“PFI – UK developments and reform” – Practice note by Mathias Cheung for Lexis®PSL

This Practice Note, produced by Mathias Cheung in partnership with LexisNexis, provides comprehensive and up-to-date legal information covering:

• PFI—UK developments and reform
• The Original Private Finance Initiative Model
• The Introduction of Private Finance 2 (PF2) in 2012
• Industry reaction to the PF2 model
• The demise of the PFI/PF2 Model since 2018
• Scotland—NPD, DBFM hub and MIM
• Wales
• Northern Ireland
• Post-COVID-19 economic infrastructure strategy and support for private investment
• Global initiatives

This practice note was first published on Lexis®PSL Banking and Finance on 8th March 2021. To view the article on Lexis®PSL, please click here (login needed).

Reprinted with permission of LexisNexis, all rights reserved.

 

PFI – UK developments and reform

Public Private Partnerships (PPPs) continue to play a significant part in UK infrastructure provision, accounting for around 12% of public sector assets. However, their use in new projects has dropped off considerably.

In the 2018 Budget (delivered on 29 October 2018), it was announced that the government will no longer use PF2 on new projects (see News Analysis: Budget 2018—what does it mean for infrastructure and housebuilding?). The government has also reconfirmed in its National Infrastructure Strategy of November 2020 that it will not reintroduce the PFI/PF2 model in new infrastructure projects.

References:

Budget 2018

National Audit Office–Managing PFI assets and services as contracts end (June 2020)

However, existing PFI and PF2 projects will continue to run, and given the typical lifespan of such projects this is likely to be for many years.

The Original Private Finance Initiative Model

The PPP model known as the Private Finance Initiative (PFI), widely used and promoted by the UK Government from 1997 onwards, underwent a rapid decline in use for new projects from around 2012. Criticised by HM Treasury for its inflexibility, and widely perceived by the general public as an example of the public sector enriching private investors at the expense of service quality, PFI was no longer considered to provide value for money. PFI projects, with a single unitary charge covering build, maintenance and services, were treated for accounting purposes as a revenue item, not capital expenditure. This kept the capital costs on the balance sheet of the contractor, and as such PFI did not add to headline public sector debt. A particular criticism was that this off-balance sheet character of PFI debt was a stronger incentive to procuring authorities than overall value for money. A 2011 Treasury plan to put new PFI debt on-balance sheet almost certainly played some part in the model’s demise.

 

The Introduction of Private Finance 2 (PF2) in 2012

2012 brought the launch of a new model of PPP, backed by the Treasury and intended to fix the perceived issues with PFI. Named Private Finance 2 (PF2) it proposed a number of structural changes to PPP procurements, principally:

• co-investment by the public sector in PPP vehicles alongside the private sector
• increased equity contribution to funding, with around 75%/25% debt to equity ratio
• no soft facilities management (FM) services (services such as cleaning, waste management and security)
• more efficient delivery, with streamlined procurement processes shortening the procurement cycle to 18 months or less
• greater transparency and more stringent reporting measures
• increased flexibility in respect of service provision eg reduced number of services in PF2 contracts, and
• changes to risk allocation, with the public sector taking certain elements ‘back’ to improve value for money such as capital expenditure on unforeseeable general changes in law, off-site contamination risk where the public sector has provided the site, utilities consumption risk subject to a two year handover test and certain insurance changes

 

Industry reaction to the PF2 model

PF2 has not been widely deployed in the way PFI was. Only two English schemes have proceeded to financial close using a PF2 structure, and both have encountered issues with other stakeholders in the market:

• Phase One of the Priority Schools Building Programme (PSBP) involving the building or refurbishment of 261 schools, was procured in part as a PF2 project. Changes were required to the deal structure, including the aggregation of individual projects into batches, in order to make the opportunity attractive to investors. PSBP Phase Two, involving a further 278 schools and £6bn capital spend, is not using PF2
• the Midland Metropolitan Hospital, a new facility being built in Smethwick, West Midlands, is the sole health project procured thus far through PF2. The procurement process resulted in only a single bid, leading the procuring Trust to consider abandoning PF2 and restarting procurement

Over the period 2012–2017 the initial project pipeline for PF2 (including a defence accommodation programme and some elements of Crossrail) fell away as procuring authorities found other ways to work with the private sector. This was in spite of one of the apparent successes of PF2—the procurement cycle for PSBP schools was significantly shorter than for a Building Schools for the Future PFI school and as a consequence the procurement costs were lower. Authorities, potential funders and contractors seem to have elected to steer clear of PF2 in the absence of a secure pipeline of projects. The attitude of the market was reflected in the conclusions of HM Treasury (as expressly set out in its report to the Treasury Committee). One of the widely held concerns around PF2 (as expressed by the Centre for Health in the Public Interest in its 2014 Report) was that PF2 funding would cost more in real terms than PFI funding. An increased equity ratio generally results in higher costs of capital, and PF2 was expected to have around 25% equity, as opposed to PFI’s 10%.

 

The demise of the PFI/PF2 Model since 2018

Prior to 2018, the government position increasingly shifted toward support for PF2. The shift may be due to a fall in the costs of capital, or alternatively may be due to issues with the Non Profit Distributing (NPD) model (see below) which do not arise with PF2. In a very positive 2016 Autumn Statement the Treasury promised a PF2 project pipeline in ‘early 2017’, although this was later put on hold until after the General Election.

Following the General Election in the summer of 2017, the Infrastructure and Projects Authority announced two major projects to be procured through PF2 – the £1.3bn A303 Stonehenge Tunnel and the £1.5bn roads package for the Lower Thames Crossing. This was followed by a further announcement that a £1.3bn prison building programme may use PF2 for 4 of the sites, each of which will be valued at over £100m.

However, this was shortly followed by the insolvency and collapse of Carillion in January 2018 (see News Analysis: Carillion’s insolvency—infrastructure and construction), a major facilities management and construction company which was estimated to have had 420 public contracts at the time. This catastrophic incident prompted various investigations and inquiries including an evaluation of the government’s procurement approach.

For instance, the House of Commons Committee of Public Accounts published a report in July 2018 which identified various problems with the government’s procurement process, including poor contract specifications leading to uncertainty, delays and cost increases, lack of consistency in forms of contract, lack of sensitivity analysis and scenario planning, an emphasis on costs over quality, and a tendency to transfer too much risk to contractors.

References:

Public Accounts Committee—Strategic suppliers (July 2018)

Similarly, the Public Administration and Constitutional Affairs Committee also published a report in July 2018 which found that PFI financing cost more than conventional procurement, with no evidence of the benefits claimed by the government. The report concluded that the government should not approve any further PFI projects until they could clearly justify their claims about the benefits of the scheme, and it also made similar findings about the government’s approach to pricing and risk management in public sector projects.

References:

Public Administration and Constitutional Affairs Committee—After Carillion: Public sector outsourcing and contracting Contents (July 2018)

For more information about the inquiries and investigations in 2018 into public procurement processes, see Practice Note: Encouraging SMEs to bid for public contracts.

Therefore, in response to the mounting criticisms levelled at the PFI/PF2 model, the Chancellor finally announced in the 2018 Budget that the government will no longer be using the PFI/PF2 model for new projects. For more information on the impact of the 2018 Budget, see News Analysis: Budget 2018—what does it mean for infrastructure and housebuilding?

As at June 2020, there were over 700 operational PFI/PF2 contracts in place in the UK with a capital value over £57bn, 571 of which were PFI/PF2 projects in England. Most of the current PFI/PF2 contracts will be coming to an end from 2025, and the National Audit Office (NAO) has recommended that early preparations should be made by public authorities to ensure successful exits from these remaining PFI/PF2 contracts. For more information, see: LNB News 05/06/2020 65.

Based on the information disclosed by the NAO’s report, in June 2020, the top ten largest remaining PFI/PF2 contracts (including the £1,470m Airway project and the £1,360m Skynet 5 project) are going to end within the next ten years. With no further PFI/PF2 contracts being awarded since 2018, it is most likely that the PFI/PF2 model will become a legacy once the existing PFI/PF2 contracts come to an end, and that various newer procurement models will take its place in public sector projects. Indeed, the government has confirmed in its National Infrastructure Strategy of November 2020 that it will not reintroduce the PFI/PF2 model in new infrastructure projects.

References:

National Audit Office—Managing PFI assets and services as contracts end (June 2020)

HM Treasury—National Infrastructure Strategy (November 2020)

 

Scotland—NPD, DBFM hub and MIM

Scotland has continued to use PPP throughout the post-PFI period. Existing private finance projects in Scotland cover 136 contracts for schools, colleges, hospitals, health centres, roads, prisons and waste plants. That includes 80 PFI schemes, 41 hub schemes and 15 Non Profit Distribution (NPD) Schemes.

The various models have been introduced and modified over the years, with the latest model being the Mutual Investment Model (MIM) which is intended to replace the previous PFI, NPD and hub models:

• the NPD model has been in use since 2008. NPD caps private sector profit and prohibits payment of dividends to the shareholders of the SPV, providing some defence against the ‘private sector windfall’ reputation of PFI. However, the NPD model has suffered a series of setbacks in recent times. In 2015 the Office for National Statistics re-classified over £900m of projects procured through NPD, placing them on the Scottish Government balance sheet due to an error in interpreting the applicable EU Eurostat rules. These assets now count toward Scottish Government spending, effectively giving them almost £1bn less to spend. The general consensus was that the NPD model cannot be made compliant with Eurostat, and the EU had made clear that the core principles of NPD are not compatible with the rules. Accordingly, NPD did not appear viable for new projects without significant amendment. In a further setback, Audit Scotland announced an enquiry into the value for money of NPD, as the returns paid to funders are still significantly higher than potential alternatives (for instance financing through the Public Works Loan Board). In March 2016, the Eurostat’s Manuals on Government Deficit and Debt formally clarified the profit capping element of the NPD model and classified the model to the public sector, such that the NPD model could no longer count as additional investment and is no longer in use for new projects—the last modified NPD contract was signed in 2017, and it is unlikely to be used once the remaining NPD projects come to an end.

References:

Eurostat—Manual on Government Deficit and Debt (March 2016)

• Design, Build, Finance, Maintain (DBFM) is an internationally used PPP model, and it has in recent years been used in Scotland. In particular, DBFM has been utilised for a programme for the construction and maintenance of community assets such as schools and health centres, known generally as hub contracts. The hub DBFM standard form has required change in light of the ONS findings (in particular to the equity structure) but none of the DBFM projects audited by ONS has been re-classified as public sector. The modified DBFM continued to be used for social infrastructure projects in Scotland until May 2019, when the Scottish government announced that it would not be used for revenue projects after 2020/2021, and no further hub contracts have been signed since 2019.

References:

Scottish Government’s Medium Term Financial Strategy: May 2019

• The MIM is a Welsh form of PPP which was formally introduced to Scotland in May 2019 as a response to the classification rules which put an end to the use of NPDs for new projects, on the basis of SFT’s options appraisal in April 2019. Under the MIM scheme (which replicates many of the value for money features in the NPD and PFI models), the public sector is able to invest in up to 20% of the equity capital and share in the profit, and the private sector profit capping features are also removed. The Scottish government’s plan is to use MIM as an option for projects from 2020/2021 onwards, but Audit Scotland’s report in January 2021 cast a number of doubts on the merits of MIM, as it considered that the MIM may lead to greater risk of project losses. Audit Scotland recommended the Scottish government to set out how the MIM will operate, establish clear criteria for selecting programmes and monitoring risks, and provide more information on the costs and benefits of using private finance. In February 2021, the Scottish government announced £33bn of planned investment as part of a National Infrastructure Mission covering 2021 to 2026, and it remains to be seen whether the MIM will be a successful model as compared to its predecessors.

References:

SFT—An options appraisal to examine profit sharing finance schemes (April 2019)

Scottish Government’s Medium Term Financial Strategy: May 2019

Audit Scotland–Privately financed infrastructure investment (January 2021)

Scottish Government—A National Mission with Local Impact (February 2021)

 

Wales

The Welsh Parliament had, until the 2015 ONS findings, intended to procure its major infrastructure through an NPD model. However, since the viability of NPD had become all but extinguished Wales created a PPP model of its own – the Mutual Investment Model (MIM). MIM includes PF2 concepts such as a standard form shareholder agreement, limited FM provision by the SPV (no soft FM services) and an option for the Authority to take an equity stake.

As at July 2019, the draft standard form documents include roads, education and accommodation project agreements. A special feature of the Welsh government’s standard form documents is that they contain obligations to comply with the procuring authority’s community benefit requirements, and a failure to discharge those obligations can lead to liquidated damages. The MIM scheme also prescribes the use of Building Information Modelling protocols.

The current MIM schemes include the redevelopment of Velindre Cancer Centre in Cardiff, the completion of the dualling of the A465 from Dowlais Top to Hirwaun, and additional investment in Band B of the 21^st Century Schools Programme. Further, the Wales Infrastructure Investment Plan published in November 2019 set out a project pipeline with more than £33bn of planned infrastructure investment.

References:

Welsh Government–Mutual investment model for infrastructure investment