FAIR FUNDING IN PFI & PPP?

27 January 2012

Martin Corbett has been involved in PPP/PFI projects for nearly 20 years. Over that period the PPP/PFI procurement model has delivered around 700 new facilities across the UK. At a time when government is reforming PFI to give long term value for money to the taxpayer, and to make the model more flexible and transparent, Corbett provides his views.

Public Private Partnerships (PPP) are arrangements, which are typified by joint working between the public and private sector. In the broadest sense, PPPs can cover all types of collaboration across the interface between the public and private sectors to deliver policies, services and infrastructure. Where delivery of public services involves private sector investment in infrastructure, the most common form of PPP is the Private Finance Initiative (PFI).

PFIs are owned outright by a Special Purpose Vehicle (SPV), which normally comprises private equity/sub-debt providers and bank funding (senior funding). PPP can also comprise an SPV with similar funding arrangements, however they are normally jointly owned by the private and public sector. Examples of PPP models include BSF - Building Schools for the Future (which included some PFI schools) and LIFT - Local Improvement Finance Trust.

With both PFI and PPP a private sector consortia are responsible for ‘design, build, finance and operate’, however Corbett says in the industry PFI isn’t generally treated as a sub-category of PPP, but that the two are viewed as two different procurement models, which are subtly different in respect to ownership, type of project and the risk profile around the payment mechanisms.

Government austerity measures
With the austerity measures introduced over the last year or so by central government departments and local councils, such Authorities are looking at all ways to raise revenue, including making deductions against operational PFI/PPP contracts.

Some Authorities are taking an aggressive stance to developing this as an ‘income stream’ fuelled by the bad press against PFI. This doesn’t however impact on the SPV who operate the concession and who make returns of 14 per cent IRR and upwards, as the SPV pass down most of the risks to the FM contractor, who takes all of the deduction risk.

Corbett said: “I know a few FM colleagues who are responsible for PFI schemes within their companies and they say that it is now a full time job for them to minimise the deductions, which Authorities are trying to levy.”

This has become a bit ‘cat and mouse’ with the Authority wielding a big stick and spending all their time on the interpretation of the payment mechanism, instead of focusing on what is important such as working together to generate efficiencies with the customers and improving the service to pupils and patients.

There is also currently a backlash from the coalition against PFI on the back of the recent Treasury Select Committee report.

PFI funding for new infrastructure, such as schools and hospitals, does not provide taxpayers with good value for money and stricter criteria should be introduced to govern its use, the Treasury Select Committee has concluded in a new report published on 19 August 2011.
Andrew Tyrie of the Treasury Select Committee explained why tax payers are being "ripped off" by PFI schemes. "We can’t carry on as we are, expecting the next generation of taxpayers to pick up the tab. PFI should only be used where we can show clear benefits for the taxpayer. We must first acknowledge we’ve got a problem. This will be tough in the short term but it should benefit the economy and public finances in the longer term,” he said.

On the 15 November 2011 the Government’s intention to reform the Private Finance Initiative (PFI) was announced by the Chancellor who said: “We have consistently voiced concerns about the misuse of PFI in the past and we have already taken steps to reduce costs and improve transparency. But the review I have announced today will take this a step further with a fundamental reassessment of PFI. We want a new delivery model which draws on private sector innovation, but at a lower cost to the taxpayer and with better value for public services.”

The Government’s approach to reform the PFI model will look to create a model which is cheaper, accesses a wider range of private sector financing sources and strikes a better balance of risk between the private and the public sectors.

The review will create a model which:
 is less expensive and that uses private sector innovation to deliver services more cost effectively;
 can access a wider range of financing sources, including encouraging a stronger role to be played by pension fund investment;
 strikes a better balance between risk and reward to the private sector;
 has greater flexibility to accommodate changing public service needs over time;
 maintains the incentive on the private sector to deliver capital projects to time and to budget, and to take performance risk on the delivery of services;
 delivers an accelerated and cheaper procurement process; and
 gives greater financial transparency at all levels of the project, so that the public sector is confident that it is getting what it paid for, and that the taxpayer is sure it is getting a fair deal now and over the longer term.

The Government believes private sector innovation and skills can and should play a strong role in improving the delivery of public sector assets and services. At the same time, as financing markets change and develop in response to changing financial regulation and a changing global economy, the Government must ensure that if private finance is used to deliver public sector assets and services, that they access wider financing sources; and that the costs of private finance are more than offset by the wider benefits of private sector delivery.

Payment mechanism
Corbett believes from his own experience that the type of model and the payment mechanisms drives behaviours. Consultants often think that an aggressive and penalistic payment mechanism will keep the FM Contractor in check. Corbett believes that such mechanisms may be detrimental as the parties become adversarial. He believes that a more balanced mechanism helps to engender a partnership approach.

This is evidenced above as Authorities, frustrated with the inflexibility of the PFI model, punish the FM Contractor as a means to try to rectify the flaws in the model. On the other hand at SPV level, there is no incentive to drive forward any efficiency or improvements and any changes introduced by the Authority mean an opportunity to increase returns.

There appear to be two types of payment mechanisms: those used in the PFI model generally for schools, hospitals, prisons etc where there is a unitary charge and where the authority pays across this to the SPV every month and deducts any unavailability and performance deductions; on PFI there are area unavailability deductions when an area is not available and performance deductions when a service is not being provided. Where the deductions reach a certain threshold this leads to the issue of Fault Warnings and eventually termination of the FM contract as the deductions continue to escalate.

Alternatively on PPP models such as student accommodation, where an area/facility is not available, the SPV are responsible for providing an alternative room/facility. In respect of performance, where there is an unacceptable level of rooms that become unavailable or where there are ongoing performance issues, there is an escalation mechanism in the payment mechanism, whereby the FM Contractor has to increase resources and the SPV can ‘step in’ to carry out the service, eventually leading to termination and replacement of the FM Contractor against a number of Fault Warnings relating to ongoing or serious failures.

Corbett says the latter PPP model is more flexible and engenders partnership as opposed to being adversarial. Derwent operate on a large student accommodation contract at Aston University as the FM Contractor and a Trustee of the vehicle. He says at Aston, the focus is very much on how to improve the student experience, with the payment mechanism put on the shelf. We have just finished the intake and this is a time where our respective teams (Derwent FM and Aston University) work together seamlessly to make this process enjoyable for the students, many of whom are away from home for the first time.

Conclusions
Corbett believes there are a number of areas that the Government needs to re-consider as part of its review of PFI schemes if they are to be a success and get value for money for taxpayers going forward.

He believes that PPP with its more flexible payment mechanism is intrinsically a more beneficial model as it is likely to improve the partnership approach and provide value for money as there is less pricing of risk. On the other hand, PFI with its strict payment mechanisms can lead to a more expensive, inflexible and mechanistic approach.

The focus has certainly shifted to best utilisation of the money available and this will inevitably mean more refurbishment of existing stock. The Big School Makeover (www.bigschoolmakeover.org.uk) already supports this shift of emphasis towards getting the maximum impact for the least money. This can only however be achieved by the Authority allowing derogations to previously rigid specifications and payment mechanisms.

Corbett also believes that there needs to be built-in incentives to the new model for the SPV to improve efficiencies and to share the gains associated with change as opposed to benefiting disproportionately compared to the Authority in these circumstances. If the SPV declares its return in the financial model at tender stage (with administration and management charges fixed), then there is no reason why the SPV cannot share any upside with the Authority ongoing throughout the life of the concession. This will incentivise the Authority and the SPV to work together to generate efficiencies and ideas on an ongoing basis.

These are relatively simple concepts, but let’s wait and see says Corbett, as the recent Priority Schools Building Programme launched by the Department of Education doesn’t seem to have addressed these considerations yet!

Martin Corbett is managing director of Derwent FM