The new UK Conservative and Liberal Democrat coalition government has made it clear in its pre-budget report and in its parliamentary rhetoric that its forthcoming Spending Review, due to be published on 20 October, will recommend cost-saving measures across all departments, sectors and regions. The report will set government departmental expenditure limits for 2011 to 2015 and, according to HM Treasury’s preamble, it will “stop unnecessary spending of budgets at year end in a ‘spend it or lose it’ culture”.

The resultant future of the UK’s private finance initiative (PFI) programme is, as yet, unclear. Though there have already been some PFI casualties, such as the Building Schools for the Future programme which has been mostly axed, other projects, such as Crossrail and the Thames tideway sewage project, have been given the green light.

According to Paul Davies, a partner at PricewaterhouseCoopers, “The basic PFI model has been successful in delivering projects. It works well,” he says, “but there are likely to be some changes to the nature and scope of projects and risk allocation.”

Despite the spending constraints, the UK still has significant and increasing requirements for investment in maintaining and developing infrastructure. Maintenance may well trump new-build projects in a recession, but there is still a recognised need for development.

Financing pressures

As a result of the constricted credit markets, the debt profiles of UK PFI and infrastructure projects has also evolved. Mini-perm financings are regaining popularity and replacing long debt maturities, and the demand for limited-recourse debt has also waned.

However, according to a London infrastructure banker, the universal debt problems are not the only worries for UK lenders. “The government-owned banks are being, shall we say, leaned on to fulfil their lending quotas and PFI is a good way to clock up debt provision to meet those targets.”

For banks that did not require UK government bail-out, or for those foreign lenders which have been active in the PFI market for some time, the perceived competitive edge for British state-owned banks does not sit comfortably.

How the new government will deal with refinancing clauses is also a cause of consternation. “The first generation of PFI did not have any refinancing obligation written into the contracts,” explains an adviser. “When it became apparent to the public sector that the private partner was gaining from the first round of refinancing, a claw-back was introduced at 70/30 in the private partner’s favour. That figure has since become 50/50 as gearing has decreased and government contributions have gone up.”

There are market rumours of project sponsors circumventing the refinancing clauses by raising debt from banks against their equity stakes, then using the proceeds to replace project-level bank debt with sponsor loans on the same terms.

Details of such transactions and, indeed, the veracity of the anecdotes is nebulous. It may simply be wishful thinking on the part of investors. “There are now Treasury guidelines in place to see refinancing gains divided more so in the public-sector interest, to as much as 30/70,” says the adviser. “Project sponsors are, quietly, livid.”

Value for money versus frugality

UK Transport Secretary Philip Hammond’s approach to cost-saving is well documented, and was somewhat honed during his time as shadow chief secretary to the Treasury. He has outlined the government’s value-for-money agenda to the Transport Select Committee.

Value for money is a tricky concept to measure. Richard Threlfall, UK head of the global infrastructure and projects group at KPMG, points out that different government departments currently use totally different and incomparable methodologies for establishing their best value schemes. In order to break-down departmental spending silos all central and local government will need to start measuring schemes according to the economic benefits which they confer on the country or a city region.

While cutting programmes may ostensibly reduce expenditure, the idea of value for money is more complex and market participants expect further streamlining measures to be introduced to PFI procurement guidelines and legislation.

To this end, the government has also announced that it will abolish the Infrastructure Planning Commission (IPC), replacing it with a new body; the Major Infrastructure Unit, which will regulate larger-scale and national infrastructure from 2012. So far, so academic. But whether, and how, the government will use its new unit to implement changes to PFI contracts and financing structures has not yet been explained.

“PFI, and privatisation in more general terms, are contentious issues in the press,” says one government adviser, “even though PFI only accounts for 8% of project procurement in the UK. Ministers are being tight-lipped before the Spending Review partly because of the sensitivity of the issue but also partly because they haven’t really determined exactly how they’re going to address PFI and infrastructure finance.” 

With the October deadline just weeks away, such insights will hardly provide reassurance to a market that is all too familiar with where savings could be made.

Ill-considered rhetoric

Jesse Norman, Conservative MP for Hereford and South Herefordshire, published his recommendations for PFI reform in the Financial Times on 16 August. He has suggested a putative “rebate” to the government whereby existing PFI project sponsors could voluntarily reduce the availability payments they receive.

Existing projects are unlikely to be modified retroactively in this way. “It’s this kind of ill-considered rhetoric that undermines the benefits of PFI,” expresses one developer, also noting that the author was unclear on the difference between interest payments and availability payments. “The availability payments underpin the model for debt provision in the first place and, besides, they’re contractual obligations. It’s folly to think that either side could move the goalposts.”

More practicable reform is, however, widely anticipated. Jeremy Allcock, head of project finance at Nationwide Building Society, believes that there will be a governmental attempt to speed up procurement processes. “For lenders and sponsors, there needs to be a greater degree of certainty,” he says. “Firms cannot afford to spend on bids then for the project to be cancelled.”

“PFI might have its detractors, but there were key reasons why it was brought in. The comparisons between the cost of PFI projects versus traditional methods of financing are self-evident,” says Allcock.

PFI credits and “spend it or lose it”

KPMG’s Richard Threlfall believes that a likely reform will be the effective abolition of departmental PFI Credits. Under the existing model, each department has an allocation of credits which it can spend exclusively on PFI, separate to its main departmental budget.  PFI availability payments are made with these credit allocations.

The government has suggested that discrete annual budgets create a false incentive for spending because the funds can only be used for a specific purpose; and if not used by the department in a given timeframe, the funds are revoked.

Threlfall suggests that government departments will, instead, have to fund PFI from overall departmental expenditure limits, moving the incentives and risks of PFI directly on to their balance-sheets.

However, in removing the autonomy of PFI budgetary allocations, a new dichotomy is created for each department. “The government has suggested that it wants to decrease capital expenditure by 40% and decrease revenues by 25%,” notes Threlfall.

In this case, the question would become, will departments prefer to pay for schemes upfront, increasing the capital required from their existing budgets, to protect future revenues? Or will they prefer to spend less upfront, towards the 40% target, but effectively run the risk of silting up their future revenue spending capacity?

The new model?

PwC’s Davies has identified a number of ways that the government could continue to benefit from PFI’s track record of delivery and efficiency while also enhancing value for money for the taxpayer. His full recommendations are due to be published imminently.

Davies argues that there is an opportunity to look at key elements of standard PFIs and think whether they could be approached differently to reduce project costs. This might include risk share, scope and hedging.

He also believes that, although reducing the scope of existing and future PFI projects may push down the costs of any programme, there is also great potential to get value for money by increasing the scope and size of projects. “It may sound counter-intuitive,” he says, “but increasing their scope may lead to efficiencies if this means services are delivered by one PFI entity rather than alongside public sector delivery.”

Certain operations contracts, soft services and facilities maintenance could be procured across a number of local authorities, or across asset classes, as separate, individual contracts prove more costly. The exception could, however, be in the health sector, where outsourcing certain clinical-related services is politically unpalatable.

Davies also believes that there is scope for government restructuring at local authority and trust level. “The NHS, local government, magistrates, the police... They all have separate service providers, separate accommodation,” he notes. “If these services were housed collectively across a number of regional areas, with shared services like HR and IT, previous government research suggests that the savings could be in the billions.”

Though some of the key aspects of the government plans for “localism” and its “Big Society” are mutually contradictory, shared buildings and services could comfortably belong to either initiative.

Hedging interest rates

Interest rate risk, traditionally taken by the consortium, is one area that Davies believes could be adapted. “When a PFI company provides a fixed rate to an authority it incurs additional cost in fixing the rate and an associated credit margin which together can increase the cost of financing by up to 5%”

Davies advocates that as the government determines interest rates, it could assume the interest rate risk on PFIs which would, in effect, eliminate the need for hedging at the PFI company level. Government could decide not to hedge that risk, but simply to take overall interest rate risk. For smaller procuring authorities, however, there may need to be some central government contingent support if this meant they would take on uncertain and unhedged interest rate risk.

Indexing and insurance

Davies also notes that there are other financial risk mitigation measures that the government could apply to PFI structures. He explains that typical PFI project inflation, such as labour costs, and the retail prices index (RPI) do not always correspond. This results in a mismatch risk for projects, so that an inflation contingency is included in project pricing.

“Projects need a contingency in their pricing to protect against this mismatch,” he says. “If the government introduced a provision for this risk, through different indices, it would allow a reduction in contingencies in the project price, without undermining the basic risk transfer of PFI.”

Insurance is another major cost centre for PFI projects, with each concession requiring discrete insurance coverage on a project-by-project basis. Davies believes that the government could provide a centralised insurance on a departmental basis. The cost of an insurance claim on one asset, such as a hospital, could be crippling at project company level, but would be minimal for an umbrella body, such as the NHS.

“As the government backs and regulates insurance provision of these projects already,” Davies continues, “it would essentially result in self-insurance.” Cutting out the middle-man, and saving considerable expenditure.