Rumours of a Japanese PFI explosion started in 1996. In 1999, two years after an initial draft, the PFI Promotion Law was passed. The next two years witnessed numerous debates and a host of guidelines refining legislation. At the beginning of 2002 there are still only hints that PFI will fly.

A handful of projects have closed and there are many others in the pipeline. ?It is premature to ask whether the market is maturing, but there is certainly some activity emerging,? says one Tokyo based industry player. ?There is definitely a public policy desire to restructure and introduce private involvement but it is too soon to know exactly how this will play out.? Some say that the government's desire to curb public spending and promote activity in a private sector characterised by over-leveraged balance sheets is creating an impetus that will make 2002 a turning point in the development of Japanese PFI. Others suggest you don't hold your breath ? that cultural and legislative barriers will continue to arrest development and the reality is that a much longer time frame is needed.

Setting off

Research by the recently formed joint venture between Clifford Chance and domestic law firm Tanaka & Akita found that a total of 40 projects have been officially launched under the PFI initiative in Japan. Ten have reached financial close and of these, five secured non-recourse financing. Figures of 200 to 500 are often cited in reference to PFI projects on the go, although many of these may never come to fruition.

The 1999 law attempted to promote procurement through PFI by setting out financial incentives and tax benefits for projects. A significant point is that it stipulates that government subsidies can now be awarded to companies with private stockholders. In the past subsidies were only available for public bodies. However, the act was described by many as ?an embodiment of the spirit of PFI', rather than a concrete outline of correct procedures. As such, projects have been negotiated on an individual basis and even now there is no move towards standardisation. Emphasis within the project portfolio has been on small, local government inspired accommodation deals, typically the most straightforward PFI deals. Clear and easily monitored demands are made of the private contractor.

Following issuance of three separate guidelines in 2001 on process, risk allocation and value for money, plans are gaining ambition. Yoichiro Yokoyama and Takaaki Hoshino, Development Bank of Japan, point to two health deals in an early stage of development. The Kochi Health Sciences Centre Project and Ohmihachiman's City Hospital Project are calling for integrated medical services in addition to normal facilities management provision. This will include patient transport, instrument sterilisation, medical testing and electronic recording. Details on Kochi are being worked on, with some estimates indicating that a tender could be out in July 2002. Hoshino says that the progression of these relatively complex deals, which include operational aspects, will significantly advance the PFI scheme in Japan. More developed pricing structures than previous transactions can be expected, reflecting greater attention to risk transfer.

Central government bodies have also started talking PFI. Proposals include new accommodation for the Ministry of Land, Infrastructure and Transport, the Ministry of Finance and the House of Representatives and a possible tender for new state university facilities by the Ministry of Education, Culture, Sports, Science and Technology. Although retaining local government focus on accommodation, closure of these could accelerate the market into maturity. ?The emergence of central government projects can only help,? confirms Michael Hancock, managing partner of Lovells' Tokyo office. ?If people see central government making a genuine effort, it will help to establish PFI as a concept.? The projects are likely to be bigger as well, which will encourage adoption of more sophisticated financing techniques.

Most interesting for international players is the Hibiki Container Terminal PFI Project. PSA of Singapore became the first foreign sponsor to break in to the Japanese market when it signed a memorandum of understanding in January 2002. PSA has taken a 60% stake in the ¥15.7 billion project at Kitakyushu. A consortium of 16 Japanese companies hold 30%, with the city government putting up the remainder. The project was one of a number nominated by the government last year as a flagship ?urban rejuvenation' project and is being progressed according to PFI law. When completed, it will have 12 berths and a capacity of 3 million TEUs, intended to become one of the country's main international distribution hubs. ?The market focus seems to be on the application of PFI to such a large scale port transaction, rather than on the presence of foreign sponsors,? says a local player.

But for international onlookers hoping to get a slice of the potential PFI pie, PSA's involvement is significant. ?We are obviously interested in the market developing to involve foreign sponsors and lenders,? points out Hancock. ?If project documentation is entirely governed by Japanese law, then there will continue to be accessibility issues. Hibiki is significant because the RFP was put out in English, suggesting that the city was actively looking for international participation.? To date there have only been a minute number of Japanese projects in any sector boasting a foreign presence. This is largely due to the fact that they have been put off by uncertain risk allocation and offttake agreements, but also because Japanese awarders have not seemed keen to encourage outsiders.

Kazusa, signed 17 July 2001, is often highlighted as a project that laid important PFI groundwork. The waste-to-energy plant is sponsored by Kazusa Clean System, a joint venture between Nippon Steel, Emuko, Ichikawa Environmental Engineering and the four municipal governments it will serve. ¥10 billion of project finance was provided by Development Bank of Japan (DBJ) and Bank of Tokyo Mitsubishi. The balance of funds came from ¥1 billion equity and a ¥4 billion government subsidy.

?Kazusa was a very interesting deal,? explains Toru Mihara, general manager, project engineering, Mitsui Global Strategic Studies Institute and also professional member of the government's PFI Promotion Committee. ?It was not legally a PFI deal since it preceded implementation of the law but it sets important precedents.? Crucially for a country steeped in a history of relationships and government support, no official guarantees were put in place. Lenders took comfort from a security package that featured Japan's first escrow trust. Lawyers also note the significance of local governments and lenders entering into a long-term direct agreement addressing issue of termination and step-in procedures.

Moving on

These outlined developments are undeniable. PFI does exist in Japan and volume is on the increase. But whether, over the next few years, it will continue to consist of isolated projects negotiated on individual terms that often contradict historical law and practices, or whether it will really take hold as an established procurement method is still open for debate. Much depends on wider factors inherent in Japan's current economic and political landscape, not least reform of the debt-riddled banking system. Sitting on bad loans running to an estimated ¥33 trillion, the sector is in its worst condition of the last decade. Some form of government intervention appears inevitable but recent reports suggest that this will not happen at least until after an interim inspection in March. A massive consolidation program is also underway amongst the major Japanese banks.

For one source, ?there are other major structural issues that need to be addressed before we will really see a commitment to PFI. For instance, exactly where investment in the public sector should go. There has been lots of talk of liberalisation, de-regulation and privatisation but there is concern and uncertainty about how far to go.?

The biggest obstacle, however, may simply be that the UK-born concept of PFI doesn't sit easily on the culture and legislation deeply embedded in the psyche of Japanese institutions. Reconciling this could be the key. ?There are whole contracts drawn up in Japan that don't even mention risk allocation,? concludes the source. There simply wasn't a concept of concession agreements before the PFI law and it has not proved easy to take on board,? agrees another expert.

Specific elements of the new legislation conflict with Japan's established public law, crafted under the Administrative Code, which dates back to the Meiji era more than 100 years ago. Some problematic issues refer to fundamental contractual rights for private enterprises and others concern technical issues surrounding security for lenders. Contradictions also arise between the State Accounting Law, limiting long term contracts for the state to five years, and the PFI law, which attempts to extend this to 30 years.

Following the example of the UK and elsewhere, a PFI Promotion Committee was set up in 1999 as a state organ to progress PFI, overseeing and monitoring progressive de-regulation. But the Japanese body has been awarded limited real powers. This is partly due to the conflict in laws outlined but also because of the fragmented nature of governmental jurisdiction. Unlike the UK, but similar to a number of other European countries, Japan has inherited a ?Roman' legal system. State and municipal governments have a considerable degree of legal autonomy and it is unclear how much influence a central government task force can exercise.

?Japanese law capability is a crucial component for the success of a PFI market,? explains Peter Avery, head of projects at Clifford Chance in Tokyo. ?It is not perfect at the moment.? But he adds, ?our recently formed joint venture with Tanaka & Akita combines technical know-how from London and local expertise, putting us in a very good position to take advantage of any upsurge of a PFI market.?

It is not just the legislation itself that is the problem, however. Significant shifts in the ?business mentality' are needed to facilitate the demands of a PFI market. It is a country in which deals have historically been underpinned by relationships and guarantees rather than contractual agreements. It is implicitly assumed that problems can be solved from above, that the central government will step in and bail out institutions, public or private, which are in trouble. Achieving value for money is not a primary concern in such an environment and some believe that vested interests may be the motivation behind some of the proposed PFI tenders.

The 1990s in Japan saw what was know as the ?third sector of arrangements,' when private companies were brought in in an attempt to save failing public sector bodies. But the whole entity was still accountable to, and thus viewed largely as part of, the public sector. Moreover, they were invariably unsuccessful. ?Some people can't see how the ethos of PFI moves away from the third sector,? says one observer. ?They can't grasp the notion of contracts being non-recourse to the government.?

Finding funds

Those advocating growth in PFI agree that project finance should play a significant role but non-recourse financing is itself very new to Japan. The two are likely to develop in parallel, with a very steep learning curve. Major Japanese banks have built up an impressive profile of project finance expertise over recent years, but it is entirely offshore. Bringing the practices back home appears to be fraught with difficulties. Domestic financing culture typically tends towards processing enormous reams of data without really focusing on credit risk analysis.

?Japan needs to develop a risk ? return approach to financing rather than just relying on relationships,? says Rob Richards, analyst, Standard & Poor's in Tokyo. However, he does point out that ratings are becoming an increasingly serious issue. The collapse of the bubble economy has drastically changed attitudes and investors are suddenly paying attention to real cash flows.

?A big turning point recently was the fall of retail giant Mycal,? Richards continues. ?In August 2001, it was rated B by Standard & Poor's, slightly higher by Moody's and investment grade by local agencies. When it went under in September, banks refused to step in and this has made people sit up and look. Views are changing.?

Yashurio Oka head of Japanese PFI, Dai-Ichi Kangyo Bank agrees, ?Awareness is developing of project finance in general and the public sector is well placed to benefit from this through PFI. A culture of credit risk analysis is developing and longer tenors are becoming more acceptable.? And as a result, differentiated pricing is emerging from the historically very thin spreads in Japan. more robust financial market capable of assessing and taking on project finance and therefore PFI risk.

Next steps

That potential PFI deals are out there seems to be a consensus. But there is still a lot of work to be done before they are to start flowing. Much hope lay with the well-publicised structural reforms outlined by last year's popularly elected Prime Minister, Koizumi. But these have been slow in coming. Laws and forces barring diffusion of a real PFI market are still very much at large. Compared to its South Korean counterpart, Japanese PFI has been very slow to get moving.

One local banker points to a ?next phase' of PFI in Japan, with larger transactions, more complex financing structures and real consideration of risk and return. Real deal flow under these terms may be unlikely in 2002 but the stage is certainly setting. Revision of the PFI Promotion law and committee is ongoing, project financing is emerging and talk of more complex projects continues. Some precedents have been set, which can be consolidated with repetition. The international community continues to watch from a safe distance. ?Waste to energy is a sector to watch,? predicts one international player. ?New environmental legislation is currently being put in place and we will see new plants emerging in order to comply.? This may well attract foreign sponsors with expertise in the field and the typically larger projects could encourage employment of more sophisticated financing techniques.