Director and Head of Advisory, Erwan Fournis looks overseas to assess how optimising the PPP model can offer attractive procurement alternatives for UK infrastructure.
The UK Government recently announced a new 10-year programme to repair and upgrade schools across the country. The School Rebuilding Programme’s (“SRP”) £1.8bn overall commitment includes a £1bn first round, which will encompass 50 school rebuilding projects plus 21 new free schools.
Already severe social and regional inequalities in educational opportunities have been aggravated by the pandemic and necessary distance learning. In this context, the commitment to build new schools, or indeed rebuild and upgrade existing ones, is to be welcomed. As children from disadvantaged backgrounds have suffered disproportionately more from the lack of classroom teaching, the State should devote significant efforts towards improving these children’s educational attainment. For the current Government, it also fits squarely within the “levelling up” agenda.
The Programme will, however, be only one of many calls on the public purse as the Country embarks on its economic recovery, hopefully soon, thanks to the initial success of the vaccination programme. But how can infrastructure assets, such as the SRP, best be procured to maximise their impact, ideally without draining the public finances and so leaving them accessible to other areas of economic support?
It is worth briefly addressing the argument that since interest rates are always lower for a government than the private sector can command, it always looks cheaper for the government to borrow and do its own, direct procurement. With interest rates as low as they are now and a seemingly reduced anxiety about the level of public debt, particularly post Covid, one rationale for Public-Private Partnerships (“PPP”), i.e. the ability to keep the liability off the country’s balance sheet, has become less relevant. Other benefits of privately financed procurement models are worth maintaining, though, especially at a time of vast liquidity flowing into the infrastructure and energy sector. This warrants an objective discussion about procurement models best suited to different public asset types.
For some time, public debate around the procurement model to succeed PFI/PF2 has typically provided incomplete answers, for instance citing contracts for difference (“CfD”) as an example of tools in favour within Whitehall. Other alternative models such as the bespoke arrangement used for Tideway (London’s new “super-sewer”), or more generally regulated asset base models, are also often part of these discussions. However, it is questionable that those models would be relevant for assets that cannot be user-funded. Tideway is also a highly complex structure that is prima facie ill-suited for a simple asset like a schools’ bundle.
PPPs were once the go-to procurement tool for public assets such as schools in the UK. It is important to take note that they are still part of the procurement toolbox in countries like Ireland, Canada, Australia and Belgium, with live education procurement processes in all of them. Back home, devolved nations have sought to fine tune the model to their benefit rather than “ban” it altogether: some of these adjustments are discussed and analysed later. In England too, the model continues to be used sporadically, with the Surrey County Council reported to be considering procuring another elderly care scheme on a design, build, finance and operate (“DBFO”) basis.
To assess how the model could be revamped, let’s start by recollecting some the perceived shortcomings: lack of flexibility, high annual cost and excessive profit by the private sector.
Before I turn to these, let’s address the current favourite poster children for failure that are often cited: two infamous Carillion-sponsored PFI contracts, which were terminated after the British contractor’s demise, are often used as example of a flawed procurement model. Doing so dismisses two important realities.
The first one is that a traditional procurement would not have avoided some of the outcomes for the respective NHS Trusts: unexpected risks during construction would have equally emerged and increased the final bill, and construction defects would also likely have characterised the craftsmanship of a contractor on a slippery slope towards bankruptcy. In contrast, involving private sector capital did produce significant benefit: by compensating the Royal Liverpool Hospital’s and Midland Metropolitan Hospital’s senior creditors at a rate of only 18p/£ and 0p/£ respectively, shareholders losing all their initial investment, the two NHS Trusts have been estimated to save c. 30% on the revised estimates to build and run[i].
The second reality often skipped over, is that for each of these two unfortunate projects, there are many operational PFIs that have been built and operated by Carillion, and whose shareholders have succeeded in substituting the facilities managers, maintaining the service delivery and proving the robustness of the model under extreme stress. If a proof of concept was ever needed…
So how should we understand the shortcoming of PPPs in order to find solutions and improve the model?
First, the lack of flexibility is inherent to the tight monitoring requirement of the senior creditors in any project finance. It is the flip side of a 90% gearing that few other sectors lend themselves to. This means in theory that changes to the scope of the asset or the services by either the authority or the facilities manager need to be subject to creditors’ consent. In practice, few portfolio managers are really interested in being approached for routine changes and some flexibility can be enshrined in the funding documents. In my own experience as a former director on the board of project companies, when the relationship on the ground between stakeholders is good and cooperative, these changes are agreed very smoothly and are welcome, as they are typically proposed with the benefit of the users in mind rather than driven by short-term profit. Notwithstanding what can be a symbiotic relationship between stakeholders, the inclusion of facilities management (“FM”) in the scope of the project agreement is not a pre-requisite to the successful application of the PPP model. Some projects in the UK were already limited to hard FM only. Canada’s Design-Build-Finance model goes one step further: it leaves all FM services out and yet draws from the other benefits of the PPP model: construction risk transfer, and private sector discipline and efficiencies, among others. Moving away from the whole-life pricing approach of DBFM results in a reduced risk transfer, since lifecycle risk stays with the public sector. This could arguably have the perverse effect of incentivising a race to the bottom and favouring corner-cutting by contractors during the tender process. Another benefit from DBFM is also lost: the DBFM strict maintenance regime ensures a high level of condition of the asset (including after hand-back), which may not be the case if the asset is managed by budget-constrained authorities.
This is not dissimilar to direct procurement though, and boils down to the State’s views of the economic and social benefits of well-maintained public sector assets.
Secondly, the PFIs’ high annual cost can result from multiple factors: risk transfer (and the resulting contingency priced in by the party assuming the risk) and cost of capital are two critical ones, gold-plating is another.
There are limited benefits to comparing the annual cost of an early vintage contract compared to a later one, but the two factors above have undoubtedly combined to reduce the cost of PFIs as the industry matured and risks have become better understood by all stakeholders Excessive risk transfer unfortunately led to tragic consequences for the contracting world and a wholesale rejection by many of the fixed-price, date-certain contracting model, essential to any project financing’s bankability. It seems that an unintended consequence of the public sector pushing the risk transfer to take advantage of a “buyer’s market” has been to drain the market of a lot of potential suppliers, reducing the range of suppliers to select from and ultimately resulting in a less efficient market.
One way to reduce the annual cost of PPPs that is commonly used in Canada, the Netherlands and Norway, among others, are milestone or completion payments. By reducing the quantum of long-term financing at construction completion, it allows a procuring authority to reduce its annual financial burden without forsaking the principle of pay-when-built of PPPs. This is clearly a shift from revenue-funded infrastructure to capital-funded infrastructure, but so is traditional procurement. In contrast to the latter, such hybrid financing structures achieve the effective transfer of construction risk, with all the associated benefits of the detailed due diligence required by financiers. Based on Operis’ estimates, the annual unitary charge reduces by c. 30% for a milestone payment equivalent to 50% of the contract sum (with 6% change for every 10% increment or reduction either side). Market appetite in those countries proves that it does not deter finance professionals from the sector and may even renew banks’ appetite for PPPs. We know that many people don’t like bankers, but the more funding institutions come to the negotiation table, the more competitive the funding terms are likely to be, which helps the cost of the projects.
After much evidence of the razor-thin margins of construction or facilities management contracts (see Carillion!), one can be excused for assuming that excessive profiteering is a critique mainly targeted at contractors selling their original equity investment or refinancing the senior debt of the project. The latter category was addressed by ever tighter gain sharing mechanisms. To an extent, it has ended up disincentivising the shareholders by reducing the benefit they would derive from an exercise that proves invariably painstakingly slow and resource intensive, with often difficult negotiations with the authority who may have other priorities, including budgetary ones.
The profit generated on the sale of an equity investment, after the project has been built and the investment has been de-risked, should be well accepted in a market-based economy like the UK. The fact that it is “on the back” of the taxpayer makes it more problematic; shrinking entry IRRs on greenfield PPPs as the industry matured helped improve this dynamic to an extent, since the project-life return on capital had become increasingly tighter. The profit made by contractors on their equity disposals was also undoubtedly helping them price their construction contract more keenly, which reduced the ultimate cost to the taxpayer.
One innovation the Building Schools for the Future programme achieved was to allow the taxpayer to benefit directly from these market-based dynamics via the public sector shareholder (BSFi, a dedicated investment vehicle). The MIM model has maintained this principle. Beyond a few governance issues that can easily be addressed, a key concern during the early consultation on MIM was government reluctance to squeeze out private sector (i.e. financial) equity by reducing the total equity ticket, in particular on the schools project included in the early MIM programme. But, should government be concerned if fund managers decide that they cannot afford to allocate resources to a school procurement programme because they cannot wait two years to know if they can deploy less than £10m? In contrast, the public sector investing equity alongside the contractors creates highly attractive options for the public sector shareholder: either keep the investment for the long haul to maintain oversight, or join in on the profit-taking at construction completion and cash in on investors’ appetite that remains unabated, as demonstrated by the multiples paid by investors on recent secondary market transactions. The new Infrastructure Bank would be an ideal vehicle to take such equity stakes, since it would be resourced and equipped to perform the required due diligence and negotiations on behalf of the public shareholder. Local authority pension funds are also natural stakeholders, especially, but not only, when a project is in their locality.
The Government is facing tough choices in the coming years. An informed use of private sector expertise and capital can contribute positively to the procurement of new schools that are so badly needed by those most affected by years of austerity only made worse by the pandemic. This could be achieved by revamping the PPP model and resorting to milestone payments, selective outsourcing of facilities management and public sector equity. In assessing each of these school projects, maximising outcomes will require pragmatism rather than dogmatism.
[i] Investigation into the rescue of Carillion’s PFI hospital contracts, National Audit Office, 14 January 2020
This article was first published on Partnerships Bulletin’s website.