They think it's all over…

by Allen & Overy LLP
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The late, great Ken Wolstenholme, if asked about the House of Commons Treasury Committee Report on Private Finance 21, could well say the same for PF2. Just as Costa Rica's Bryan Ruiz hammered home the final nail in the coffin of England's World Cup prospects (by beating Italy on Friday), this Report may well achieve the same outcome for PF2.

We gave the world football and a vibrant PFI/PPP product and are now scarcely registering as credible in either. Having offered, with PF2, a new approach to deal with the issues raised by critics of PFI, we are pretty much back where we started when the Coalition came to power in May 2010 – a limited greenfield infrastructure pipeline planned (privately owned and regulated utilities/infrastructure companies aside) and a reticence to use or advocate PFI/PF2 in the public sector. As alarming as any of the observations in the Report, raising doubts about the likely efficacy of PF2, is the statement that “the full details of [PF2] are still being worked out”.

The contrast with other countries is as stark in PFI as it is in football – we have fallen from top spot to a place outside the top 20; a fact evidenced by the number of former UK PFI experts delivering infrastructure in other countries.

General

Public-private partnerships and their place in the procurement of public services (such as hospitals, schools and roads) have been the subject of more debate over the last few years than anyone thought possible in 2010, with very little to show for it. The conclusion reached as part of the PF2 announcement at the end of 2012 was2 that, when used appropriately, public-private partnerships3 can deliver benefits to governments4. The Treasury Committee concluded this month (June 2014) that there are now greater concerns about value for money than ever before. This they claim is due to a combination of the increase in the cost of capital compared to “conventional PFI”; the opportunity cost of the Government investing in equity rather than allocating such amounts elsewhere across Government5; and the inability to demonstrate value for money (in a theoretical sense as the National Audit Office has regularly opined that PPP/PFI deals offer value for money).

It is true, as the Treasury Committee observe, that the “new” PF2 approach6 is not really new in many respects, in that it retains the same basic concepts of long-term contracting for services, financed by long-term debt with changes confined to a level of detail. The obvious observation to make on the Treasury Committee Report is that the concerns exist largely at a theoretical level, with the clearest statement made being that:

“There has been an absence of clear evidence that PFI projects offer sufficient savings and benefits to justify their higher cost as compared to traditional procured projects and, as the Government acknowledges, PFI has “led to sub-optimal value for money in some projects””.

Implicit in this statement and, as the rest of the world is recognising, optimal value for money has been delivered by PFI in other projects and, if only a small number of PFI projects are delivered in the UK in the future, we are unlikely to have any “clear evidence” either way.

This firm has always been aware that there is not, and has never been, a “magic bullet” for the provision of infrastructure in any country. Certain techniques have proven to work well in some circumstances, but not others (e.g. licensed and/or tax incentivised based models work well for extraction and generation infrastructure, provided there is a deep and liquid market in which the relevant product can be sold; PPAs and feed-in-tariffs work well for power generation projects where a subsidy or support element is required (either because there is no deep and liquid market or because the technology choice is not (yet) cost competitive); RAB based models work well for incremental additions to an operational infrastructure estate where its costs are paid for by consumers (e.g. water and energy networks) and PPP has worked well for certain single asset capital procurements).

None is easy to deliver and each requires careful consideration of their individual pros and cons. Whatever Government preferences may exist there is no substitute for a detailed evaluation of particular infrastructure needs and a decision between various options or designing specific techniques for their delivery and financing, as much as possible, uninfluenced by politics or partisan opinion. The more tools a Government has at its disposal for attracting private sector capital in a competitive global market, the better. We should not forget that PPP is just one such tool.

Looking back over 20 years of PPP in the UK, and setting political views to one side, it is hard to disagree with the conclusion of the National Audit Office (the auditor to the UK Government) from April 2011 in “Lessons from PFI and other Projects” that: “private finance can deliver benefits but is not suitable at any price or in every circumstance”

The National Audit Office also, interestingly, pointed out that “Our examination of PFI hospital contracts indicates that most are well-managed and achieving the value for money originally envisaged. This is a positive result.”

The Global Perspective

Looking beyond the UK, PPP is now truly a global phenomenon as shown by the Allen & Overy LLP Global PPP Guide7 and its sister publication, the South East Asia PPP Guide8 These publications provide introductory summaries to PPP in over 30 jurisdictions. In each of the countries covered (in the US9, Europe, the Middle East, South East Asia and Australasia), it is clear that PPP has its place, as a small but important part of the overall procurement of assets and services needed by a country.

Key issues

As we have noted before10, there are three key issues that arise repeatedly in all countries that dictate the success or otherwise of PPP transactions and which need to be understood in some depth.

These are:

• the risk allocation for PPP transactions;

• the process followed by public bodies for procuring PPP transactions; and

• the manner by which PPP transactions are financed.

While they are all certainly connected (e.g. the risk allocation and the process dictate the available financing options), it is worth analysing them separately to identify the potential pitfalls that could arise.

We have concluded (and agree in this respect with the Treasury Committee) that reducing the risks allocated to the private sector, as is done under PF2 (compared to PFI) will have an effect on price, if not value for money. On the procurement process, significant improvements are still possible in the UK, but most of the issues arise, in our view, from overcomplicating the process and guidance rather than running a competitive procurement (our experience is of fiercely competitive procurements). Finally, on financing, the broader range of financing options that are already being accessed by sponsors in markets untouched by UK Government intervention11 do not seem to have been considered and, to a large extent therefore, the Treasury Committee may be debating concerns with the financing markets that, if they exist at all now, are not close to be being as significant as they were 5 years ago when the debate started.

Conclusion

The internationally recognised benefits of PPP contracts through the risk allocation achieved in them (which will also be offered through PF2) are:

• They deal with the short- term time horizons that traditional procurement practices pull both the public and private sectors toward (e.g. incentivising the use of cheap/poor quality materials due to the focus of a “traditional” competition being capital cost).

• They remove or reduce the scope for expensive interference (e.g. not to maintain assets with a view to the long term when the public purse is under strain or other political imperatives arise), which has regularly been exercised for political expediency (there is, we all recognise now, when booking a flight or rail ticket, a price to flexibility, but flexibility is something the public sector has traditionally under-priced).

• They can, if processes are managed properly, be highly competitive – for example, every PPP contract in the UK was subject to a rigorous competitive process before being let.

These advantages are similar to those identified in the statutory risk allocation that arises as a result of a privatised, regulated industry (which also has a higher cost of capital than the UK Government) subject to price regulation. Transferring “ownership-like” responsibility, whether through contract, statute or a licence is an effective way of transferring the long-term risk for the delivery and maintenance of infrastructure. Where price regulation is not suitable for market or political reasons, a well-run competition ensures this is done in a manner that delivers value for money.

What the Treasury Committee has failed to do is explicitly recognise the advantages of all of these key benefits as part of the value for money debate. The Report concludes that theoretical value for money guidance is critical to improving the process for the Government in delivering new infrastructure in the UK – although clearly they recognise it is not sufficient on its own12.

In our view, focussing on guidance and theoretical approaches to contracting, while the rest of the world delivers new infrastructure through a mix of PFI/PPP and PF2, is missing the point and will lead to further delays. It is rather like arguing that England would still be in the World Cup if, rather than playing 4-2-3-1 against Uruguay, we had played 4-3-1-213.


1 Tenth Report of Session 2013-14 – Published June 2014

2 See http://www.hm-treasury.gov.uk/d/infrastructure_new_approach_to_public_private_parnerships_051212.pdf

3 The terminology used in this section does not distinguish PPP from PFI (or the new UK terminology "PF2". Certain distinctions have been drawn, (e.g. joint venture arrangements can be a PPP without being a PFI), but the terminology here is used to refer to a single capital asset, procured by a government entity, based on a concession agreement under which payment is almost exclusively made for services, significantly funded by third party debt and involving a development phase.

4 Expressed in the following manner: "Well-formed partnerships with the private sector have delivered clear benefits: in driving forward efficiencies; getting projects built to time and to budget; and in creating the correct disciplines and incentives on the private sector to manage risk effectively

5 Particular emphasis appears to have been given to the comments of Richard Abadie of PwC that a 10% increase in costs would be the likely result of PF2 as compared to PFI.

6 Called "PF2" – see http://www.hm-treasury.gov.uk/infrastructure_pfireform.html  

7 http://www.allenovery.com/AOWEB/Knowledge/Editorial.aspx?contentTypeID=1&contentSubTypeID=7944&prefLangID=410&itemID=55199&LangID=410

8 http://www.allenovery.com/publications/en-gb/Pages/Global-Guide-to-Public-Private-Partnerships-(PPP).aspx

9 Interestingly, in the US there are certain tax exemptions for infrastructure investments, thereby deepening the investor market (e.g. Private Activity Bonds).

10 See “Project Finance” (4th edition) by Graham Vinter, Gareth Price and David Lee.

11 For example, Brussels Airport, Gatwick Airport and the A11 in Belgium.

12 We agree wholeheartedly with the point made on p43 of the Report that:
“Even if a value for money case could be demonstrated for the PF2 approach, institutional investors would need to enter the market in sufficient numbers to create the kind of competition that could lead to the cheaper equity pricing that the Government is seeking. Investors have indicated that this is only likely to happen if there is a clear pipeline of PF2 projects and a flow of deals. Such a deal flow has yet to materialise…..”

13 Apparently a 4-3-3 formation is in prospect for Costa Rica today.

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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