Australia's first UK-style PFI project is expected to be financed later this year as the bidding process for the project reaches its final stage. With the flow of transactions in other corners of the project finance market slowing, the development of a PFI market will be a welcome prospect for the country's project bankers. Recent policy documents from state governments and PFI-friendly tax reforms are also expected to nurture the market.

These, however, are small beginnings. The Department of Education and Training schools project which is in the bid phase bundles together the design, construction and ancillary services of nine schools in Sydney and the Central Coast but the total project cost is just A$80 million ($42 million).

Peter Clark, head of project finance at Citigroup, Sydney, estimates that of the A$13 to A$15 billion worth of projects which will be financed in Australia this year, less than 1% of financing volume will be accounted for by public-private deals (defined in the narrow PFI sense and excluding road transactions). This year, indeed, the schools project is the only PFI venture which may reach the financial markets.

Nevertheless, in its publication ?Working with Government, Emerging PFP Opportunities,? the New South Wales government alone lists 21 separate projects which could be financed on a private basis (PFP stands for Privately-Financed Projects), with a total estimated project value of A$2.549 billion. Notable schemes in the state's list include a project for the upgrade of ?major ocean outfall sewage treatment plants for Sydney Water? (Sydney Water accounts for 12 separate projects), worth A$500 million, and a $400 million scheme for the Department of Transport for integrated bus transitways.

Arguably due to the general slowdown in project finance activity in Australia, many sponsors and banks are eager for involvement in the opening PFP deal. ?We saw enormous interest from the private sector in the initial round of bidding in December?, says Joanne Evans, a partner at Blake Dawson Waldron's project finance department which is advising the Department of Education and Training on the project.

Evans says a short list of bidders, which involves a concession period of 30 years, was announced in March. In the short list are: ?Axiom Education?, including ABN Amro; ?Community Education Partnership?, including Baulderstone Hornibrook and its parent, Bilfinger Berger; ?Living Schools?, including John Holland and Jarvis Plc; and the ?Total Education Environment? consortium, including Thiess and Tempo Facility Services. Detailed proposals were to be submitted by 21 May and an announcement regarding the project is expected by 30 June.

?The schools project is an interesting test of market interest,? says Peter Doyle, partner at Mallesons Stephen Jaques in Sydney. He adds, ?although the financing structure may be broadly similar to UK deals, the model and the risk allocation framework has not been fully tested in an Australian environment. The private sector has certainly been involved in Australian public infrastructure for a long time, but on more of a build-own-operate-transfer (BOOT) rather than PFI basis.?

Many states, one template

The state governments of both Victoria and New South Wales have made clear public commitments to develop the PFP market. Both states have issued comprehensive documents giving detailed explanations of issues such as value for money and risk allocation. Evans says New South Wales has also established an Infrastructure Council, a high level forum comprising chief executives, ministers and union representatives, charged with putting together a comprehensive strategic infrastructure plan.

So similar are these documents to PFI templates developed in the UK that a number of legal and accounting firms have brought to Australia experts with previous experience working on UK deals, thus ensuring they are, as Rob Milliner, a second partner at Mallesons Stephen Jaques puts it, ?up the knowledge curve as quickly as possible?.

But with state elections on the horizon for New South Wales (to be held by March next year) market observers believe the government may be loath to introduce a large-scale PFP program. At least the realistic choice before the electorate is between an incumbent right-leaning Labour government, which is behind the current PFP programme, and an even more PFI friendly liberal party. The election outcome is therefore unlikely to be detrimental to the nascent PFI business.

Queensland has also recently issued its own Public Private Partnerships Guidance Material. ?This is a big step for Queensland, as it has been quite a bit slower than New South Wales or Victoria in developing a PFI plan,? says one financier.

According to a source at Queensland's infrastructure partnerships task force, the material unashamedly draws on the Partnerships Victoria documents, and follows the risk analysis and allocation principles contained in those documents. The source also says readers should be aware that Queensland uses the PPP term in a broad sense. ?Our use of the term includes both PFI and BOOT style projects.

Queensland has no PFI projects out to tender at the moment, but Milliner says the state is considering a number of projects for the scheme including the A$800 million Gateway Bridge duplication project and other transport and infrastructure projects. It is understood that the government has appointed advisers (Deloitte Touche Tohmatsu) for its Paradise Dam development. The accounting firm has been asked to look at a range of funding options, including PFI.

In fact, the Queensland government official says that every major project with a net present value of over A$30 million will now go through a process to examine if private sector involvement generates better value for money. ?Projects won't be identified as potential PPP projects unless they meet the necessary criteria in this preliminary analysis,? says the official. He adds that 7 projects are currently being reviewed in this manner with a total capital value of approximately A$7billion.

Corporates clean up

Citigroup's Clark notes that a range of infrastructure projects, including new hospitals and prisons, have been financed before on a public-private basis. ?The big difference now is that the government doesn't usually ask the private sector to get involved in running the operations housed within these assets,? says Clark. Despite this history of public private partnership, Clark is skeptical that the new PFI market will grow to a significant size in the short term. But he says, ?over three to four years if all politicians and bureaucracy get on board there could be significant opportunities?. Not surprisingly, therefore, Citigroup has not rushed out to acquire a dedicated PFI team at this early stage.

Another banker is equally skeptical: ?My concern is that there is a big divide between politicians who support PFI initiatives and parts of the civil service in attitude to PFI. Typically, the state treasurer is on board the PFI train but not, for example, the health minister?.

In Australia PFP is seen as a shift away from outright privatization. But privatizations of select infrastructure assets may still take place, and Citigroup's Clark notes another significant trend in the infrastructure domain. ?In the early stages of Australian privatization during the mid 1990s the state tended to clean up companies prior to putting them on the market. Now government is increasingly selling an asset as it is and telling bidders to price existing problems into their bids,? says the banker. Clark suggests this is a sign that the market has matured. ?The clean-up of state assets previously extended to trying to resolve such problems as over-staffing, in an attempt to remove all impediments to a sale to make sure it was successful,? he says.

The recent sale of the Federal and State-owned rail companies National Rail and Freight Corp was a good example. ANZ and Citigroup, joint leads in arranging finance for the winning consortium, assisted the purchasers in cleaning up or mitigating $160 million of bonds and cross-border leases on the former state assets. This is a process that governments would traditionally have worked through themselves. ?The process of cleaning up the funding structure is now pretty much done,? says Clark. He adds a tripartite agreement governing default and step in rights took care of the US cross-border lease while the outstanding bonds were bought up and a series of swaps unwound. In a current deal, to sell Sydney Airport (Citigroup is again working on the transaction but this time as adviser to the government) the state asset has outstanding bonds which government will again leave to the private sector to deal with.

In the infrastructure market at large, transportation is the flavour of the month. One aspect of the recent Cross City tunnel mandate that several financiers note is Deutsche Bank's involvement as a sponsor. To have banks acting as sponsors is not an entirely new trend and Macquarie has been active as an infrastructure sponsor for many years through its various infrastructure funds. ?This can be a selling point in picking up advisory mandates but it is not the only reason banks are getting involved,? says Clark. He continues, ?particularly in the roads sector equity investments have done well. Traffic flows on established road bring in a return a little like the revenue stream from a utility. The returns can actually be better as roads provide inflation-linked gains of about 3% to 4% per year plus gains linked to growth in traffic volumes and GDP growth of a further 3% to 4%.?

Tax reform

As states in Australia have moved to issue broad policy documents on the development of a PFP market, the federal government has simultaneously shown its willingness to restructure or abolish sections of the tax code that hinder PFI-style initiatives.

The two key segments, says Evans, are Section 51AD and Division 16D. The provisions contained in Section 51 AD, she says, can restrict or deny the claiming of tax deduction benefits associated with asset ownership (including interest, depreciation and maintenance expenses) by a private owner/operator, where the government is deemed to have control of the asset. ?The effect can be to make privately financed infrastructure projects extremely expensive, compared with public sector comparators,? comments the lawyer.

Under Division 16D a lease to a tax-exempt entity is treated as a notional loan by the private owner to enable the tax exempt entity to purchase the relevant asset. The private owner is therefore denied deductions associated with ownership of the asset, other than interest deductions, although only the notional interest component of the income is assessable, making Division 16D slightly less onerous than Section 51AD.

Both 51AD and 16D were targeted by the Ralph Report, the broad review of the Australian tax system, for reform (in the case of 51AD Ralph in fact recommends the section be abolished entirely). ?There seems to be broad agreement between the government and private sector regarding the principles of the Ralph report and Section 51AD and Division 16D, and the federal government recently acknowledged that these issues need to be resolved,? Evans says.

The Federal government has in fact announced a timetable indicating the implementation of much of the remainder of Ralph over the next two years. New legislation dealing with Section 51AD and division 16D is planned for the Autumn session next year.

A more imminent tax change, and one which could affect the general project finance market, concerns a new consolidation regime for company groups which will come into effect from 1 July. ?It's especially significant for the M&A market,? says Milliner, ?but is also significant for project finance, because of the issue of possible joint tax liabilities for group members.?

Doyle explains that under the new tax regime, different companies with a company group may have joint and several liability for tax if another part of the company is unable to pay. ?So we could see a situation where SPVs set up for project finance purposes become liable for a portion of tax liabilities of the head company (project sponsor) if the company goes bankrupt,? says Doyle. Doyle adds that tax transition rules will allow companies to defer entry to the system for up to a year.

Milliner notes that the new legislation may include a mechanism by which separate parts of a company group can apportion tax liabilities in advance, similar to the US system. However, since to date the details of the new regime have not been released, it is not clear that this mechanism will be included.

Peter Clark agrees the new regime is significant. ?In circumstances of joint and several liability, at the very least we'll be looking for indemnities from project sponsors,? he says.

Clark highlights another important aspect of the consolidation regime, namely that a parent company will be able to utilize the tax losses of the SPC to set against its own tax payable. ?Where companies do so, creditors will either want the parent company to reimburse the SPC, or to resize the debt to reflect the reduced cashflow.

Citigroup has already worked on several deals (including a sewerage project in Gerringong) which involved an agreement for the sponsor to reimburse the SPC if its tax losses were utilized.