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Managing the PFI legacy

A year on from the government's tentative announcement regarding a reinvigoration of the PFI project pipeline, Labour promised to undertake a review of all PFI contracts and look to bring some "in house" if voted into power. Although this has not yet been adopted as official Labour policy, these statements continue to place the value of PFI/PPP in the limelight. And now, of course, the market has the collapse of Carillion to consider.

The recent comments also frame a wider issue regarding the impact of austerity on the PFI market. With more than 700 current PFI projects in the UK, many having more than 20 years left to run, public authorities and contractors are slowly being drawn together towards challenging and potentially costly negotiations. The management of the PFI legacy therefore remains a continuing challenge for both public and private sector partners and, given recent events, scrutiny will continue to be applied to achieving value for money whilst preventing any perception that the private sector is profiteering in a manner which puts the continuity/viability of public services at risk.

Value for Money

The National Audit Office has yesterday, 18 January 2018, delivered its report on the cost-benefit of PFI, including a report on managing and making savings from legacy PFI and an analysis of the changes under the “new” (largely untested) PF2 model. The findings of that report are not the key subject of this article.

Even prior to the report, recent headlines on PFI in the UK have naturally focussed on the continuing perception that PFI projects deliver poor value for money.

The impact of austerity has required local authorities to consider an increasing variety of methods to achieve cost savings (and enhanced value for money) under their PFI projects, thereby sharing this pressure with private partners.

These can be achieved through a number of forms, including those discussed below.

Refinancing

The traditional approach to achieving savings was to assess the refinancing mechanics of the project agreement and require the contractor to go out to the bank market and seek terms for replacement financing of the original project finance bank debt.

More recently, authorities are considering more innovative options, such as directly purchasing the whole of the debt from the original lender group; purchasing some of the original bank debt and becoming a lender alongside the other project finance lenders to the project; enabling the project company to prepay the original debt and putting in place new loan terms directly from the local authority to the project company; or enabling the project company to prepay the original debt and reducing the unitary charge as a result.

These options, however, must be considered carefully against the backdrop of the project's financing and general document structure. Issues to be considered could include the cost of terminating the interest rate swaps; trying to ensure that any Public Works Loan Board funding terms are back to back with the main financing structure; benefits of "accountability" of a typical project finance funding structure; consideration of risk allocation between public and private sector; and PFI credit promissory note controls.

Payment Mechanisms

Payment mechanisms rarely make direct provision for cost savings, beyond "best value" type provisions, leading to the aggressive application of performance frameworks in some instances. While this approach has worked in some instances, there are pitfalls – some authorities have found themselves engaged in legal action where they have applied the payment mechanism too aggressively.

Variations

PFI/PPP projects are inflexible, but variations may need to happen with regularity to take account of changes that arise over time in a 20-30 year contract. Moreover, reducing the scope of services (or changing risk allocations) through a variation is one way of achieving the substantial cost savings sought by both local authorities and central government (even though the private sector will often seek to protect its profit margin). Local Partnerships has suggested that local authorities should renegotiate the terms of each project every 5-7 years (to achieve savings). Local Partnerships has also set up "savings programmes" (for example, the Waste Operational Savings Programme, or WOSP) aimed at working closely with local authorities to identify and implement savings in their projects. Examples of areas that could be re-negotiated include:

  • Increasing occupancy of joint service centres / office accommodation
  • Reducing the frequency of non-essential services
  • Utility savings through introducing new technologies
  • Negotiating lower margins

However, implementing variations of this nature can be complex, and for large variations the process of contract closure can almost be as involved and time consuming as the original financial close. Furthermore, close attention needs to be paid to ensuring that procurement rules are not breached.

Benchmarking/Market Testing

What looks like a simple exercise in the Project Agreement can cause significant problems on operational projects. The timetables for carrying out these exercises can be too tight, and the scope for disputes is extensive.  In some cases these exercises can lead to a full scale variation if the procuring authority considers the services have become too expensive and de-scoping is required. However, as the NAO Report notes, public sector bodies should carefully scrutinise these processes to ensure fairness and transparency is achieved.

Early Termination or Expiry

Early termination of a project is, in most instances, what all parties seek to avoid. While it can often be prevented through careful management and negotiation, in some instances it will be an inevitable outcome of a local authority's needs and/or strategy. Careful consideration will need to be given to the termination compensation mechanics in the project agreement, the potential termination triggers (e.g. Contractor Default or Authority Voluntary Termination) and the processes that must be followed for termination.

Furthermore, some of the early PFI contracts are now approaching their natural expiry dates, and consideration needs to be given to handback of the assets.

In most cases, parties need to be well prepared to ensure the continuity of the underlying services.

Disputes

The difficulties presented by disputes between the parties are heightened by the contractual structure of the standard PFI model.  Various levels of SPVs, contractors and subcontractors will be contracted to provide different services, all of which will be necessary for the efficient running of the project. Disputes can arise at every level of this project structure, meaning that a party will need to consider the position of a range of stakeholders to properly develop its negotiating position. Given the PFI structure lends itself to flow down of liabilities, the "pinch point" is often at the end of the contractual chain with the project company's subcontractors. For the procuring parties it is tempting to leave the subcontractors to resolve matters between themselves, but this can have unintended consequences that then threaten the operational functioning of the project itself.

Summary

The inevitable and essential drive for greater efficiency and value from existing PFI/PPP projects will require careful planning and implementation by all parties involved to ensure the delivery of the true savings required whilst maintaining essential national infrastructure.


The new PF2 contract is deliberately more stream-lined than its predecessor around its scope of operational services and risk allocation with a view to achieving cheaper PFI contracts.

Paragraph 2.14 of https://www.nao.org.uk/wp-content/uploads/2018/01/PFI-and-PF2.pdf

 

 

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