17 November 2011

Reform of the Private Finance Initiative: PFI is dead, long live PFI!

On 14 November 2011, the Chancellor, George Osborne announced the Government's intention to reform its approach to the Private Finance Initiative (PFI). A call for evidence will be launched on 1 December 2011, commencing a Treasury-led engagement process with stakeholders. In a press conference following this announcement, Lord Sassoon, Commercial Secretary to the Treasury, called time on PFI in its current form.

The Government likes the discipline that PFI creates in terms of risk transfer but believes that benefit does not justify the cost of private capital or the inflexibility of the contracts. In one sense PFI, in its purest form, is dead. However, the Government still needs to invest in infrastructure and requires private sector delivery and capital to achieve that. A concern is the extent to which this review will create a hiatus in investment at a time when that investment is badly needed as an agent and facilitator of economic growth.
 

There are approximately 700 signed PFI contracts in the United Kingdom, with an estimated capital value of £53 billion. 61 PFI projects, with an estimated capital value of £7 billion, are currently being procured. These projects currently in procurement will not be affected by the call for evidence.

PFI has been the subject of scrutiny for some time. The National Audit Office produced a Report in April 2011 analysing the merits of PFI, and the Treasury Select Committee published a PFI Report in August 2011. This latter report described the PFI model as "extremely inefficient", and concluded that PFI contracts are too inflexible and the procurement processes are too lengthy. The Government has been attempting to address issues relating to PFI, having abolished local authority PFI Credits, as part of the 2010 Spending Review in an attempt to remove any inherent advantage for PFI over other methods of public procurement. It has also pledged to deliver £1.5 billion of savings from existing PFI Contracts in order to reduce the long term cost burden of those commitments.

PFI's stock has fallen as the Government's sights have been trained on its cost to the taxpayer and the fact that the cost of raising private finance, in the current market, is significantly more expensive than equivalent government borrowing. The Treasury Select Committee Report noted the tendency of public bodies to use PFI irrespective of whether it provides value for money, as PFI debt can be excluded from calculations of Public Sector Net Debt and headline debt and deficit statistics. If PFI debt were to be included in these statistics, national debt would rise by £35 billion, or 2.5% of GDP. Government departments have also used PFI to leverage up their budgets by bypassing Departmental Expenditure Limits, impacting future budgets.

Although the Treasury is of the opinion that elements of the PFI model provide discernable benefits, in particular by incentivising private sector risk management and by delivering projects on schedule and within budget, it is seeking alternatives which achieve greater cost-efficiency, flexibility and clarity. The Government intends to identify methods by which it may provide an accelerated procurement process, greater financial transparency and enhanced taxpayer value, in addition to general project cost effectiveness, access to a wider range of financing sources (including investment by pension funds and insurance companies), a better balance of private sector risk and reward and the continuing incentivisation of the private sector.

Representatives of the construction industry have proposed that project companies be established as companies limited by guarantee, with a restriction on the distribution of profits to shareholders, ensuring that funds are retained within the company for investment. This is based on the Non-Profit Distributing model used in Scotland where excess profits are passed to a designated charity or channelled back to the public sector by way of rebate. 

Attracting upfront funding for projects from pension funds and insurance companies presents challenges as those institutions are not currently set up to assess projects for investment purposes, and so simple direct investment is not likely on a solo basis, at least in the short term. Government could fund the riskier construction phase of a project, and subsequently refinance that government debt with privately-raised funds once the operation and maintenance stage has been reached and established and stable performance demonstrated. At that point long term investors such as pension funds and insurance companies should be attracted to the stable returns which projects can deliver, at margins that would reduce overall financing costs. The Government could also consider guaranteeing private finance during the construction phase in order to reduce financing costs. The issue however will be how to structure public/private financing in order to reduce the costs of borrowing, in a way that avoids or minimises any incremental impact on the overall level of Government debt.

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© Herbert Smith LLP 2011