Even before the Railtrack fiasco, the PFI/PPP market has been in the headlines for the wrong reasons. The concept meets with fierce resistance from the public service unions and the coverage of the refinancings benefits for investors was an embarrassment for the Government. But few thought that anything on the scale of Railtrack was likely to happen. In one ill-conceived move, the Labour government undid a great chunk of the work it had to do to get itself elected after 20 odd years in opposition: namely prove that it could handle a modern economy where the boundaries between public and private sectors are increasingly blurred. Gordon Brown ? fond of using the word prudence wherever he can apply it to Labour's handling of the economy ? must be fuming.

Effectively the government expropriated Railtrack's assets, by necessity without obvious warning, but less understandably without due thought as to how this would play out firstly with Railtrack equity and debt investors and secondly with the broader financial markets.

?The Railtrack administration has certainly caused some consternation,? says Tony Poulter, global head of project finance and privatisation, at PricewaterhouseCoopers in London. ?It's not so much the use of the special administration regime. Many people probably accept that ?something had to be done'. Government action could in fact have helped the market by at last establishing the basis for infrastructure investment through SPVs. But they are not felt to have handled things well. They needed to be clearer sooner about what the new regime was going to be, and more specific about how the new entity would be sufficiently creditworthy. Perhaps this wasn't possible. But the short term result has been concern in the debt markets and a sharper focus on lenders' security in other deals?

Robust contracts

Several key themes flow from Railtrack's administration for the PFI/PPP market in the UK. Firstly, bankers point out the critical differences between Railtracks's situation and the robust contractual position of PFI/PPP schemes.

?There is an important distinction to be made between the Railtrack situation and a PPP project,? says Liam O'Keeffe, head of project finance at Crédit Lyonnais in London. ?In a PPP concession agreement the risks and responsibilities for all parties involved are very clearly set out.?

Furthermore, and it is a crucial distinction, there is no reliance on public subsidies for these schemes. ?There is no direct analogy between Railtrack and PFI/PPP,? says Michael Wilkins, director of infrastructure finance ratings, at Standard & Poor's in London. ?Rated PFI projects' income streams are based on direct, long-term contractual agreements with either the government or other public sector bodies, not public subsidies. Public subsidies are subject to appropriation risk. As Railtrack's administration demonstrates, appropriation risk can become acute when the subsidised entity fails to meet politically determined performance expectations. Where the PFI contract is directly with the government, we believe that the UK government will honour its direct contractual obligations.?

Indeed, one real positive result of the Railtrack administration for the PFI/PPP market has been the confidence people have felt in the contractual basis for these deals. For projects financed under PFI/PPP concessions, subsidies have never been an issue and therefore appropriation risk has effectively been non-existent. ?Overall we see the PPP market rather differently than Railtrack's position,? says Jeff Thornton, managing director, infrastructure finance, at Royal Bank of Scotland. ?Going into a PPP contract has never worked on the basis of there being an underlying government guarantee. Within the PPP market we have always assumed that if the SPV does not perform you would not get paid beyond what is in the termination provisions of the original contract. There was never any belief that if a PPP project was in trouble that the Government would step in to support it.?

But there is caveat: ?However, there was an assumption over Railtrack that the ultimate counterparty would behave in a predictable way,? says Thornton at RBS. ?Now investors, even within the PPP market, may make different assumptions ? working from the perspective of a worst-case scenario.?

Not all PPPs are equal

This worst case scenario is particularly applicable to two high profile PFI/PPP transactions, which by their very nature, have a different set of risk characteristics to the typical assets financed through PFI/PPP. Like the railways, these two projects may reveal a central flaw in the government's pursuit of private sector capital and expertise for certain public sector services. The two projects are the London Underground PPP and the National Air Traffic System (NATS) scheme.

An inescapable fact, demonstrated by Railtrack, is this: privatizing the risks of a monopolistic and critical public service where there is no alternative provider of the equivalent services makes little sense from a risk transfer perspective. The Government can never de-couple itself from these projects and can never allow the projects to fail. If the private sector cannot deliver under the terms of the contract, the Government will have to step in. The political cost of not doing so would be immeasurably higher than whatever drain on public funds this situation might incur.

Whatever the intricacies of the contracts and concession agreements, these types of projects will always remain backed by the Government. And as such, the transfer of risk is ultimately meaningless. A hospital or a school PFI/PPP can fail and, while it will cause local difficulties, the services can be transferred to other nearby centres. However, like Railtrack, these two particular schemes might go to the wall but the service they provide has to be continued.

Transferring what?

The NATS PPP is the largest PFI/PPP to date and is the first European air traffic control financing. It is a highly political transaction given the developing global airline crisis, the Railtrack fiasco and widespread union and public concern over the privatisation of the air traffic system.

The deal is sponsored by The Airline Group ? a consortium comprising Britannia, British Airways, British Midland, Virgin, Monarch, EasyJet and AirTours, most of whom are struggling with their own falling profits. And during October, there have been press reports that the consortium is seeking government support for the project following declining air traffic volumes since the US terrorist attacks on September 11.

The £1.45 billion financing for the privatisation was mandated and fully underwritten by Abbey National Treasury Services, Bank of America, Barclays Capital and Halifax who describe the reports of bail-outs as pure speculation.

What is not denied, however, is that the consortium is energetically seeking to cut its cost base and is to lay off some 20% of management and support staff as well as postponing the development of new air traffic centre in Scotland for some two years.

Underground woes

But perhaps, the biggest victim from Railtrack and the Government's treatment of it is likely to be the £13 billion London Underground PPP programme. There are two competing schools of thought on this project and the two side's positions have become greatly more defined since Railtrack's administration.

The positive school of thought argues that the benefits of the strength of concession agreements should prove the key differentiator between Railtrack and this project.

?The LU PPP is a very different proposition from Railtrack,?says Poulter at PricewaterhouseCoopers. ?Railtrack has a statutory regulator, a high reliance on subsidy, and performance rules which don't incentivise investment well enough. In this structure there are no detailed contracts to determine what happened when things went wrong, and the capital base was public equity. In the Tube there is a clear contractual relationship between the public sector operator and three infrastructure companies; a performance regime which gives the Underground and the public what they want, including higher capacity; and specialist funders who have done detailed technical and legal due diligence into the structure.?

The belief in the importance of the concession is echoed by Standard & Poor's who published a research note after Railtrack's administration stating: Many parallels have, however, been drawn between the Railtrack administration and the proposed PPP for London Underground beyond the obvious proposed separation of responsibility of the maintenance and upgrade of the network (by the Infracos) and operations by Transport for London AA/Negative. These include the political risk caused by the dispute between the Mayor and central government over the funding structure; the likely unknown ?grey' asset risk; and the payment to Infracos through Transport Grant funded by central government. The key difference, and potential mitigant in this case, is that the PPP will be based on defined contractual arrangements (similar to a PFI) rather than the more ?open-ended' arrangement that existed with Railtrack as a privatised company.

Political risk

However, the opposing school of thought takes a more brutal approach to the issue, arguing that focusing on the relative strength of concessions misses the key point that these services have no transferability and that any failure to provide them ultimately means the Government stepping in.

?Whatever people say about the different financing arrangements between London Underground or NATS and Railtrack, there are common themes,? says one banker in London. ?All three of these are part of the country's ? or the capital's ? core services and fabric. The second theme is that the Government is heavily involved in all of them from a number of different perspectives.?

Whatever the truth about these two opposing views, one fact is already clear, the NATS and LU projects will have a greater element of political risk attached than any previous PPP scheme. This is especially so for the capital's tube system. ?The whole issue of political risk now has a much higher profile,? says Wilkins at Standard & Poor's. ?The dispute between the Mayor and the Government over the LU PPP scheme is a negative factor for the market.? And this well?publicised battle between Ken Livingstone and the Government continues, with neither side showing any signs of backing down. This is a fight which is almost certainly going to make the project a more expensive one. ?There is likely to be a premium payable on the London Underground PPP scheme as a result of the Mayor's well known opposition to it,? says O'Keeffe at Credit Lyonnais.

Uncertain markets

How much the pricing for this project will increase is still to be seen. Few bankers expect that it will be less that 12.5bp, in itself a relatively modest step-up. On the approximate £4bn of debt financing for the project this amounts to £5m a year in extra margin costs.

However, to get these big deals to sell, pricing is likely to have to increase by considerably more than 12.5bp. And as pricing levels remain uncertain, so too does underwriting risk. ?There has been a tendency for some institutions to underwrite very large elements of PFI contracts, perhaps on the assumption that there is an underlying government guarantee,? says Thornton at RBS. ?These institutions will need to revisit these assumptions now.?

Even then, pricing alone may not convince some banks to continue investing in PFI/PPP assets. ?There will certainly be repercussions following the government's actions over Railtrack,? sys O'Keeffe at Crédit Lyonnais. ?This will not be so noticeable on the smaller deals but for the very large financings it will be clear. In particular, the smaller players in the PPP market who come in as participants on the big deals and those with credit committees abroad may have trouble seeing the distinction between Railtrack and PPP deals.?

The syndication of the debt facilities supporting NATS was originally due to get underway in October but this was postponed reportedly due to the negative sentiment and uncertainty in the global aviation sector. The 20-year loan is priced at a margin ranging between 125bp over Libor and 170bp. How much the market has moved on by the time the deal is launched remains hard to call, but it is likely to look too skinny for some at least.