James Larmour of Freeth Cartwright considers HM Treasury’s “Standardisation of PF2 Guidance”
The PFI has always been subject to criticism, but is now something a pariah. Once New Labour’s preferred procurement technique for capital infrastructure, PFI is seemingly unloved by the Conservative party which created it. So much so that in November 2011 the Chancellor announced the Government’s intention in to undertake a fundamental reassessment of PFI. The result is PF2. But as the name suggests PF2 is not fundamentally different to its predecessor.
According to Danny Alexander PFI “has become tarnished by its waste, inflexibility and lack of transparency”. Government claims to have overhauled PFI to create PF2 a new procurement tool which will dispense with the many evils of PFI that have caused so much heartache.
In truth, what government has done is simply to cut away some of the rougher edges of PFI. PF2 is broadly similar to PFI and although certain aspects are unlikely to go down well with the private sector, deal flow is likely to sugar the pill. Large swathes of SoPC4 (the previous guidance for PFI contracts) remain unchanged and for the critics of PFI, this must surely smack of tinkering at the edges.
There are few, if any, surprises in the PF2 guidance. Above all, whilst some aspects may appear over engineered or bordering on the inequitable, there is nothing fundamentally unworkable. Indeed, in some respects there are a number of positive developments. Some of the key changes include:
– the introduction of public sector equity investment and ‘third part equity’ sourced through an equity funding competition;
– changes to FM services in order to promote flexibility;
– a more enlightened approach to risk allocation with a view to promoting better value for money (and also with an eye on the bond market);
– a lifecycle gain share mechanism; and
– a streamlined procurement process.
These are considered further below.
The guidance envisages that under PF2 there will be up to three sources of equity financing (a) ‘traditional’ developer equity (b) public sector equity and (c) ‘third party equity’.
Public sector equity is perhaps one of the most significant changes. The proposal is that HM Treasury will now invest 30 to 49% of equity, via a new central government unit. A standard form Shareholders’ Agreement is currently under development which will regulate the relationship between the public and private sector shareholders. The Shareholders’ Agreement will cover the usual ground, such as initial subscriptions, further capital, voting, reserved matters, shares transfers, tag along rights and a lock up period.
Public sector equity is not a new concept – see for example LIFT and BSF. This change is unlikely to be welcomed by the private sector, not least as it might be perceived to be adding additional complexity to what are already highly structured transactions. But what is positive for the private sector is that Government has held back from introducing a gain share on the disposal of equity investments in PF2 projects.
However, government is seeking to reduce the scope for primary investors to make ‘windfall gains’ on their investment, through ‘third party equity’, which is to be sourced after preferred bidder selection by means of an equity funding competition. The Government is hoping to engage with investors with long-term investment horizons, with pension funds cited as possible targets. Government also perceives that the introduction of public sector equity and third part equity should result in more competitive equity pricing, thereby promoting overall value for money.
Clearly, these changes will not be positive developments for Infra funds. However, it remains to be seen whether pension funds will have the appetite to invest directly in and manage investments in PF2 projects.
The PF2 guidance confirms that Soft FM will not form part of PF2 projects. Under PF2, there will be three categories of services:
– ‘Services’ being those services provided by the Contractor, which will now be limited to Hard FM;
– ‘Authority Services’ being services retained by the Authority and either carried out by the Authority or by its subcontractors; and
– ‘Elective Services’ – services individually priced by the contractor which the Authority may call off at the pre-agreed price.
As the guidance recognises, the key issues are likely to be around interface, but these issues will be familiar to the market, particularly NHS PFI schemes have been Hard FM only deals for some time now.
For the private sector, one of frustrations of PFI was the obsession with risk transfer, which in some cases militated against the value for money aspects. An odd approach perhaps, where value for money is meant to be one of the key virtues of PFI. It was almost as if government missed the simple point that the private sector usually writes a number against a risk. Certainly, if one looks at other jurisdictions, the approach to risk transfer is generally more enlightened. So it is encouraging to see that Government has reviewed some aspects of SopC4 with this is mind.
The following changes have been made:
– Change in Law
The Authority now bears the risk of unforeseeable changes in law requiring capital expenditure during the operational phase. As a result Contractors should no longer need to build contingencies into the unitary charge to address this risk.
The insurance premium risk sharing mechanism has been updated to allow Authorities to take a greater share in the risk of market changes in insurance costs, thereby reducing the Contractor’s overall exposure. Whilst this is a welcome development, arguably if value for money truly were the order of the day, these changes might have been more radical.
– Utilities consumption risk
Under PF2, Contractors will not bear the risk of utilities consumption. However, the Contractor will be responsible for the energy efficiency of the project facilities. It is proposed that energy efficiency should be measured over a two year period; if the facilities do not meet the agreed efficiency target the Contractor will be required to either rectify the facilities or to pay compensation to the Authority. Subject to those arrangements, volume risk will be taken by the Authority, recognising the lack of control that Contractor’s generally have over the operation of a building.
– Site Contamination/Latent defects
Under SoPC4, Contractors were required to bear the risk of sites being contaminated by the migration of contamination from elsewhere and latent defects in the existing estate. The guidance provides that rather than simply transferring these risks to the private sector, it may be better value for money for the public sector to bear or share these risks.
SoPC4 required Contractors to undertake their own title due diligence, even where the site was owned by the procuring authority. Under PF2, the authority will be required to provide a title warranty to the Contractor, thereby obviating the need for the Contractor to carry out detailed due diligence. Additionally, the Authority will be required to procure ground condition surveys and to make them available to all bidders with the benefit of a warranty. These are welcome developments which should reduce the due diligence burden on bidders and also provider better value for money.
As practitioners will recognise, the above issues have been a matter of intense debate between the private and the public sector, chiefly because these are largely risks that the private sector is not able to manage in a cost effective manner. A more circumspect approach to risk allocation ultimately improves the bottom line, but a comparison with other jurisdictions would suggest that the government might have been bolder.
Traditionally, lifecycle represented an area where the private sector could make additional returns from a PFI contract, by managing the lifecycle spend to ensure that funds were disbursed in an efficient manner, whilst achieving compliance with the requirements of the contract.
It is no secret that this has been something of an anathema to the public sector. If the rumour mill is to be believed, some poorly calibrated performance regimes allowed contractors to neglect lifecycle, on the basis that it was cheaper to suffer deductions rather than disburse the lifecycle fund.
Under PF2, the Contractor and the Authority are required to undertake reviews of the actual and planned lifecycle send every five years on an open book basis. Any surplus will be recorded and on expiry or termination, the aggregate lifecycle surpluses will be shared equally.
For the private sector, the prospect of having to bear all of the risk associated with lifecycle but having to share any upside will not be welcome. There may also an argument that the Government is seeing ghosts – lifecycle funds in recent schemes are far less generous when compared against earlier deals.
Government is committed to streamlining the procurement process and proposes three specific measures to do so.
Firstly, the competitive tendering phase of a project (from issue of the tender documents to PB appointment) is to be limited to 18 months in duration. If this timetable is not achieved, Treasury will not approve funding, unless the Chief Secretary grants an exemption.
Secondly, a renewed focus on standardisation, with a comprehensive suite of standard documentation being issued (including standardised contract guidance, shareholders’ agreement, FM output specification and pro-forma payment mechanism).
Finally, additional checks will be incorporated into the Treasury business case approval in order to ensure that projects are fully prepared by the time that they go to market.
With the advent of competitive dialogue, the competitive phase has become unduly protracted and costly. Clearly the government’s aims are laudable; however, greater strides could be made in expediting the procurement process if authorities were prepared to bring greater focus to their bid submission requirements.
Overall, PF2 is something of a curate’s egg. Whilst some of the changes are far from ideal for the private sector, in many respects PF2 does not go as far as some of PFI critics might wish. However, the bigger issue is the lack of deal flow. Sat here today, it is difficult to see a pipeline of deals which will be implemented through PF2. Revised guidance is all very interesting, but without any projects in the pipeline, it is all fairly meaningless.
James Larmour is a Partner in Freeth Cartwright’s Commercial team, specialising in infrastructure and PPP.