hence the potential benefits of PFI, are great;
and
© particularly where the nature of this investment makes it possible to draw
clear lines in the allocation of risk, giving a potential private sector contractor
responsibility for the design, construction and maintenance of the assets.
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Waste 7.52 Waste and recycling are areas of high priority for Government investment whose
characteristics mean that PFI investment could offer significant value for money gains.
Specifically:
© waste reduction is a strongly outcome-orientated policy initiative, with scope
for innovation as to how those goals will be achieved. For example, there is a
statutory requirement to achieve a 33 per cent recycling target by 2015, driven
by the landfill tax — set to more than double to £35 per tonne in the same
period. This means that the public sector can clearly define outputs, and make
use of private sector innovation and expertise to deliver them;
© this is a high turnover, low margin sector with the potential to harness large
economies of scale. The waste sector therefore involves the procurement of
very significant capital assets, potentially increasing the benefits of PFI and
the risks of conventional procurement. Private sector estimates of the
investment required to deliver on policy goals run to £8 billion by 2008-10.
Social housing 7.53 Delivery of the Government's objectives for housing are dependent on significant
programmes of capital investment. The Government is turning round a £19 billion backlog in
repairs and maintenance in the social housing sector and has set a target to make all this
housing decent by 2010. PFI is already contributing to delivery of that objective, but its role
could also be expanded to assist with the major programme of affordable house building for
social housing tenants and keyworkers, as one possible element in a range of public-private
partnership approaches to the procurement and ongoing management of different kinds of
affordable housing stock. Affordable housing provision could benefit from PFI investment
because:
* itinvolves the provision of capital assets where effective project management
incentivised by appropriate risk-sharing would bring significant benefits; and
° because of their long life, these assets could benefit from design, construction
and costing made on a whole of life basis by private sector parties incentivised
to ensure best value.
Prisons 7.54 The prisons estate could potentially benefit from further PFI involvement in its
refurbishment, management and maintenance. New investment in the prisons sector already
involves an extensive and successful programme of new-built PFI prisons, and this suggests
that the management of the existing prisons estate could benefit from investment through
PFI. Involving PFI in the prisons estate could bring benefits because:
¢ the prisons estate sector is characterised by large, depreciating assets, with the
expectation of an extensive life into the future. Consequently, it could benefit
from PFI's potential to assess and make repairs with the long-term life of the
asset in mind because of a long-term contract structure; and
¢ the structure of services to the prisons estate is suitable for PFI, allowing the
public sector to specify quality standards for the facilities it needs, and
effectively enforce performance against those standards.
Process of Assessment
7.55 Before any major use of PFI in new areas like those outlined above, the Government is
committed to ensuring:
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© that the involvement of PFI in delivering investment is appropriate on the
basis of the Government's principles of efficiency, equity and accountability;
* — arigorous assessment of the applicability and value for money offered by PFI
in the sector, including an assessment of its impact on employees, in
accordance with the reformed decision-making process outlined in
paragraphs [7.x to 7.y] above; and
¢ — apilot stage, which could present demonstrable evidence that PFI in this area
is potentially capable of delivering its benefits in practice.
7.56 In preparation for the Spending Review, HM Treasury in consultation with
Departments will be collecting evidence of PFI's applicability in the sectors outlined above,
and considering next steps as part of the Spending Review process. This preliminary
assessment will involve:
* consultation with frontline public servants on what benefits and difficulties
could be involved with the use of PFI to procure new investment in a sector;
°¢ examining NAO, Audit Commission and other bodies’ evidence on
procurement in these sectors; and
* conducting research along with and through Partnerships UK on both the
appropriateness of the sector and, in areas where it is likely they will add
value, the potential to put in place procurement vehicles to deliver
investment.
7.57 If this preliminary value for money assessment suggests that PFI indeed offers
significant benefits as a procurement route for capital investment in these sectors, then a
pilot programme will be put in place to collect and assess the delivery of that potential in
practice.
FUTURE AGENDA
7.58 Acrucial part of this process of value for money assessment, separate from but feeding
into the reformed process for determining where PFI can and should be used, is an open and
continuing evaluation of PFI. This process will involve further research into aspects of PFI
which cut across individual areas of the public sector, building on the research reported in
Chapter 4, and a commitment to transparency in that evaluation and in the progress of the
PFI programme.
Ongoing 7.59 The research reported in this document into horizontal aspects of PFI has been a key
monitoring of PFI input into the refinement of the PFI programme outlined in this and succeeding chapters.
The Government intends to continue with this process.
7.60 In particular, the future agenda of research in this area is intended to focus on the
operational performance of PFI projects. Chapter 4 included limited data on this operational
performance. The Government intends that the preliminary opinion data produced by this
research to be the starting point for a thorough, objective data set on the operational
performance of PFI projects. Future research into this project sample and others will focus,
among other factors, on:
¢ the impact of performance regimes and payments deductions on private
sector responses;
¢ the ability of the public sector to manage the flexibility of PFI contracts (see
paragraphs 8.45 and 8.47);
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¢ the impact of private sector asset management on the workload of frontline
public sector staff like teachers; and
* the assessment of factors leading to the small number of reports of
unsatisfactory performance in PFI projects.
Transparency 7.61 At the same time as conducting this further research on cross-cutting aspects of PFI,
the Government seeks, where possible, to increase the availability of information concerning
PFI and the PFI process. Since 1997, it has increased the information disclosed in the
Financial Statement and Budget Report to include:
* — arecord of future payments contracted for by each PFI scheme; and
° the capital value of contracts signed to date and in procurement.
7.62 The Government believes it is important to increase the data available concerning the
PFI process. With the increasing number of projects being completed and becoming
operational, it is now possible to contemplate seeking to publish further information on their
performance on a regular basis. This will not only lead to better management of programmes
and projects in the future, but also increases the accountability and openness of the
programme.
7.63 The Government also recognises that to help the private sector to plan its investments
in PFI it would be useful to publish, on a more comprehensive basis, what the short and
medium term plans are for future projects to be delivered under the PFI process.
7.64 Consequently, the Government plans to publish on an annual basis a comprehensive
statement concerning the progress of the PFI programme to include:
° arecord of transactions committed to in the previous year;
* a statement of future transactions, indicating the different stage of
development;
* arecord of projects that have been completed in the year in question and their
performance against expectations; and
© astatement as to progress made on standardisation of contracts.
7.65 HM Treasury will consult over the next six months with private and public sectors as to
what further information it would be possible to collate and publish on the following
subjects:
¢ the operational performance of PFI projects;
¢ developments in the cost of financing PFI projects; and
® returns on equity actually achieved by the private sector.
7.66 The more detailed research behind the conclusions set out in Chapter 4 will also be
published via the internet shortly.
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Determining and applying where PFI offers value for money is only part of the process in
the delivery of quality public services. It is important that the procurement process is
managed efficiently, intelligently and in a timely manner in order to maximise the benefits
of PFI, and to secure value for money from other forms of procurement too.
The evidence shows there is still room to improve delivery of investment in public services
through PFI, as well as through conventional procurement, by reducing the timescales over
which investment is delivered and looking at ways of further reducing procurement costs,
so that value for money is not compromised. The Government will be taking action in both
areas.
Introducing measures that help the public sector become a better client, the Government
will:
* continue to prioritise improving the general skills of the public sector
to deliver value for money in Government investment;
* rigorously enforce contract standardisation across the public sector to
reduce bid costs and ensure a consistent approach to risk sharing is maintained
throughout the public sector;
* enhance the role of the Project Review Group in monitoring PFI
procurement by local authorities; and
* increase the level of support provided through Partnerships UK, in
developing and supporting standardisation and enhancing procurement skills.
Ensuring the benefits achieved by co-ordinating activity as a client, the Government will:
© set up a system for the accreditation of public sector advisers and
introduce an information resource accessible to all public authorities
to make sure that external advisers appointed by the public sector are of the
highest quality, and provide services to Government in a manner which recognises
its status as a single significant client;
* create vehicles to coordinate procurement in particular areas and put
in place procurement support so that best practice is shared across the public
sector, the public sector can control the flow of projects to market to maximise
competition, and procurement expertiss injected into PFI investment projects
undertaken at all levels; and
© promote the sharing of best practice and better harnessing of
institutional memory across the public sector.
As part of the ongoing agenda of improving delivery the Government will also be evaluating
public sector skills in bid evaluation and flexibility, to ascertain whether, where and how
further support can be provided.
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OVERVIEW
8.1 Having assessed what procurement option offers the best value for money for the public
sector in a particular case, and put in place a programme of PFI or conventional investment,
the Government must ensure that the benefits of that investment are delivered as quickly and
efficiently as possible without compromising the achievement of value for money gains.
8.2 The Government believes, and the analysis of PFI procurement reported in Chapter 4
demonstrates, that while investment is delivering significant benefits in practice, there is still
aneed to concentrate efforts in certain areas to secure maximum value for money for all types
of procurement. In particular, the analysis suggests that there are two areas where further
measures could increase overall value for money:
© procurement timescales. Putting in place the skills and processes necessary
to reduce them will improve the swift delivery of the benefits of investment to
public service users and reduce the costs of delay and long lead times; and
*® procurement costs. The Government is committed to improving the value for
money of all types of procurement by reducing transaction costs.
8.3 Following on from this analysis, there are a number of measures the Government can
and has put in place to improve delivery and value for money in PFI particularly, such as the
standardisation of contracts, making available procurement expertise through the Office of
Goverment Commerce (OGC) and Partnerships UK and ensuring consistent project quality
through the Project Review Group. Chapter 5 has already outlined the significant steps taken
in this area, but the evidence and analysis suggests that more action can be taken on two
fronts.
8.4 First, the Government needs to put in place policy initiatives and measures designed to
make the public sector a better client in procurement across the board, and in PFI in
particular. Measures outlined below are that the Government will:
*¢ continue to prioritise improving the general procurement skills of the public
sector to deliver value for money in investment;
4 rigorously enforce the standardisation of PFI contracts across the public
sector to reduce bid costs and ensure a consistent approach to risk sharing is
maintained throughout the public sector;
¢ enhance the role of the Project Review Group in monitoring PFI
procurement by local authorities; and
¢ increase the level of support provided through Parternships UK, in
developing and supporting standardisation and enhancing procurement
skills.
8.5 Second, there have been difficulties in the past in acting effectively as a client in a co-
ordinated way, sharing experience and best practice and extracting the benefits that flow
from acting as a single client to the private sector, while maintaining local autonomy and
accountability. In this regard, the Government will:
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¢ put in place an information resource accessible to all public authorities
providing accreditation of public sector advisers to ensure the public sector
appoints experienced and qualified advisers who have performed well on
other procurements;
* create vehicles to co-ordinate procurement and provide expert support so
that best practice is shared across the public sector, the public sector can
control the flow of projects to market to maximise competition, the
economies of scale and other benefits that can come from bundling projects
and procurement expertise is injected into PFI investment projects
undertaken at all levels; and
* promote the sharing of best practice and better harnessing of institutional
memory across the public sector.
8.6 The improvement of delivery, procurement and other public sector skills is a continuing
priority of the Government, and so this chapter outlines further areas of research on the
Government's agenda to establish where improvements can be made in PFI. In particular, this
future agenda will examine:
* how bid evaluation is carried out in practice in the public sector; and
‘Ss how the flexibility built into PFI contracts is delivering value for money in
practice.
BACKGROUND
8.7 As set out in Chapter 5, the Government recognises that procurement skills are an
important factor in securing value for money in public procurement. Better procurement
skills lead to lower transaction costs, better value for money in projects procured, and faster
delivery of investment to public services. In PFI in particular, improved procurement skills:
¢ enable the public sector to maximise the benefits available in the
procurement process by effectively conducting the options appraisal
necessary both to determine whether the PFI route is value for money, and to
secure best value from PFI bidders taking into account the whole-of-life
benefits and the quality of assets and services that different PFI bids may offer;
¢ improve value for money, by reducing delays and lowering procurement
costs for the public sector and actively managing the specialist advisers, such
as technical, financial and legal advisors necessary for PFI;
¢ secure value for money from contract negotiations, achieving the
Government’s aims in risk sharing, and ensuring a smooth and timely
procurement process; and
¢ should create an environment that encourages the private sector to bid for
PFI projects, improving competition and delivering a stronger PFI market.
8.8 In order to ensure that these benefits are secured, the Government believes it is
important to address past difficulties in providing effective procurement expertise to all
procurement projects. In particular the Government is determined to ensure:
© that procurement skills in the public sector are highly valued, and that where
they have been built up they are maintained and utilised;
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© that procurement expertise is delivered to the frontline to help procuring
authorities secure the best deal for their money; and
¢ that where best practice in procurement is identified, it is effectively spread
across the public sector, with the Government acting in a coordinated fashion
securing the benefits that flow from that spread.
8.9 The remainder of this chapter details measures the Government will take in the future
to address these issues. These measures will help spread the necessary expertise and provide
expert support to make accurate value for money judgments and ensure a smoothly running
PFI process. They will enable investment to remain locally controlled and locally accountable,
while helping authorities improve the value for money they obtain in PFI projects.
NEXT STEPS IN IMPROVING THE PUBLIC SECTOR AS A
CLIENT
Upgrading Procurement Skills
8.10 It remains an overall Government priority to improve general procurement skills across
the public sector. A lasting step-change in the quality of public services in the UK can only be
achieved if Government and the public sector have the skill sets necessary to ensure that
public investment projects deliver value for money improvements in frontline public service
facilities. Addressing this need to upgrade procurement skills is a part of the OGC's ‘Successful
Delivery Skills’ programme, a framework of assessment against an agreed benchmark and
training in public sector delivery skills.
8.11 The OGC’s latest figures from its Gateway process across the public sector's
procurement programme, up to April 2003, indicate a number of systemic weaknesses. These
included a weakness in identifying the adequate skills and business resources for investment
projects. The Successful Delivery Skills programme aims to address this by providing a
benchmark level for each of the common programme and project management roles against
which the potential project team members can be assessed before the start of the project.
This drive to improve the procurement skills of the public sector can, in the context of PFI,
ensure that the right value for money options are identified, and that the process is effectively
managed to ensure smooth and cost-effective delivery investment in public services.
8.12 OGC has supported Centres of Excellence in departments that bring together the
essential functions needed to support the successful delivery of programmes and projects,
the aim of which is to ensure there is:
* coherent upward reporting to the management board on its key programmes
and projects to support effective decision making;
© timely sharing of information and lessons learned through outward
relationships with departments and beyond; and
* inward support to help delivery programmes and projects with the right
expertise when they need it.
8.13 Further improvements in this area need to focus on both the quality of public sector
procurement skills and on the way in which they are utilised. Public sector managers need to:
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© beskilled enough to assess procurement options over the long term;
° effectively identify the value for money option, not simply opt for the least-
cost option, including taking full account of the quality of design in bids;
© negotiate effectively with the private sector;
* apply skills with sufficient confidence to ensure that appraisal is a real test of
procurement, and not an exercise in fulfilling set criteria without regard to a
wider view of which option is in the public interest; and
© carry out the evaluation and management of investment delivery in a way that
ensures that the public sector is accountable for both the public money which
it spends and the public services which it provides.
A key challenge for managers is understanding the contribution high quality design can
make to raising the standards of service in line with public expectations, and to greater cost
effectiveness in service delivery and asset maintenance over time. Box 8.1 explains the
Goverment's approach.
Box 8.1 Design and PFI - the CABE report
Good design in public buildings is a priority of the Government, and evaluation of bids in
PFI should place the proper weight on the design quality of options presented. Procuring
authorities need to extract the benefits in design and whole life costing which PFI
potentially offers by making sure they select bids on an a comprehensive assessment of
their quality, including the merits of their design.
The Commission for Architecture and the Built Environment ‘CABE’ was established to
promote high standards in the design of public buildings. It aims to help public bodies
towards improved performance as a client, so that public buildings are known for their
design quality. Sound, creative design is an essential ingredient in delivering value for
money; and through the working life of a building, design excellence can make service
delivery more efficient, and enhance the working environment for all those that use public
buildings.
To ensure the public sector receives a high quality of design from public procurement in
PFI projects, the OGC published ‘Improving the Standards of Design in the Procurement
of Public Buildings’ in conjunction with CABE in October 2002. The report highlighted the
importance of ensuring the public procurement process produced buildings that facilitated
the delivery of high quality services and which provided optimal value to the tax payer. The
report set out I recommendations to ensure the implementation of good design in PFI.
An example of how some of the CABE recommendations are being applied in practice is
the DfES plans for exemplar school design, described in further detail in paragraph 8.40.
Recent evidence from the NAO indicates that the standard of design in PFI is highly rated.
Its survey of departments and project managers reported three quarters of both
Departments and projects teams rated the design quality of their PFI projects as good or
very good, and none as less than adequate. To date, PFI buildings have been twice
nominated for the Prime Minister’s award: the Norfolk and Norwich University Hospital
and the Cumberland Infirmary.
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Standardisation of Contracts
8.14 As outlined in Chapter 5, the process of standardising PFI contracts helps spread best
practice, improving PFI procurements across the public sector, and significantly reduces the
length and cost of PFI procurement. These standard terms maintain the individual flexibility
of a particular procurement to set its needs and requirements, but provide a standard form
for those aspects of PFI common to all its procurements. Further action to drive through
these advantages, and ensure they are enjoyed across the public sector, will improve the value
for money of PFI projects being procured across the board.
8.15 The Government accepts that it is important, if all parties are to gain from the effective
implementation of the guidance on the standardisation of PFI contracts, that there is not
significant variability from transaction to transaction in the application of the standardised
PFI contract. It is also important that a more regular assessment and consultation with
private and public sectors as to how the application of the standardised PFI contract is
undertaken. In future, therefore, the Government's approach to developing and
implementing the standardised PFI contract will be as follows:
© there will be a regular dialogue with the private and public sectors over how
successfully the standardised PFI contract is being applied;
* any future change to the standardised PFI contract will be incremental, rather
than a wholesale review, and will be on the basis of specific issues raised by
public or private sectors or resulting from new legislation being enacted
which impinges on the standardised PFI contract; and
¢ the Government will act to ensure more rigorous enforcement of the
standardised PFI contract across both public and private sectors with a more
robust line to be taken by the Project Review Group, Gateways and by HM
Treasury.
8.16 To help with this process, HM Treasury has agreed with Partnerships UK that it will
increase the resources it will make available to both public and private sectors to support the
adoption of the standardised PFI contract across the programme. In particular, Partnerships
UK will:
* provide greater resources through its Help Desk to public and private sectors
in implementing the standardised PFI contract; and
© engage with private sector and public sector authorities on a regular basis to
assess progress in implementing the standardised PFI contract, reporting
quarterly to HM Treasury.
8.17 HM Treasury will periodically review the application of the standardised PFI contract,
taking account of Partnerships UK’s recommendations and any other representations which
the private and public sector may wish to make. These reviews will be focused primarily on
the implementation of the standardised PFI contract across the public sector and address
new issues and concerns which may arise which are not adequately addressed by the current
standardised PFI contract. The Government will, however, seek to avoid any wholesale review
of the standardised PFI contract or shift the current risk sharing balance of the standardised
PFI contract, unless there are strong arguments for doing so in light of the findings of any
review.
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Enhancing the Project Review Group
8.18 As the gatekeeper to PFI credits, the PRG has an important role to play in identifying
obstacles to successful delivery early on and taking action to ensure that only high-quality
deals proceed to tender. The PRG is developing a number of innovations to deliver this role
more effectively.
Enforcing 8.19 The PRG plays an important role in making sure that proper judgment and discretion
standardised are employed in the PFI procurement process, and that procuring local authorities have had
contracts access to and implemented all the necessary support. As part of this, ensuring compliance
with the standardised PFI contract is crucial to avoid poor commercial deals and higher
transaction costs for local authorities. For this reason the PRG already assesses compliance
with the standardised PFI contract at an early stage and will take an increasingly robust line
against non-compliant projects in the future, including the possibility of withholding credits.
8.20 Often, the PRG only has the opportunity to judge compliance with the standardised PFI
contract if projects experience difficulties and revert to the committee for additional
resources. In order to better promote compliance with standardised terms, the PRG is
currently developing new mechanisms to apply a specialist evaluation of contract
compliance:
° prior to, and as a condition of selection of preferred bidder, this would identify
all derogations from the standardised PFI contract and any sector specific
guidance, and ensure that adequate commitment letters have been obtained
from bidders, subcontractors and lenders; and
¢ shortly before financial close, when a PFI project contract is signed, to identify
and rectify late deviation from the standardised PFI contract.
Monitoring 8.21 It is important that sponsoring departments are aware of procurement difficulties at an
procurement early stage, so that the proper support can be provided to local authorities to help them
secure value for money. The PRG has conducted a review of how departments monitor the
development of projects once they have been awarded PFI credits. Practice varies widely
between departments and the PRG will be developing a clear framework to spread best
practice across the public sector.
CO-ORDINATING THE PUBLIC SECTOR CLIENT
Accreditation of Public Sector Advisers
The role and 8.22 As well as increasing procurement skills within the public sector, the Government
quality of advice believes that it is important that public sector managers are well advised, especially when
undertaking complex procurement projects such as PFI. In the past, the difficulties which the
public sector faces in acting like a single client, sharing experience and expertise and
presenting a single face to the public sector, have hampered the public sector's ability to
secure and make use of the best advice in a PFI project. Poor advice contributes to slowing the
procurement process, can inflate procurement costs, and will impair the ability of the public
sector to identify value for money in options appraisal and negotiation. In particular, there is
a potential difficulty in a fragmented approach to securing advice because:
© the public sector cannot negotiate the best deal if it does not have the capacity
to benchmark price and quality of advisors; and
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© — where the retention of advisers is undertaken in a fragmented ‘one-off’
fashion by the public sector, there is little potential to reward good advice with
further work, and so ensure that advisors are incentivised to use their best
people to provide support to a public authority.
8.23 Itis also important that private sector advisers fully support the Government's approach
to standardisation of contracts and appraisal including public sector comparators (see
paragraphs) and that the appointment of such advisers takes full account of potential
conflicts of interest.
Asingle 8.24 To assist in meeting these objectives, the Government will seek to put in place over the
information next 12 months a single information resource, covering accredited advisers who have
resource on demonstrated their expertise and performance in PFI projects in fields such as law,
accredited commercial structuring or finance. This resource will be developed over time, reflecting the
advisers experiences of departments and public sector managers. It will provide recognition for the
contribution of high-quality advisers, and reduce uncertainty over quality on the part of the
public sector. It is crucial to its successful implementation that this single point of
information and experience in hiring and managing professional advisers reflect the
qualitative judgment of public sector clients on the standard of the advice they have received,
rather than representing simply a list of potential advisers in different areas of expertise. By
implementing this single information resource and its use by procuring authorities, the
Government is therefore able to:
* ensure that the public sector is able to act as the single, important client for
advice service in PFI that it is;
© benchmark the price and quality of advisers, based on evidence of their past
expertise and performance, to help authorities secure value for money from
their advisers; and
© provide positive incentives for advisers to ensure that they give the best advice
to Government, utilising their most skilled personnel and full resources, as the
accreditation system will provide an effective means for the public sector to
reward excellence.
8.25 The Government will also explore the greater use of framework agreements for advisers
whereby they can be engaged over more than a single project to provider greater consistency
across the public sector's procurement programme and possibly lower the costs of such
services.
CO-ORDINATING AND SUPPORTING PROCUREMENT
Overview 8.26 To improve both the quality of the public sector client, and its co-ordination across a
sector, the Government is introducing a range of new procurement models that can increase
the involvement of PFI experts in some clearly defined areas of the public sector's
procurement process, from the earliest stages through to the operational phase of projects,
where there is benefit in bundling projects together and ensuring that the timing of projects
maximises market interest. These models are designed to bring all the necessary expertise
and experience to locally procured PFI projects, providing procuring authorities with the
support they need to obtain value for money, while maintaining local control and local
accountability in the delivery of public services and public service investment. They are
therefore likely to be most applicable where small projects can be grouped together, and there
is no obvious centralised procuring authority.
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8.27 To obtain the full value for money benefits of PFI procurement, public services need to
be able to call upon experience and expertise in managing the PFI process and making value
for money appraisals. Making these specialist skills available to the local providers of public
services, who are best placed to determine what investment is actually needed but not
necessarily procurement specialists, is an ongoing priority which these new methods will
help to deliver.
8.28 These new models of PFI delivery will help to provide that procurement expertise,
supporting the local public sector in its own assessment and delivery of local public service
investment needs. Responsibility for and control of the planning and delivery of local public
services and local investment remains with the local manager, who will have improving
access to the support and expertise needed to get the most out of that investment.
8.29 These models involve the establishment of public sector procurement bodies
specialising in structuring and delivery of PFI projects, which will work with local public
sector managers in certain suitable areas to procure such projects, to increase the quality of
specifications and reduce delays in the process. These procurement vehicles can then
support local procuring authorities in particular markets.
8.30 By increasing the public sector's ability to procure quickly robust and effective PFI
projects, these supporting vehicles will also allow the introduction of PFI into new areas such
as those proposed for further consideration in Chapter 7, as well as offer a way to increase the
number of PFI projects in existing areas. It should also provide the private sector with the
confidence to invest in the additional capacity necessary to facilitate the Government's plans
to increase investment in new public sector infrastructure. Four different examples of how
this approach will work in practice are set out below.
LIFTs— 8.31 The NHS Local Improvement Finance Trust (LIFT) delivers investment in primary and
excellence in community-based healthcare facilities to achieve more integrated local service provision.
primary Individual primary care facilities are often relatively small — typically less than £5 million in
healthcare capital value, and in many cases less than £1 million. The occupants and users of the facilities
procurement reflect the diverse mix of providers of primary health care — employees of Primary Care Trusts
or local authorities, and self employed contractors or partnerships such as GPs, Pharmacists
and Dentists. To meet the needs of these groups across a variety of small sites and retain
private sector confidence in the programme requires a high level of procurement skills.
8.32 To meet this challenge, NHS Primary Care LIFT was created as a nationally managed
procurement programme by Partnerships for Health (PfH), a company formed as a joint
venture between the Department of Health and Partnerships UK. The key features of PfH’s
role are to:
¢ develop a standardised procurement approach, including the agreements to
be entered into in relation to each scheme;
le create a team of experienced transactors who assist local teams to define their
requirements effectively and to procure long term partners who can meet
their objectives; and
® create a sustainable, predictable flow of transactions for the private sector to
permit forward planning of future capacity to bid and implement such
schemes.
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Batched acute 8.33 The procurement of major hospital schemes in batches is a new approach developed by
hospitals the DoH, with the support of HM Treasury and Partnerships UK. The invitation to bid for the
first batched scheme was issues in May 2003. This approach has three objectives, to:
- reduce bid costs and procurement times for major acute hospitals. The PFI
batch partners will incur only one set of bid costs before being given preferred
bidder status for the three schemes, without losing the benefits of PFI;
© provide greater certainty over the future flow of investment which will enable
the private sector to invest in new capacity to delivery such schemes; and
* increase opportunities for greater standardisation of design and service
delivery, which will improve value for money.
8.34 Although this approach should reduce the costs of the PFI procurement process, it will
not be at the expense of the desired risk-sharing arrangements for each hospital, which will
enjoy a separate contract with the PFI batch partner based on the standardised PFI contract.
8.35 The Church of England (CofE) schools estate comprises around 2,000 schools,
dividually the responsibility of the school governors and trustees, with a major aggregate
investment need of £1.5 billion over 10 years. As most of these schools are small primary
schools with a new build capital cost of £2 million, their staff, governors and trustees do not
have the procurement experience to access the flow of investment that has been delivered in
schools more generally through PFI.
Partnerships for 8.36 To meet this challenge, a new vehicle has been established to manage a programme of
Church of centrally procured schemes, each covering a grouping of CofE schools. The scheme brings the
England schools potential benefits of PFI, in terms of on-time, on-budget delivery and whole-of-life design and
costing, to a sector where without bundling it would not be economic to use PFI. Partnerships
for Church of England Schools (PfCS) is a joint venture between DfES, Partnerships UK and
the National Society (responsible for education within the CofE), that will scope, develop and
procure private sector partners for geographically coherent groups of dioceses.
8.37 PfCS is expecting to take 13 schemes into procurement in three tranches in the next two
years, each scheme covering between two and four dioceses, so that all 42 dioceses
England are covered, establishing in each case a local partnership under which the future
investment requirements can be delivered efficiently. The first schemes are expected to go
into procurement in the summer, with all 13 local partnerships expected to be in place in
around three years. Each local partnership is expected to require an investment programme
of at least £40 million over its first three years.
in
Building Schools 8.38 In ‘Building Schools for the Future’ the Government has committed to a programme of
for the Future rebuilding and renewal to ensure that all secondary schools in England have facilities to 21st
century standards. With over £5 billion a year available for capital investment in schools by
2005-06, over £2 billion of which is earmarked for strategic renewal of the secondary estate,
the Government is committing the resources necessary to enable local education authorities
(LEAs), schools, parents and governors to work together to achieve 21st century standards for
every school in the country over the next 10-15 years.
8.39 DfES is currently working with Partnerships UK and 4Ps to develop a new national body
to manage its programme of PFI and conventional investment in secondary schools, and to
work with LEAs on solutions to meet their needs. This offers a way to increase procurement
skills and reduce procurement costs and delays in the schools sector, and ensure that the
expertise is in place to identify where PFI can offer value for money and where conventional
procurement will provide the better option. This new national procurement body is planned
to launch in the autumn, ready to take forward the first local strategic plans.
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8.40 The DfES is in the process of developing exemplar designs that will set a new benchmark
standard for school design, and which can be customised to meet local needs and
circumstances. Much greater support to LEAs and schools in negotiating terms for large-scale
investment will also be provided, reducing the procurement burden on local authorities,
while helping them realise their local vision and strategies. The new body would be expected
to:
*® manage the delivery of the programme of strategic investment, supporting
local procurements to reduce time, cost and complexity;
¢ use both PFI and conventional procurement, efficiently and as appropriate to
local needs;
* work with LEAs and schools to develop the programme of strategic renewal;
¢ ensure supply chains are tested to achieve best value and gains are passed on.
to schools; and
*® encourage and develop the market of private sector suppliers.
FUTURE AGENDA
8.41 The Government is committed to improving the effectiveness of the public sector in all
kinds of procurement, and in PFI procurement in particular. HM Treasury intends to research
in more detail the performance of the public sector in the two particular areas of PFI below,
which are important in securing value for money from PFI procurement. Once HM Treasury
have concluded a research and consultation process, the evidence will be published and an
assessment made of any guidance or policy measures that might be required. HM Treasury
expects the research and consultation process to be completed over the next year. The
specific areas involved are:
e the public sector's evaluation of PFI bids; and
© the public sector's record in managing PFI projects to ensure: first, that they
offer in practice the flexibility built into standardised PFI contracts; and
second, that authorities are equipped to manage their contracts effectively,
particularly when termination or the exercise of step-in rights is required.
Bid Evaluation
8.42 The proper evaluation of bids for PFI projects is essential in securing value for money. It
is important for the public sector to evaluate bids for PFI projects from the perspective of
overall best value in the long term. It can be a mistake for the public sector to confuse least
cost with value for money (see paragraph 8.13 and Box 8.1).
8.43 Three additional factors of significance make sound bid evaluation even more
important:
¢ the new Green Book's unbundling of the discount rate to make separate
assessments of risk and uncertainty and optimism bias mean that the public
sector's evaluation of bids presented must be more rigorous, with a particular
need to assess the trade off between value for money and affordability of bids;
*¢ because the PFI market is increasingly competitive, in bidding to the public
sector and in the financing terms offered by funders (see Annex C for technical
details) public sector bid evaluation has to be expert and comprehensive
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enough to take into account the financial robustness of each bid, to ensure
that bidders have not reduced safety margins in their financing arrangements
to a level that endangers their own long-term financial stability. The public
sector does not underwrite private sector partners, but it does need to ensure
the long-term viability of its private sector contractors; and
© the public sector needs to consider and value the flexibility offered by different
bids. Paragraphs 8.45-8.47 cover this in more detail.
8.44 To take account of these concerns, HM Treasury will be reviewing, in consultation with
public and private sectors, the current effectiveness of the public sector's approach to bid
evaluation. The research will look particularly at the expertise deployed by the public sector
client to undertake bid evaluation and the grounds on which bids are evaluated.
Delivering Flexibi
ty
8.45 It is important that the public sector client has the ability to ensure that the flexibility
mechanisms built into standard PFI contracts, to accommodate changes in the public sector's
requirements over the life of a PFI contract, are effective in practice. Chapter (3.38 - 3.44)
outlined what those mechanisms are, the circumstances where they might be used, and
compared them to the inflexibilities also inherent in conventionally procuring major capital
assets.
8.46 In a PFI contract, the public sector needs to secure value for money in meeting its
changed requirements through exercising its rights under PFI contracts. To exercise those
rights effectively it must:
* ensure an effective co-operative relationship with the public sector client,
which can facilitate changes swiftly, and secure a fair agreement with the PFI
contractor on cost that represents value for money;
© negotiate effectively over changes with the PFI contractor, to ensure the best
value for money;
have in place the expertise and capability to run effective competitions for
changes to PFI facilities where the public sector client deems it necessary to
secure value for money; and
* — maintain the ability, where necessary, to terminate PFI contracts without
private sector default in the rare event of a radical change in public sector
requirements. Paragraphs 9.24-9.29 examine this area in more detail, and
outline measures to make it easier to safeguard the public sector's position
where termination is necessary.
8.47 The Government is concerned to ensure that these capabilities are in place. To establish
the extent to which the public sector is capable of ensuring the flexibility of PFI contracts it
manages, HM Treasury will be conducting research and consultation on the public sector's
record of securing flexibility in PFI contracts on value for money terms over the next year.
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PRIVATE FINANCE
The involvement of third-party finance is an important factor in the success of PFI. Private
finance offers value for money in PFI procurement in circumstances where the benefits it
brings outweigh any cost involved.
The Government seeks to ensure that it receives the best value for money in securing the
benefits of private finance for PFI projects. Consequently it is determined to:
© maintain a variety of sources of funding for PFI projects to ensure that
competitive tension provides value for money, that the risks associated with a
major investment programme are spread in a sustainable fashion, and that the
Government's exposure to systemic market risks is mii
* explore the provision of framework funding, aie in bundled
small PFI schemes to provide a faster, cheaper funding solution for these kinds
of schemes; and
* explore through pilot projects and consultation the potential of a form
of credit guarantee finance, as one of the variety of sources of funding that
could be available for PFI. This type of financing separates funding and risk taking
by retaining the involvement of private financiers as risk takers in PFI, but funding
projects through Government gilts; thus saving the cost of the private sector
securing funds, which is separate from the cost of it taking risks.
Also, the Government wishes to ensure that the involvement of private finance does not
lead to unnecessary inflexibility in privately financed projects because of excess
termination costs. It will explore measures to assure this flexibility, including:
* consulting on the role of the Spens clause in the termination of PFI projects
funded through bonds; and
* examining and consulting on the value for money of requiring the private
sector to hedge interest rate risk on a project specific basis.
BACKGROUND
9.1 The Government's approach to PFI, laid out in Chapter 3, makes clear that the
involvement of private finance in taking performance risk is crucial to the benefits offered by
PFI, incentivising projects to complete on time and on budget, and to take into account the
whole of life costs of an asset in design and construction. It is necessary for private sector
capital to be at risk for it to take responsibility for the work it carries out. The involvement of
third-party finance in PFI brings with it extensive due diligence work to identify, allocate and
enforce risk sharing in a project that can significantly improve its value for money. The
evidence presented in Chapter 4 demonstrated that these benefits of private finance are
being realised.
9.2 Because of the benefits it brings, the involvement of private finance in PFI should
represent good value for money, reducing the overall cost of delivering certain types of public
investment. The Government recognises that to obtain the benefits of private finance there is
an associated risk premium compared to the risk free rate of government gilts. This risk
premium represents value for money in PFI, as it reflects the private sector taking on and
managing the appropriate risks — risks which, although inherent in a project however
procured, are not reflected in government borrowing. An explanatory comparison of the
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relative costs of public and private finance is laid out in paragraphs 3.60 onwards, which
outlines how the cost of capital in a PFI project, which explicitly calculates the risks involved,
cannot be compared with the cost of gilts, or government borrowing, as these rates are set
‘risk-free’ although there is an extra cost to funding PFI through private sector finance,
associated with the higher cost of the private sector securing funding in the capital markets
compared to the Government. Moreover, these costs of finance are:
* controlled by competitive pressure — not only do PFI contractors bid to win
contracts, but they themselves typically put the financing arrangements out to
bid;
© not the most important cost in evaluating PFI bids, as a bidder's proposals for
construction and operation of the asset are likely to have a more significant
effect on unitary charge; and
I a shared interest of both the public sector and the private sector PFI
consortium, who both have an interest in securing value for money for the
finance raised.
93 PricewaterhouseCoopers are publishing separately on their website a study
commissioned by OGC into the rate of return bid by the private sector in PFI projects. The
findings of the report are summarised in Annex C.
The role of Government in private finance
9.4 For most PFI contracts, the Government's direct role in raising the finance for a PFI
project is limited although there can be exceptions in unusual or particularly complex
schemes. It is the responsibility of the PFI contractor to put in place its own financing
arrangements to fund the investment required by the PFI project. It is recognised that each
PFI contractor has its own relationships with sources of private sector finance, which it may
wish to use throughout its portfolio of projects. It is also important to ensure that the private
sector funders do not infer from any Government involvement in this aspect of the PFI
project that it is in any way underwriting the finance raised. The key role of the Government
is to set the terms of the competition for the PFI project, which gives the private sector the
right incentives to obtain the best value for money, including in terms of the finance secured
in the PFI contract.
Financing PFI projects
9.5 The private sector has typically financed PFI projects with a combination of all or some
of the following: bank finance; debt raised in the capital markets with a credit guarantee; debt
raised in the capital markets without a credit guarantee but rated by one of the established
rating agencies and finance provided by the European Investment Bank, which usually
benefits for part of or all of the project's life from a bank guarantee. In addition, a limited
number of projects have been financed by the private sector without the involvement of third
party finance.
9.6 The Government wishes to ensure that all the traditional means of funding PFI will
continue to be available to be used by the private sector, with the private sector left in charge
of the process for selecting which financial counterparty to engage in support of its bid. The
Government's overall aim is to maintain a ‘mixed economy’ in finance provision:
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¢ that there is healthy competition between different sources of finance,
ensuring value for money;
¢ that the risks associated with the major investment programmes undertaken.
through PFI are spread in a sustainable fashion across a number of sources of
credit;
© that the Government is not overly exposed to systemic market risk on one
particular source of finance; and
¢ that the terms of credit support for the private sector are part of the tender
process.
IMPROVING VALUE FOR MONEY
9.7 The Government continues to be committed to working with the private sector and
their funders to identify new approaches to financing PFI projects which may offer value for
money benefits. In assessing any new financing schemes, the Government will seek to ensure:
sal that it retains the benefits of risk sharing with the private sector, including
with the funders of the PFI project (as set out in Chapter 3);
© that it avoids any Government guarantee of the funding raised; and
© that it does not interfere unduly with the ability of the private sector to raise
funds for their project or add costly delays to the procurement process.
9.8 Within this framework, the Government will always be interested in proposals which
reduce the costs associated with private finance, but which do not compromise its desire to
ensure that the disciplines, value for money and risk sharing brought by private financiers to
the PFI process are retained. At present, the Government wishes to pursue further two new
financing schemes, set out below, which may achieve these objectives.
Framework Funding
9.9 The Government is looking at framework funding solutions, particularly for application
in those schemes which bundle together smaller schemes, for example Partnerships for
Church of England Schools (bundled schemes are explained further in Chapter 8). The aim
will be to provide a faster, cheaper funding solution, which maintains the benefits of third
party finance but reduces its inherent inefficiencies when applied to smaller schemes. The
finance would continue to be provided by the private sector, with the same advantages for the
PFI project this brings.
9.10 While such a framework funding solution would make access to third party finance
easier and more cost-effective for smaller schemes, all control and accountability for those
schemes would remain at the level of the procuring authority itself. Funding for locally-driven
schemes would become cheaper to access, allowing authorities to get better value for the
investment they control.
9.11 Work is underway to analyse the benefits of these framework funding conduits, and look
at the degree of flexibility on drawdown that would be available within such a scheme. It is not
envisaged that framework funding schemes would be applied more widely to stand alone
schemes. The benefits are seen to occur predominantly in grouped small projects potentially
using the procurement of the kind outlined in Chapter 8.
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Credit Guarantee Finance
Overview 9.12 The Government will pursue a small number of pilot projects to test the practicality,
attractiveness, and applicability of a different means of funding the senior debt raised to fund
some PFI projects which has been called Credit Guarantee Finance. The aim of this scheme is
to retain all the benefits to the public sector of banks and insurance companies’ risk taking in
PFI projects, described in paragraphs 3.54 to 3.59, but funding the PFI project's senior debt
requirements with loan finance provided directly by the Government, fully guaranteed by
these private risk takers, which it would fund by the issuing of gilts. This approach combines
the lower cost of the Government borrowing funds with the benefits of paying a risk premium
to private financiers to take, allocate and manage risk. By doing so, this approach offers the
prospect of a cost saving in terms of the overall cost of finance for the PFI projects involved.
9.13. The cost of private sector debt finance for a PFI, as explained in paragraphs 3.62 to 3.63,
contains a risk premium charged by the lenders for assuming, allocating and managing the
risks inherent in the project. This risk premium, typically 0.3 to 1 per cent, represents good
value for money for the public sector in a PFI project, because the lenders’ involvement
contributes significantly to on time and on budget delivery and whole-of-life costing in PFI
investment. This risk premium is not paid in financing conventional procurement through
gilts; but the risks in conventional procurement are instead paid for in full by the public sector
if and when construction runs over budget or projects are delayed.
Chart 9.1: Cost of finance
Expected Cost
Private Sector Gilts
[EB Cost of funds (I) Private financier's funding premium B Risk premium
9.14 Inherent in raising private finance is the cost of the private sector securing funds in the
market due to the higher risk in funding private sector credit providers as opposed to
Government (see Chart 9.1). Paying this funding premium has provided good value for money
overall, and will still represent value for money in future PFI, because of the benefits flowing
from the private sector assuming risks.
9.15 However, the Credit Guarantee Finance option explores a way (for some projects), of
continuing to pay a risk premium to the private sector for some projects, but reducing this
funding premium and hence improving further overall value for money offered. This option
could lead to savings in some PFI projects which pursue it, but it would not be possible to use
it for a large number of projects, because of the importance of maintaining a variety of
funding sources and bearers of risk and for the reasons set out in paragraph 9.19 below.
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How it works 9.16 If adopted, this approach could be implemented on an individual PFI project in the
following manner.
9.17 As currently, the PFI contractor would be responsible for engaging its financial partners
subject to a limited number of restrictions, related to the credit worthiness of the credit
provider selected. The funders would provide guarantees to pay principal and interest as and
when they fall due, rather than cash advances to commit to fund the project. At signature of
the PFI contract, the Government would lend to the PFI project the sums needed to finance
the senior debt portion of the overall financing package, provided the PFI contractor was able
to offer credit guarantees for the full amount of these loans from credit providers of
acceptable standing
9.18 With this arrangement in place, the Government would be lending funds to the PFI
project with the benefit of a guarantee from the credit providers. If there was a default by the
PFI contractor for any reason, these credit providers would fully repay the Government's
loans in a timely manner. The Government’ principal risk in lending would therefore be the
credit worthiness of the credit provider, not the PFI project itself. In using this approach, the
Government would not seek any significant additional rights, either in respect of drawdown
limitations, covenants or in respect of events of default to those normally required by
investors in similar transactions where they are currently guaranteed by specialised
insurance companies.
Scope of use 9.19 If adopted, there will be natural limitations to the use of guarantee finance in PFI
projects, being, among others:
© the Government will need to manage its overall exposure to each credit
provider, whether it be a bank or an insurance company;
© the Government may also need to ensure that it will limit its exposure to
certain types of credit provider, for example it will need to limit its exposure to
insurance companies as a group;
¢ the Government will only wish to use this for PFI programmes that are well
established, where the risk profile of the PFI project is well known; and
° itis unlikely to be attractive to use this for a large number of projects, as it is
necessary to ensure the maintenance of a mixed economy in financing PFI,
and the lower exposure to systemic market risk that comes with that.
9.20 If Credit Guarantee Finance is adopted for some projects, the Government will seek to
use both banks and insurance companies to provide the credit guarantees, as a part of its
interest in maintaining a variety of risk takers and sources of finance in PFI.
The Pilots 9.21 A small number of pilot projects will be chosen, one of these being a pilot of how Credit
Guarantee Finance could be used with banks as the credit provider, a second with an
insurance company as the credit provider, and the Government will also wish to test the
scheme on two different types of PFI projects. In pursuing the pilots, the Government will be
concerned to ensure that these will not delay the financial close of any PFI project and all
relevant concerns which could arise for the public and private sectors as a result of Credit
Guarantee Finance are addressed in consultation with all relevant parties.
9.22 Following a successful conclusion to these pilots and consultation with both private and
public sectors on whether and how this approach could be implemented more widely, the
Government will decide whether or not to proceed and will issue guidelines for its use.
However, the Government envisages that it will not use Credit Guarantee Finance for more
than a limited proportion of its PFI programme and is committed to maintaining a mixed
economy in PFI financing.
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ty
9.23 As part of the consultation exercise, HM Treasury will be providing further detailed
technical information concerning Credit Guarantee Finance on its website in the early
Autumn.
FINANCE AND FLEXIBILITY
9.24 Flexibility is important in the delivery of public service investment in PFI, just as in
conventional procurement, to take account of major changes in requirements or technology
in the long term. Natural limits are placed on flexibility by the very nature of the capital assets
being built, and they are present in both PFI and in conventional procurement. However, the
means by which this flexibility is realised differ in the case of PFI, and Chapter 3 outlined the
measures in place in standard PFI contracts to deploy that flexibility. In brief, these measures
are:
° the public sector has a right to change any aspect of the building or service
provision, subject to agreement with the PFI contractor on cost;
* to ensure agreement is reached quickly and that value for money is
maintained, for changes over £100,000 in value, the public sector can require
a competitive tender for any works, to be appropriately audited; and
© where there is a requirement to change service configuration, there is a similar
right for the public sector to change any aspect of service provision, subject to
agreement on costs, with the ability to require a competition for the services
provided to ensure best value for money. This is in addition to their rights to
re-tender service provision regularly throughout the contract's life.
9.25 In very rare circumstances, where there is an unanticipated wholesale change in the
public sector's needs which makes public infrastructure redundant, or requires very radical
change in its use, the public sector will need to be able to implement such change whatever
the procurement route originally chosen.
9.26 In conventional public sector procurement there will be costs in implementing such
change. As in PFI, the costs may relate to the financing arrangements, and may involve the
termination of service provision contracts. When a public sector project is financed by the
Government, it typically issues gilts to fund the project. Even if the building is now redundant
the Government will still need to repay and meet the interest costs of the gilt issue over its
remaining life. Likewise any service contracts terminated would also lead to compensation.
This would typically be calculated as a payment of foregone profits for an agreed period.
9.27 If the Government voluntarily terminates a PFI contract in such circumstances (rather
than where the private sector is in default) it will face similar costs. There are, however, areas
where PFI contracts are more expensive to terminate. In a standard PFI contract,
shareholders would receive compensation for their loss of profit from the PFI project. This
would typically amount to a present value of the foregone profits. The level of this
compensation is dependent upon the performance of the project as well as the proportion of
equity in the deal. Generally the low level of equity in the financing of these projects reduces
the significance of this element of compensation.
9.28 The other elements of compensation on a PFI contract in these circumstances relating
to the private finance elements of the project can represent an unnecessary cost. In
particular, the Spens formula which is normally applied to the termination of PFI-linked
bond issues — a small proportion of PFI projects — can be an unnecessary cost in the voluntary
termination of a project, as it compensates the bond holder for the risk margin on the debt
for the remaining life of the bond. The hedging of interest rate risk in a PFI project can give
rise to similar issues.
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9.29 To examine these issues further, the Government will be consulting with the public and
private sectors on the role of the Spens formula in limiting flexibility in project termination,
and on hedging risk.
Spens Formula
9.30 The Spens clause, which applies to listed bonds in the UK only, provides for a
termination payment that compensates the bondholders for lost risk margin when a bond is
terminated. This will only be an issue in extremely rare circumstances and for the small
proportion of PFI projects financed by bond issues.
9.31 The Government is concerned that the Spens related payment represents an
unnecessary extra cost of termination for a PFI project over a traditionally financed project in
the rate circumstances where it wishes to voluntarily terminate due to major changes in the
public sector's requirements which cannot otherwise by accommodated. The Government is
content to retain the Spens payment in circumstances of authority default and force majeure.
9.32 The Government is aware that a change in the application of the Spens clause would be
considered a major change to the way bond investors preserve their long term interests when
they invest in PFI projects. The Government also recognises that the circumstances in which
it wishes to voluntarily terminate without the Spens clause are extremely rare, and should be
limited to major changes in public service needs. It intends to enter into consultation with
issuers and investors over the next six months to see in what circumstances investors would
be willing to voluntarily forego this protection in these limited circumstances.
Hedging
9.33 As outlined above, the key role of Government in the private finance raised by PFI
projects is to set the terms of the PFI competition. In setting these bid requirements, the
public sector sets out its approach to the unitary charges to be paid, and provides a formula
for any permitted changes in these charges over the life of the contract. In doing this, the
public sector determines in advance some restrictions on the financing options which will be
feasible to the PFI contractor. For example:
¢ — if unitary charges are only permitted to increase annually by the rate of
inflation, this is likely to lead a PFI contractor to fund its project through an
index-linked bond issue, which relates changes in inflation; or
¢ ifunitary charges comprise a mixture of a fixed element, equal to the amount
needed to service the finance raised for this project, and a second element
which varies with inflation (usually relating to operating costs) this will lead a
PFI contractor to fund its PFI project with a fixed rate of interest by way of a
bond issue or, if it chooses to use bank finance, the introduction of a hedging
instrument to mitigate the interest rate risk normal with such bank financing.
9.34 The key choice for the public sector regards its preferred approach to unitary charges.
Guidance has been given on these matters, but the Government believes an alternative
approach to interest rate risk is now possible, given the large number of projects now in
operation, which could improve value for money futher.
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9.35 The Government will review the current approach to managing interest rate risk under
a PFI. To date, interest rate risk and its management primarily lies with the PFI contractor,
which raises two issues:
= where it is necessary to terminate a PFI contract to ensure flexibility for
delivery of public services in the circumstances described above, the cost of
breaking the hedging contracts put in place by the PFI contractor are typically
passed back to the Government; and
* itis also difficult to ensure that the process of agreeing a fixed interest rate at
financial close is sufficiently transparent and cost effective.
9.36 The Government is now in a position to consider its exposure to interest rate risk in PFI
contracts in the context of its PFI programme as a whole, securing better value for money
than through continuing to require the private sector to put in place such hedging itself.
9.37 The Government therefore plans to review whether its current approach to requiring the
private sector to hedge interest rate exposure offers best value for money. It will consult on
these issues with both public and private sector participants in PFI on whether an alternative
approach can be found which offers better value for money.
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ANNEX A — PuBLic SECTOR
COMPARATOR REFORM
CONTEXT FOR THE REFORMS AND THE GREEN BOOK
Al Asset out in detail in Chapter 7, Assessing Value for Money, the government proposes to
introduce a new framework for value for money appraisal for PFI procurement. This Annex
sets out in more detail some of the criteria that could be examined under each stage of the
new value for money appraisal process. The criteria included are indicative, and will be laid
out in more detail in future guidance on which the Government will consult.
APPRAISING VALUE FOR MONEY IN THE INVESTMENT
PROGRAMME ASSESSMENT
A2 Examples of the criteria that could be included in the value for money appraisal at the
stage the decision is made on how to procure investment projects as part of a programme are:
* outline of the objectives of an investment programme and definition of a
successful outcome, financial and non-financial, including for example, social
outputs and skill development;
© public equity, efficiency and accountability reasons for providing the service
directly;
© whether the service is contractable on a long-term output specified basis. The
outputs should take into account, inter alia, the potential need for changes
and requirement for flexibility during the contract terms, including for
example, whether output levels could be affected by technological change in
the short to medium term;
¢ the experience and track record of similar projects that have demonstrated the
wider value for money and costs savings that PFI can deliver. The analysis will
need to consider the benefits and costs of other procurement routes
compared with a PFI route such as the costs of a complex procurement
process, and the scope for risk transfer;
¢ identification of the potential distributional implications of the various
options across society and how the costs and benefits might accrue across
different socio-economic groups;
© assessment of the benefits and costs in relation to employment issues under
each procurement route. For example, options being considered should take
into account the need for flexibility in the delivery of public services and the
ability to pursue PFI, for example, without full workforce transfer (retention of
soft services); and
° establishment of central departmental (or agency) management
arrangements to support the procurement programme and potential
transaction costs of the programme.
43 This appraisal will be aided by appropriate quantitative analysis to ensure transparency
and robustness. At the stage that decisions are taken on how to allocate capital, the analysis
is likely to focus on the following:
© preliminary assessment of projected operational and capital costs for
investment programmes;
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* broad transaction and financing costs of different procurement routes, where
such information can be extracted from experiences to date from the sector;
* assessment of the potential tax impact for each route;
*® accounting for optimum bias on the overall investment programme for capital
costs, duration of works, operational costs and benefits — which in the public
sector has historically been caused by both inadequate project definition and
poor project management. Optimism bias within private sector bids should
also be factored into the overall risk analysis, such as the level of variation
claims (which impact price), using the information available from actual
experience from projects. The application of optimum bias to PFI project
appraisals will require further development and the Treasury will work with
Departments to develop project or sector specific methodology;
¢ distinct from optimum bias, quantification of uncertainties surrounding the
public sector's ability to estimate the cost and benefits of a public sector
alternative, for example, the value in a fixed price contract offered by private
sector compared with relying on internal estimates to price the contracts. This
may be less of an issue where similar transactions exist for comparison but
may be applicable for unique or more complex projects;
© preliminary appraisal and quantification of benefits and costs arising across
the different sectors and across income groups, such as improved productivity
of workers, loss of workforce and environmental improvements of each
procurement route. The Green Book suggests use of multipliers or indexes to
differentiate the potential impact across the different sectors or socio-
economic groups; and workforce issues; and
* potential for alternative revenue streams such as third-party revenues
generated or cost savings by or to other programmes based on experience
from previous similar projects.
APPRAISING VALUE FOR MONEY AT THE PROJECT LEVEL
A4 Below are some examples of the criteria that should be considered as part of a value for
money appraisal of a PFI project in a reformed PSC at outline business case stage and before
procurement commences, at the project stage:
¢ the scale, nature and scope of the project. For example, adding a new wing to
an existing hospital (that has not been procured under PFI) would be an
unlikely candidate for PFI procurement, whereas expansion of Design, Build,
Finance and Operate (DBFO) road is likely to be more suitable;
¢ build on initial quantitative assessments, including confirmation of capital
values and operational costs of the project, factoring in target service and
usage levels;
¢ identification and quantification of the key risk transfer elements, potential
tax impact, and optimum bias estimates specific to the project. As details on
projects are developed, Departments will need to look to producing greater
detail on appraising the benefits and costs of the relevant value for money
issues, for example, for a pathfinder PFI, broader benefits including the
workforce, strategic or environmental impact will need to be considered;
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¢ identification of non-market impacts where feasible, such as strategic
considerations, timing implications, health benefits, design quality, approach
to innovation, and health and safety;
* assessment of the affordability of options, including upfront transaction costs,
in addition to the economic costs and benefits;
¢ early establishment of an approach to project and risk management, and an
evulation of the make-up and experience of the project team;
*® assessment of the financing costs of a PFI scheme and competition issues,
including preliminary expectation of competitive interest and quality of
potential bidding parties having considered the current market situation;
© updating the framework for pre-tender dialogue; a key evaluation approach is
to ensure a level playing field for the competition to facilitate the appraisal
and decision making process and flexibility to take into account of bidder
input during the bid process.
AS The supporting financial analysis will include:
‘s cost estimates. This will assist future sensitivity analysis;
© adjustments for optimism bias. The Green Book recommends that optimism
bias adjustments should be made to each major category identified based on
the best empirical evidence relevant to each stage of the appraisal;
¢ the quantification and probable impact of the different taxes, such as stamp
duty, VAT, employment, corporation tax liabilities and other relevant tax
regimes; and
¢ identification of the benefit categories, financial (for example, operating costs
reduction) and non-financial (quantitative, such as reduction in road
accidents, and qualitative, improved staff skill level).
VALUE FOR MONEY APPRAISAL DURING THE PROCUREMENT
STAGE
A6 At the procurement stage the value for money appraisal should focus on the effects of
market conditions and competition issues on the bids received, and will not be an evaluation
of PFI as a procurement route, which will have been tested using the reformed PSC. This
assessment is different from the full bid evaluation process to determine which bid offers the
best value for money. Instead, the aim of the assessment is to ensure that the preferred PFI
bid offers a value for money PFI scheme.
AT Additional factors relevant to the procurement stage will include:
e the quality of the competition through the expressions of interest received;
¢ market factors such as the effect of capacity constraints on prices; and
quality of the proposals received; where the project attracts inadequate
quality of responses and may require adjustment as to scope and timing.
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ANNEX B — REPORTING AND
ACCOUNTING ISSUES
BI The Government's publication of statistics on the PFI programme to date has used a
very broad definition covering several different types of private investment in public services
and there are a number of areas where there are benefits in making changes to the statistics
that are reported. Specifically:
* statistics have not distinguished between investment undertaken under PFI
and under other very different PPP transactions or arrangements with the
private sector like the Channel Tunnel Rail Link (CTRL);
*® some departments report annual expenditure by the private sector in the year
it is actually intended to occur, while some have aggregated the full capital
value of investment undertaken by the private sector into the year the project
contract was signed; and
© there is some overlap in the figures for ‘on-balance sheet’ PFI investment in
the ONS published statistics on PSNI and the figures for the PFI programme.
B2 The Government intends to treat the publication of statistics on PFI differently in future,
beginning with the Autumn 2003 Pre-Budget Report (PBR). The aim is to present more
comprehensive statistics that are transparent with regard to the kind of transaction — PFI
contract or PPP joint venture ~ to which they refer. This will include publishing biannually, in
the Budget and PBR, more data on:
* signed projects;
° future PFI transactions;
* the level of expected payments to the private sector under unitary charges;
and
¢ other information which could be of use to all participants in PFI.
Sources of Information
B3__ The Government has routinely published a range of statistical information on PFI. The
Financial Statement and Budget Report sets out:
© departmental estimates of the capital investment in public services to be
undertaken by the private sector under PFI, PPP and other similar contracts
signed to date;
¢ the estimated aggregate capital value of projects which have reached
preferred bidder stage; and
* estimated payments to be made by government under PFI contracts signed to
that date. As the Financial Statement and Budget Report points out, actual
expenditure will depend on the payment mechanism and deductions for poor
performance in each individual contract.
B4 The Office of Government Commerce (OGC) has maintained a database of PFI and PPP
signed projects and the capital values involved. Responsibility for this database transferred to
TIM Treasury on April 1st 2003. The publicly available electronic database will transfer from
the OGC website to the HM Treasury website in the early Autumn.
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ANNEX B — REPORTING AND ACCOUNTING IssuES
BS The Government has published a detailed regional breakdown of PFI and PPP contracts.
These regional maps illustrate the distribution of projects across the country, their capital
value, the date the project scheme was finalised and work begun, and some details on what
the project will provide.
B6 Other sources of information include:
¢ published Departmental Investment Strategies;
* alist of approved local authority PFI projects, available on the ODPM website;
) the NAO database “PFI and PPP/Privatisation Recommendations’, and
¢ regular presentations of information to Parliament in response to specific
requests.
PPPs and PFls
B7 The use of two terms — ‘PPP’ and ‘PFI’ - to refer to Government relationships with the
private sector can cause confusion, with the terms often used interchangeably. However,
there is an important purpose in having two terms: to make it possible to differentiate
between two different types of transaction. Specifically, to differentiate between PFI as a
procurement tool, and PPP as an ownership structure.
B8 This distinction is especially important in financial reporting. The vast majority of PFI
contracts represent a liability for a stream of payments that stretches over the long term, and
which the Government will have to meet from revenue expenditure in the year in which they
are liable. In a PPP deal by contrast, the Government owns an equity stake in a company, an
asset, and this is therefore different in kind from a PFI transaction.
B9 It is important to highlight this distinction when considering aspects of the public
finances, and the Government intends to ensure the transparency of information presented
in the future by isolating and identifying, where appropriate, data on PFI projects and PPP
transactions. Consequently, the data presented in the report focuses on PFI investment and
the liabilities associated with it, and excludes PPP transactions and other kinds of
Government relationship with the private sector.
BIO The data presented in the report therefore includes the early forerunners of PFI, such as
the Queen Elizabeth II bridge which commenced before the formal launch of the Private
Finance Initiative on 12 November 1992, because these early projects are functionally similar
to PFI in that they too involve long-term payments to the private sector in return for provision
of a public service asset.
BIl_ Investment in other kinds of Public Private Partnerships, such as the National Air Traffic
Control PPP and the Home Office Airwave PPP are not included.
LUL and CTRL BI2 Two major transport transactions, the Channel Tunnel Rail Link and the London
Underground Limited PPP, are sufficiently significant in size to require a separate account of
their treatment. LUL and CTRL are reported in the Financial Statement and Budget Report
2003 in the following way:
¢ the annual capital investment being undertaken by London and Continental
Railways on the CTRL is included in the departmental estimate of capital
spending by the private sector under the Department for Transport;
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ANNEX B — REPORTING AND ACCOUNTING IssuES
Overview
© the total capital value of the first 15 years of infrastructure investment under
the Tube Lines London Underground contract is reported in financial year
2003-04. The expected unitary charge service payments to be made under the
contract are reported in the estimates of future revenue payments under PFI
contracts; and
¢ the total capital value of the first 15 years of infrastructure investment under
the Metronet London Underground contracts is reported as part of the
Department for Transport's estimated aggregate capital value of projects at
preferred bidder stage in 2003-04. (These contracts have now been signed.)
BI3_ The data on the PFI programme differs from that represented in the Financial Statement
and Budget Report due to the different treatment of CTRL and LUL. Specifically:
© capital investment undertaken by London and Continental Railways on the
CTRL is not included in the data, as the investment does not occur under a PFI
contract. CTRL is not a PFI because the Government has no fixed contractual
liability for set values of future service payments to the private sector, but
instead guarantees CTRL bonds. The risk transfer involved in the project is
therefore different in kind to a PFI contract, utilizing a different transfer
mechanism;
¢ the PFI contracts for the modernisation and maintenance of London
Underground are included in the data. Under the Tubelines and Metronet
contracts, the Government has incurred fixed price service payment liabilities
into the future (with the contracts reviewed every seven and a half years) in
return for a guaranteed level of service. It has transferred risk in the same way
as in other PFI contracts;
e to maintain an approach consistent with previous reporting, LUL PFI
contracts are reported at their value estimated over a 15-year period in the
year in which they were signed (as the contracts are reviewed periodically, the
actual capital investment undertaken may vary); and
* to improve transparency in the figures, the proportion of capital investment
represented by the London Underground contracts is indicated in data for the
capital value of signed PFI contracts.
THE GOVERNMENT’S APPROACH TO ACCOUNTING FOR PFI
PROJECTS
BI4_ The Government accounts for PFI investment according to accounting principles set by
the independent Accounting Standards Board (ASB). The accounting treatment of PFI
projects entered into by central government bodies are then audited by the independent
Comptroller and Auditor General on behalf of Parliament.
BIS The Government uses PFI where it delivers value for money in public services, not for
balance sheet reasons. Approximately 57 per cent of PFI capital expenditure is scored on the
public sector's balance sheet.
Hg
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ANNEX B — REPORTING AND ACCOUNTING IssuES
Independently written, independently audited principles
Principles of BI6 The Government is committed to increasing the accuracy and availability of
accounting by information about the public sector's assets and liabilities. Accurate, transparent and credible
Government accounts allow the public to judge the scope, direction and sustainability of public spending
and investment. The Government has undertaken to use best practice accounting methods in
the production of its accounts. This commitment is enshrined in the Code for Fiscal Stability
and the Government Resources and Accounts Act 2000 (GRAA 2000).
BI7_ In accordance with the GRAA 2000 Government accounts are required to follow UK
generally accepted accounting practice (UK GAAP), adapted as necessary for the public sector
context. These accounting practices and principles are independently set and independently
assessed in their application. Accounting standards are set and developed by the Accounting
Standards Board (ASB). The Government is required by the GRAA 2000 to take advice from an
independent advisory board — the Financial Reporting Advisory Board (FRAB) - on the
application, timing and introduction of these standards, and the FRAB can highlight any
departures or modifications in its annual report to Parliament.
Treatment of PFI BI8 The specific accounting treatment of the Government's PFI investments also follows UK
GAAP developed by the independent ASB. The accounting standard most applicable to PFI is
the ASB's ‘Financial Reporting Standard 5 (FRS5) — Reporting the Substance of Transactions:
Application Note F — Private Finance Initiative and other similar contracts.’ This reporting
standard is followed, supplemented by a Treasury Taskforce Technical Note (TTN1 Revised)
that sets out how Application Note F is to be followed in the public sector. TTN1 Revised
reflects extensive consultation with the ASB, the accounting profession and contractors. The
Technical Note was also approved by the FRAB.
Independent BI9 Witha few exceptions Government accounts are audited on behalf of Parliament by the
audit independent Comptroller and Auditor General (C&AG). The C&AG can qualify his audit
opinion on the accounts of any Government body if he believes either that accounting
guidance has not been properly complied with or that the accounts do not present a true and
fair view. The C&AG's most recent report — the General Report for 2001-2 — made it clear in
relation to PFI that:
“where he considers that the liabilities arising from financing arrangements are not correctly
reflected in the financial statements of the bodies that he audits he will qualify his opinion
and report to Parliament accordingly. He has not yet had the need to do so”.
Principles of PFI accounting
Property vs. B20 Accounting treatment draws a distinction between property — which may be booked as
services an asset — and services, which are accounted for as current expenditure. It is not generally
accepted practice to account for future service payments under a contract as an asset by, for
instance, capitalising their present value. The issue of importance when accounting for PFI
projects, therefore, is whether, on balance, to regard the resulting property as an asset of the
Government or to report the stream of unitary charge payments as expenditure in the year in
which they occur.
FRS5 — balance of B2I The overall principle set out in FRS 5 is that a party must account for the economic
risks substance of a transaction, rather than simply its legal form. In order to reflect this economic
reality, the financial reporting standard insists that a party that will reap the benefits and bear
the balance of risks of ownership of a property ‘has an asset of the property’ and must report
this on its balance sheet.
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ANNEX B — REPORTING AND ACCOUNTING IssuES
B22. When a property has been built through conventional procurement methods, the public
sector is almost always considered to bear the risks of ownership, and the capital invested in
that property is booked as an asset in the Government's accounts. Future maintenance and
other service charges associated with the property are, of course, not booked but expensed in
the year they are incurred and no disclosure of those likely future costs is made.
B23 PFI provides value for money to the Government by transferring the risks associated
with a capital project - risks around design, construction or ownership - to the party best able
to manage them. This transfer of risks is reflected in the terms of the PFI contract, and in the
payment of an annual unitary charge across the life of the contract with deductions made
when the property is unavailable (for instance if unfinished) or for poor performance. If, as a
result of this transfer of risks, the Government did not enjoy the potential rewards accruing
from ownership (not merely use) of the property — for example from renting out unused space
to a third party — nor did it bear the risk associated with owning the property — for example
the risk attached to the anticipated value of the property at the end of the contract term-then
it would be inaccurate for the Government to book that property as an asset.
B24 It is important to note that the risks of ownership are only a subset of the risks that may
be transferred under a PFI contract. For example, FRS 5 does not take into account whether a
party bears the risks involved with building a property. So it may be that a PFI contract
delivers value for money through transferring significant risk to the private sector, but that
the accounting principles require the public sector to score the property concerned on its
balance sheet.
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Pricewaterhouse-
Coopers study
The price of risk
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ANNEX C — PRICEWATERHOUSE-
Coopers RATE OF RETURN STUDY
COST OF PRIVATE FINANCE
ca PricewaterhouseCoopers (PwC) have published alongside this document a report
which seeks to assess the rates of return bid by private sector participants in the PFI market
since 1997, and to assess such private sector return expectations against appropriate industry
benchmarks. This report was commissioned by OGC in July 2001. A full copy of this study is
available on the web site of PwC. This Annex is a brief extract of some of the data, analysis,
and conclusions set out in this report. The study should be read in full for a clear
understanding of its analysis and conclusions.
(C2 PwC analysed 64 projects that reached financial close between 1995 and 2001, covering
a wide sample of activities, such as health, education, office accommodation, prisons,
transport, defence and water projects, but excluding IT projects. The total construction value
of the sample was £4.4 billion, representing 23 per cent of the total value of transactions
closed by the end of 2001, with the average capital value of transactions being £70 million.
C3 A PFI scheme's cost of finance is the combined cost of its debt and equity, taking
account of the proportion of equity in the scheme, usually being ten per cent of the total. The
PwC study provides data which is useful in assessing the expected overall cost of capital
which is usually referred to as the Project Internal Rate of Return (Project IRR). This is usually
equivalent to the cost to the project of the debt, equity return and tax paid thereon. As Chart
C1 illustrates, since 1995, this “all-in” cost of private finance has fallen from 13.5 per cent to
just under 10 per cent by 2001.
Chart Cl: Pre-tax project IRR analysis
18
16
§
B14
s
g 27
£
& 10
E
$8
2 R2=0.6558
6
Ce
P 9 0 9h gh 9 dP ch sh dh sh a ob of oP CAA CM cf PH SH OH SS SS Sr
FLV S EIS SoS SF
Financial Close
[—— Nominal Pre-tax Project IRR (Trendline) ——— Swap Rate (Trendline) I
C4 Typically, the private sector takes account of risk by using higher rates of return to
compensate. Whilst the Government accepts that this is a valid approach by the private
sector, and fully supports the point that the risks associated with public projects should be
properly quantified, its preference is to separately evaluate and quantify such risks. This
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Annex C — PricEwaTERHOUSECOoPERS RATE OF RETURN STUDY
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124
approach to measuring risk is set out in the Green Book and discussed more fully in Chapter
3. It is therefore inappropriate to compare a “risk free” cost of gilts with the cost of private
finance, which is set by the private sector to take account of project risks, without also
considering the benefits of the private sector's capacity to absorb risk. Box C1 cites some of
the comments in the PwC study which address this issue.
Box CI: Public versus private sector cost of capital: PwC study
“There are two common assertions made to justify the claim that the private sector cost
of capital exceeds the public sector cost of capital:
‘Governments can borrow at a risk free rate of interest’
This is not the case, there is a risk premium either way, it is just explicit in the price of
private capital. Where gilts are used, tax-payers effectively underwrite the associated risk
and the price reflects this fact. The taxpayer takes on the contigent liability, and where the
risk materialises, they carry the cost as a result. If the taxpayer were to be compensated
it would be equivalent to paying the risk premium at the point of raising the capital,
making the public and private sector’s cost of capital equivalent.
‘The government are better at diversifying the risk than the private sector’
This assertion is based on the Arrow-Lind theorem, an academic theory which assumes
that project returns can be treated as wholly independent of National income. In fact this
is rarely the case as public investment is not risk free”.
Cost of debt C5 The PwC study also analyses the specific costs of the debt finance used in PFI schemes,
which have also been improving from the public sector's perspective over the period of the
PwC study. The cost of debt comprises of the margin paid for credit risk taken, the
requirement lenders have for equity, which is reflected in cover ratio calculations, and levels
of financial gearing and front end fees. Key results of PwC's analysis are laid out below.
C6 The length of the average final maturity of debt achieved for PFI schemes has increased
to approximately 30 years, with margins declining 20-30 basis points.
Chart C2: Debt Margin Analysis
1.80
1.60
1.405
1.205
Margin
?=0.667
1.00
0.80
0.60 Zz as
iY Fi sf RS $3 oP 9?
SFL F PH MH MHI
Financial Close
14 res
SAS oe PLHP PASS
Soe FP ye
[—— Construction Margin (Trendline) Operating Margin (Trendline) I
Source: PicewaterhouseCoopers study, academic adviser Professor futon Franks.
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ANNEX C — PRicEWATERHOUSECOoPERS RATE OF RETURN STUDY
7 This improvement has been accompanied by a fall in cover ratios from 1.40 to 1.25.
Chart C3: Average debt service cover ratio
190
1805
170
1.60
150
1.40
130+
1.20
1.105
100-11 1-1
9 PP ob si ab.h dh dhs\ Do oP
Pes S89
EVE E IE FOE PIE FEV IE
Financial Close
Ratio
R2=0.0434
7=0.0245
a> I
Source: PricewoterhouseCoopers study, Academic adviser Professor juin Franks.
Minimum ADSCR (Trendline)
‘Average ADSCR (Trendline) I
C8 Gearing levels have also increased in part due to the banks’ acceptance of lower cover
ratios.
Chart C4: Gearing analysis
100%
95%
R°=0.0118
Py
3
e
Gearing Ratio
2
&
&
80%
75% ™— " " M 1 yn T H T a TT
ooh RAMEE ESA LE ons
SESE A ew AO eS
Financial Close
Gearing (Trendline)
Source: PricewaterhouseCoopers study, Acaclemic adviser Professor julian Franks.
Cost of equity C9 PwC, based on a small number of projects sampled, assess that the nominal equity
return bid over the period of the study has declined from over 15 per cent to circa 13.5 per
cent, with the average value across the sample analysed being 14.5 per cent per annum.
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Core analysis ClO The PwC study takes the returns that the private sector expected to make when bidding
for the PFI contract as the key benchmark for its calculations. PwC focus on the nominal,
post-tax, Project IRR as projected in the cashflow forecasts prepared by the private sector at
financial close of the project. The Project IRRs compared with its calculation of the Weighted
Average Cost of Capital (WACC) for each project.
Cll This WACC is calculated as the return that “should” be expected from a project by a
diversified investor, taking account of the project's risk, calculated in accordance with the
Capital Asset Pricing Model (CAPM) used in conventional corporate finance theory. Using
CAPM, it is possible to derive an appropriate cost of equity for a project and, by adding the
cost of debt for each individual project, produce a rate of return equivalent to the WACC. This
approach is possible provided an appropriate benchmark is established for the type of project
and risks taken by the equity investor. The study suggests that the most appropriate
benchmark to use for the WACC is the regulated utility sector. Further assumptions used in
the study are the risk free rate of return, being the long term government bond yield, and the
equity market risk premium, which is assumed to be 5 per cent.
Cl2_ There are certain aspects of the study which need to be carefully considered in
interpreting its results as the future experience of investors may differ in practice from that
posited in the report. The PwC study:
* looks at “ex ante” results. This is the rate of return bid by the private sector
participants, not the returns actually received from their PFI projects. As yet,
insufficient data is available to either private sector participants or observers
on the returns actually achieved over 15-30 year contracts to estimate whether
the rate of return bid is likely to be matched by the actual outturn;
is compares bid returns with a calculation of WACC using the CAPM, which uses
various assumptions and benchmarks which may not prove an accurate
benchmark for PFI's real risks; and
* uses the water and gas utilities sector as a benchmark, citing this as a
comparable sector. This analysis of the relative riskiness of a PFI project to a
regulated utility may not be shared by all private sector participants in the PFI
market and may not be a true estimate of PFI's riskiness.
CI3_ The conclusions set out in the PwC study are set out in Box C2, but in summary, the PwC.
study calculates that taking account of various factors, the rate of return bid seems to be 1.7
per cent p.a. above what one would expect, given the benchmarks used. The report shows this
conclusion can vary given small changes in some key assumptions, one being the effect of bid
costs on bidders behaviour.
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ANNEX C — PRicEWATERHOUSECOoPERS RATE OF RETURN STUDY
Box C2: Conclusions of PricewaterhouseCoopers study
° “The average spread between the project IRR and benchmark WACCs has been
some 2.4 per cent in total;
* on our assumptions about unsuccessful bid costs this reduces to between I.1 per
cent and 1.7 per cent - say 1.4 per cent. To the extent that the assumptions on bid
costs are changed it affects conclusions on the allocation of the spread but not the
total figure of 2.4 per cent;
* some 0.7 per cent of the spread is explained by swap costs;
° after considering other factors, we believe the other 0.7 per cent indicates excess
projected returns to investors, and that this is due to structure issues that limit
competition in the PFI market;
© bidders’ target equity returns average 14.5 per cent over the period before
adjustment for bid costs, whereas the cost of equity implied by a traditional WACC
calculation is in the range 8.3 per cent - 9.4 per cent depending on the assumptions
used;
© there is some evidence that spreads were increasing until 1998 but that since then
this has reversed;
© changes in the general capital market environment - such as declining interest
rates and margins — have been reflected in PFI financings to the benefit of the
public sector; and
© we expect the trend towards reduced returns to continue. The effects of steps
already taken to standardise processes and share market information have not yet
been fully reflected in closed deals because of the length of the procurement
process.”
Cl4_ The PwC study identifies certain features of PFI which could give rise to such a spread:
e the risks of political intervention given the novel nature of this form of
contract, the long term nature of the commitment and perception of political
risk;
© corporate investors may use corporate hurdle rates, based on for their core
business on pricing their investors, which in PwC's view will nearly always be
higher than is appropriate for PFI projects;
. returns may be influenced by the requirements of debt funders and their cover
ratio requirements;
© long periods of negotiation which result in financing terms being agreed early,
but closed at a later date after financial markets have moved favourably.
Policy CI5 The PwC study represents a useful contribution to the debate about the costs of private
ions sector finance. It points out the importance of taking account of risk in comprising public
private finance costings, the reduction in the cost of private sector finance over time and a
number of factors which may keep bid returns higher than ideal.
Cl6 However, it remains to be seen whether in practice the outturn returns achieved of PFI
schemes match the rates of return bid at their inception. It will take time for more evidence
to emerge before a judgement can be made about whether:
© the risks of PFI Special Purpose Vehicles (SPVs) match those of regulated
utilities; and
¢ the actual returns achieved differ significantly from those bid.
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Future actions CI7 There are, however, a number of important findings of the PwC study which suggest
further evaluation:
e the costs of hedging interest rate risk may be high - see Chapter 9 for
proposals to review this;
*® the connection between bid costs and equity returns reinforces the need to
improve the procurement costs of PFI; and
¢ the actual outturns of PFI schemes should be regularly assessed (see
Chapter 8).
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