The media portrayal of PFI projects may be of contractors pocketing fat profits at the expense of the public purse, but in reality the risk of taking on work is rising, profits are falling and the pipeline of promised projects has yet to materialise. Is the fate of the funding mechanism up in the air?
Those working on PFI schemes - or PF2, as it was rebranded in 2012 - are used to their projects being a political punchbag. While the Conservative Party dreamed up the funding mechanism in 1991, and New Labour turbocharged it to fund a new generation of schools and hospitals after their 1997 victory, media and politicians from all parts of the political spectrum now happily line up to give it a kicking.
Alongside accusations of contractors鈥� superprofits from PFI have come reports of 拢300 charges for changing a lightbulb, horror at the interest payments for PFI buildings and huge concern over the 拢10.5bn annual cost of PFI payments on a cash-strapped public sector. It was inevitable then that last year鈥檚 revelation over construction failures at a host of Scottish PFI schools led to calls for the financing mechanism to be scrapped - despite the fact an independent inquiry didn鈥檛 find PFI was the reason for the failure.
Politically it鈥檚 very sensitive; the public don鈥檛 like the model - there鈥檚 an antipathy to PFI
Stuart Burr, Pinsent Masons
But if public outrage at PFI has become expected, revelations in recent months over how these public-private deals are working out for contractors themselves are perhaps much more surprising. Following on from the disclosure that contractor Laing O鈥橰ourke was writing off 拢93m related to a Canadian hospital PFI scheme, came the news that Carillion was taking a 拢375m hit in its UK business, which it said was primarily related to three (unnamed) PFI contracts.
And while many in the industry are still disappointed that the pipeline of PF2 projects promised by chancellor Philip Hammond last November has not yet emerged (see box 鈥淪o where鈥檚 the pipeline?鈥�), there is also evidence of a change in the industry鈥檚 attitude to it. Increasingly, the opinion in the industry is that rather than the fabled gravy train of popular perception, the public sector鈥檚 fear of being taken for a ride has put such pressure on PF2 deals that contractors are concluding it is not worth the trouble.
PFI - What is it?
PFI and its successors - PF2 in England and Wales and NPD in Scotland - are deals in which the private sector funds up front the cost of designing, building and operating new public buildings, with the costs paid back over time - commonly 30 years - via an annual unitary charge. Critics say it doesn鈥檛 offer value for money because the private consortiums delivering PFI projects borrow money at a much higher rate than the public sector, and take large profits in return for their risk. Defenders say it enables the public sector to pay for infrastructure without incurring additional borrowing.
Fat margins
It is not hard to see why accusations of contractor profiteering on PFI projects were made. When the financing was first used, contractors priced in margins fat enough to make them comfortable with the novelty of the system and the risks attached to operational performance over 30 years.
This was not surprising, given that construction contracts sitting under PFI vehicles commonly include heavy penalties for delays to the programme. Stuart Burr, partner in the projects group at law firm Pinsent Masons, says these can add up to millions of pounds a month in the largest schemes, and mean a large degree of risk transfer to the contractor.
Mike Peasland, former UK chief executive of Balfour Beatty Construction Services, says: 鈥淟ike any new contract style, people are a bit nervous at first and put in bigger margins. Commonly, contractors would make a 15% margin and then add a risk premium on top, meaning total return could be 20%.鈥�
However, the way deals were structured also meant problems were much less likely than on traditional contracts. Alastair Stewart, analyst at Stockdale Securities, says: 鈥淪tandard PFI new-build is simply not meant to go wrong. Everything should be designed to the nth degree in the preferred bidder stage with back-to-back fixed price supply chain agreements.鈥�
Mark Baxter, managing director of investments at contractor Galliford Try, says: 鈥淭he perception at first was of the big bad contractor walking off with a sack-load of money, pricing in risks that didn鈥檛 manifest themselves.鈥�
Pinsent Masons鈥� Burr says this has fed into its political unpopularity. 鈥淭here鈥檚 a general view of concern about complex projects taking ages to come through. Politically it鈥檚 very sensitive; the public don鈥檛 like the model - there鈥檚 an antipathy to PFI.鈥� From the height of PFI use in the early 2000s, when more than 60 deals were being signed every year, just six PF2 schemes have been signed since the revamp was launched in 2012.
But they remained popular with the industry. With builders both contracted by the special purpose vehicles set up to deliver these projects and being an investor in them, they got a double benefit when lucrative building contracts delivered buildings that became solid investments yielding good returns. Hence in the summer of 2014, when contracting giant Balfour Beatty was in the depths of financial woes brought on by dozens of failing contracts, it was largely the 拢1bn value of its portfolio of operational PPP projects that enabled it to keep the wolf from the door, giving it the balance sheet strength to absorb repeated profit warnings cumulatively worth hundreds of millions of pounds.
But fast forward three years and the situation is flipped on its head. Carillion - ironically the firm trying to buy Balfour back in 2014 - is now in trouble, in large part because of problems on three PPP contracts responsible for more than half of last month鈥檚 拢375m UK writedown.
Heavy penalties
So how has this happened? Peasland says: 鈥淎s the market matured then naturally it became more commoditised as contractors got more comfortable. The government side also got more attuned to the wrinkles in the contracts.鈥� As a result, he says, margins are down to more like 7% including risk - which leaves little room for error if problems arise. But rather than just correcting earlier high profits, Burr says there has been a 鈥渞ace to the bottom鈥� in terms of pricing.
Galliford Try鈥檚 Baxter says: 鈥淭he pendulum has swung too far away from the contractor. These recent jobs have obviously got too much risk in them. While the man in the street thinks the private sector has the government over a barrel on PF2, the reality is now the other way round.鈥�
However, the new contract form following the coalition government鈥檚 revamp of PFI in 2012 is not seen as responsible for the problem. Mark Elsey, partner at law firm Ashurst, says the wider issue has been primarily commercial: 鈥淭here has been some very aggressive construction pricing with resultant financial hits for some of those companies. And we can see that those who say there is no risk transfer in PFI are clearly wrong.鈥�
Of the three projects widely suspected as being behind Carillion鈥檚 recent woes, only one - the 拢430m Midland Metropolitan hospital scheme - is a PF2 deal, with one other being a Scottish roads PPP and one other - the 拢335m Royal Liverpool hospital - being a classic PFI project.
So where鈥檚 the pipeline?
Since the 2012 revamp, which saw the replacement of PFI with PF2 in England and Wales, only six PF2 projects have been signed: five batches of the Priority School 好色先生TV Programme, and the Midland Metropolitan Hospital. Together, they have a capital value of 拢1bn.
In his Autumn Statement last year, chancellor Philip Hammond promised to develop a pipeline of PF2 projects to be published in 鈥渆arly 2017鈥�. The industry was briefed to expect PF2 to be used to fund hospitals, schools, prisons and Ministry of Defence estate redevelopment, plus a few other large projects, and that it would update the PF2 standard contract set (called SoPC - standardisation of PF2 contracts).
However, while the 拢6bn Lower Thames Crossing and the 拢1.4bn A303 Stonehenge tunnel are progressing, no pipeline has been published and the only other sign of progress has been publication by Calderdale and Huddersfield NHS Foundation Trust of a business case for a 拢300m PF2 transformation of its estate. KPMG鈥檚 Richard Threlfall concedes that while expectations of a much bigger pipeline may have been 鈥渙verstated鈥�, the government has 鈥渘ow stopped talking about publishing a pipeline full stop鈥�.
Instead, PF2 schemes are thought to be likely to come forward on a much more piecemeal basis. Ashurst鈥檚 Mark Elsey says this is despite the fact the Treasury itself is in favour, as evidenced by Hammond鈥檚 original announcement. 鈥淭he Treasury doesn鈥檛 wield the same influence as it did, and it has faced kicks from government departments who say PF2 is too complex and lengthy to procure and too politically toxic, and that the public sector can borrow more cheaply anyway,鈥� he says.
Clyde & Co鈥檚 Meakin says: 鈥淚t is driven on a department by department basis now. Given a choice, most departments would seemingly rather have their projects centrally funded than have to engage with lots of bankers and investors.鈥�
However, despite this, the Treasury is understood to be pushing ahead with its plan to update the SoPC. Pinsent Mason鈥檚 Burr says the Treasury has a draft of the new standard contracts, which is being reviewed by external lawyers prior to consultation.
[The Treasury] has faced kicks from government departments who say PF2 is too complex and lengthy to procure and too politically toxic
Mark Elsey, Ashurst
A spokesperson for the Treasury declined to answer whether the government still expected to publish a pipeline of PFI projects. However, he said PF2 remained the government鈥檚 鈥減referred model of public-private partnership鈥�, as it was value for money and reduced procurement times.
鈥淭he government is committed to increasing spending on infrastructure, including the use of private finance where appropriate,鈥� he said.
Risky business
Nevertheless, those pushing for a more collaborative industry where contractors and clients work in partnership see a contradiction with the degree of risk transfer expected under PF2. While PFI is ostensibly a form of public-private partnership, this partnership occurs primarily between the ultimate client and the special purpose vehicle (SPV) set up to deliver the scheme. The relationship between the SPV and the contractor is not so cosy. 鈥淭here鈥檚 collaboration around the SPV,鈥� says Burr, 鈥渂ut the contractual risk position is very old-school.鈥� Baxter says: 鈥淎t the moment, the partnership bit is missing from some PPPs. They just want a price and if it鈥檚 not realistic, it鈥檚 not their problem.鈥�
Richard Threlfall, head of infrastructure and construction at KPMG, says: 鈥淐reating a bidding war on price for contracts where you have to give an absolutely fixed price over a 30-year period puts enormous pressure on the construction side, and is what sows the seeds of destruction. It is set up to create maximum financial exposure to the contractor at the thinnest possible margin.鈥�
And any assumption that being equity holders in the PFI special purpose vehicle might insulate contractors from losses has not proved correct. 鈥淨uite often the equity-holding contractor has been pushed to take more of the pain than other subcontractors,鈥� says Burr.
In addition to these concerns, there is also the spectre of the ultimate public clients to PFI contracts attempting to use contractual conditions, in an age of public spending austerity, to reduce their payments, and even force PFI vehicles back to the negotiating table long after deals have been concluded. This hits the value of the projects once construction has been completed.
Meanwhile, other potential bidders for PFI work are concerned that the strictures of the PF2 model - which works best to deliver programmes of projects such as schools, hospitals or prisons that are well-understood and have replicable elements - are not suited for the huge one-off schemes that have recently come forward: a tunnel under Stonehenge, and two new crossings under the River Thames. Ashurst鈥檚 Elsey says: 鈥淧F2 is quite a purist model - it鈥檚 not suitable for all clients and projects. You may need something more flexible depending on the particular challenge you鈥檙e facing.鈥�
The final challenge is that, with a lack of a significant pipeline or prospect of one, many firms have shed their PFI expertise. Robert Meakin, partner in the projects and construction group at law firm Clyde & Co, says: 鈥淧eople have retired or moved. You can鈥檛 keep highly skilled and expensive people hanging around, given the hiatus.鈥� This makes it less likely firms will bid.
Baxter says Galliford is 鈥渙ne of the few鈥� to have held on to a reasonable-sized team by finding other things for people with PFI knowledge to do. But others have not. 鈥淎s a company we鈥檇 very rarely bid on a project if we didn鈥檛 have an expert in-house,鈥� he says.
All of this adds up to a much less attractive prospect than the lucrative PFI contracts of old. Carillion, which has taken forward two of the six PF2 deals signed, has now announced it is withdrawing from bidding for PFI projects. And while Galliford鈥檚 Baxter says he would be interested in bidding on any forthcoming pipeline of school or prison projects, he has not bid for the A303 PFI tunnel under Stonehenge or the Silvertown tunnel under the Thames. 鈥淭he risks in construction and bid costs for PFI make it internally quite a hard sell to go for. It鈥檚 certainly going to make some less keen. The market鈥檚 saying it still has appetite - but only at the right level of risk,鈥� he says.
He is not alone in thinking that. Burr says: 鈥淭here鈥檚 a real sense that people are saying the risks aren鈥檛 commensurate with the rewards. Some massive PFI schemes are potentially group-threatening if they fail. You always get some companies who are more bullish, but across the piece I wouldn鈥檛 be surprised if a number of contractors are changing tack.鈥�
Despite all these challenges from both the public and private sides of the equation, there are still many who are worried about what seems to be the slow death of a model that has funded more than 700 projects worth nearly 拢60bn since the 1990s. Elsey says the market will still bid for properly structured deals. 鈥淭here鈥檚 no alternative to private sector finance if we want a serious programme of infrastructure investment in this country,鈥� he says. 鈥淭he UK can鈥檛 afford this current round of projects to be the last throw of the dice.鈥�
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