Operis welcomes the news that the UK government intends to reexplore the use of public-private partnerships to bring forward and expand the development of the key infrastructure on which we all rely.
Our team has a huge range of experience in financial modelling for PFI/PPP projects. This is true both historically in the UK, and currently abroad (particularly in Canada. where they continue to be a popular and successful way to procure infrastructure).
With sound incentive structuring a PFI project gives good value for money to the taxpayer and allows risks to be allocated to the party best able to manage them. As we await further news on what this new programme will look like, here are some of the commercial decisions facing the UK government:
Pay Now Or Pay Later
PFIs can be used to spread the cost of an asset over the period that they are used. We commonly see this done through a unitary charge paid throughout the project’s operational life. It’s also possible to have DBF (design build finance) projects which essentially allow the government to purchase the assets off the private sector for a pre-agreed price once they are built and ready to go. This DBF structure still provides the benefit of risk transfer. It needn’t be either/or, we see many projects whose revenue is structured through a mix of construction milestone payments and unitary charge payments.
One way or another the taxpayer will pay for new infrastructure, but the PFI structure gives the government the ability to decide when and how is most appropriate to pay for any given project.
Does One Size Fit All?
Historically, the UK only used PFI for DBFO (design build finance operate) projects. Perhaps it is time to rethink that? Relatively simple social infrastructure projects such as schools are different from large, complex hospitals or waste processing facilities, which are also very different from transports projects.
Bidders need some level of certainty and clarity of the model to be used and they need a reliable, known pipeline so it is not practical to apply different models for every transaction as there are economies of scale to be gained from applying the same one repeatedly. However, Canada has shown that you can employ variants of the model to suit project needs better.
Should DBFOs remain the default or are there instances where it makes sense to stop at the DBF point for reasons other than those mentioned under 1 above, or is there yet another, better way to do it?
Time = Money
A key element of when the government chooses to pay is the fact that a pound today is worth more than a pound tomorrow (because of the time value of money). The government will need to decide how it defines value for money. In this it will need to consider the discount rate used to calculate the overall cost of a proposal (i.e. how much it values paying later over paying earlier).
Another consideration is how much to tie any unitary charge revenues to inflation. As the revenues must cover the same costs either way a flat (non-inflated) unitary charge results in higher costs in earlier years (and lower costs in later years) compared to an inflated one.
How Firm Is This Price?
PFI projects look to ensure value for money by going through a competitive tendering process – i.e. several consortia submit a bid and the one with the most attractive offer is appointed. However, under the old UK regime, changes could be made that would affect the price between bid stage and financial close (to give an example from our industry, if the model audit picked up any mistakes in the model after bid stage then these could be rectified).
By contrast, in Canada, bids are committed. Often the only modelling change that is permitted between bid and financial close is to update for the swap rate agreed at close. This means that the final price is set using the same methodology that was deemed to be the competitive winner. To ensure companies are incentivised to spend the time necessary to prepare a fully committed bid, the winning bidder must pay a pre-determined amount of compensation to the losing bidders. This is a fixed cost which is known upfront and viewed as the cost of procuring the project but something akin to it is necessary as preparing and submitting well thought-out bids takes time and effort so at least partially compensating bidders for that cost helps encourage companies to put in that time and effort.
Why are committed bids better? Firstly, the time from selecting a bidder to closing the project and commencing work is much shorter but, more importantly, it increases transparency which, in turn, increases trust in the process and ensures the projects have good public support and are more politically palatable.
The Carrot = Upside Sharing
For a DBFO project the revenue paid by government covers all the project’s costs anticipated at financial close (construction, operating and financing). However, over time as base rates move it may become possible to achieve cheaper debt with a refinancing.
The government can ensure it shares in any upside realised here by including mechanisms such as a refinancing gainshare in the agreement with the project company. If the project’s financing costs do go down these reduce the future revenues the government needs to pay to the project (whilst still leaving enough benefit to the project company that they are motivated to refinance).
The Stick – Performance Penalties
The success of a piece of infrastructure depends on how well it is operated. If it is a hospital, is it clean and is the equipment kept in good condition? It if is a road, is it well maintained, or pothole ridden? If it is a waste processing facility, is it able to accept as many tonnes of waste as promised?
The key benefit of project finance is risk transfer, and the risk of poor operations must be contractually transferred to the private operator. Clear and fair revenue consequences to poor performance may be implemented through a performance penalty structure.
Operis looks forward to hearing more about the projects that the UK government is planning and the commercial decisions made.
