Warning: Steep road ahead

“An enormously costly, inflexible and non-transparent way to procure and manage public infrastructure”. These were the words of Conservative MP Jesse Norman in an article he wrote for the UK’s Telegraph newspaper in November 2011 entitled “Why we should celebrate the death of PFI”. Small wonder that a Private Finance Inititiative (PFI) expert recently told Infrastructure Investor that the “litmus test” for the political acceptability of “new PFI” would be whether Norman gives it his nod of approval.

“New PFI”, “Son of PFI” or various other monikers have been applied to the as-yet non-existent PFI replacement which is set to be unveiled in Chancellor George Osborne’s autumn statement on December 5th. Osborne has a tricky task on his hands (and not only in persuading us that December is part of autumn). The UK’s traditional method for the delivery of public-private partnerships (PPPs) – originated by John Major’s Conservative government in the early 1990s – has had more than its share of critics across the political spectrum. But any successor still has a lot to live up to. According to a report in the Financial Times, in the pre-Crisis month of October 2007 (around the peak of market activity), PFI projects had been signed to the tune of £68.0 billion (€83.6 billion; $109.1 billion) – implying future spending over the life of the contracts to the tune of £215.0 billion.

Magnitude

As the magnitude of these numbers would suggest, finding a viable method of delivering the UK’s infrastructure is vital to the health of the country’s construction industry – as well as to the future prospects of PFI fund managers and all other stakeholders. Well, good luck with that, Mr Chancellor – particularly as there is a view that criticism of PFI has been misplaced and that, in the majority of cases, it represented a good deal not just for the private side of the equation, but the public too. “We’ve spent 20 years doing this and the government occasionally struggles to appreciate that PFI is a very liquid market: if they could have got a better deal, they would have done,” says Andrew Briggs, a partner in the London infrastructure project and public finance practice of law firm Hogan Lovells.

There has been much speculation that the new version will be little changed from its predecessor (and may run the risk, therefore, of failing the ‘Norman test’). If so, some would jump on this as an embarrassing u-turn, though the current government would perhaps be justified in pointing to an historic precedent. When in opposition prior to 1997, members of the Labour Party had been highly critical of PFI. But when Tony Blair’s government came to power , it was reportedly urged by civil servants in the Treasury to persist with the model as they believed that – whatever its faults – it essentially worked. The rest, as they say, is history.  

“Most of what I hear is that it [the new model] will lead in the same direction [as the old model],” says Briggs, “and that would be no bad thing. The fundamentals are a product of two decades of competitive evolution: I think the new version will retain 98 percent of the previous one’s DNA.”

Whether or not they are perceived to be minor, there certainly will be some changes. From conversations with industry professionals and perusing available public documentation, it seems fairly clear that the new model will seek to do away with the more expensive aspects of soft facilities management, for example. The focus of procurement will in future be on the delivery of the asset rather than providing solutions through the whole life cycle of an asset. This is an obvious move and a politically sensible one, avoiding outraged media coverage of – to pick a notorious example – £300 charges for changing light bulbs.

Less gearing

There will also be action taken to ensure projects are less highly geared. The government will seek to enhance credit ratings in order to entice institutional investment and to help address the lack of liquidity that has followed the contraction of bank finance post-Crisis. However, out of this arises what will be one of the tougher selling points of the new model: namely, higher cost.

“Institutional Investors won't give money away. They will be looking for a return and there is every likelihood that this funding could prove more expensive than the PFI market of years gone by. We are however living in different times,” says Nick Prior, a partner and head of infrastructure and capital projects in the London office of professional services firm Deloitte.

A third possible change – though it is not currently clear whether this will be incorporated in the new model or not – is some form of capping of what critics see as excessive private sector profits on equity investments. Hence, there is talk of profit-capping similar to that already deployed by the non-profit distributing (NPD) model that was introduced by the Scottish National Party in Scotland. This approach has been derided as “window dressing” by Unison, the UK’s largest public sector union, but could help to detoxify the PFI brand. It’s also something that investors may have reconciled themselves to.

“If the equity upside is going to be capped then for the majority of players it will be accepted as the rules of the game,” says Briggs.

Where’s the pipeline?

But even if the refinements referred to above make the new model more politically acceptable, more efficient and better value for money, there is a question being asked with increasing urgency with regard to UK infrastructure delivery: “Where is the pipeline?” After all, without a flow of pending deals, even the best procurement model in the world will prove to be of limited use.

One beneficiary will surely be the schools sector, with many PFI deals to be carried out under the government’s recently launched Priority School Building Programme, the scaled-down version of new Labour’s Building Schools for the Future programme. Beyond that, however, market sources speak of a handful of waste and housing projects, a few legacy healthcare deals…and not much else. Certainly nothing sufficient to haul levels of activity up to the pre-Crisis peak referred to earlier.

The irony of a lack of deals would be that the government could probably extract better value from projects now than for many a year thanks to the hunger for work of a deal-starved construction industry. “It is no secret that there are a significant number of developers (and their supply chain) who have got workers and plant sitting idle,” says Briggs. “If the government were to launch a construction programme now, sort the procurement process and get spades in the ground within the next 12 months, it would see great value. The competitive landscape should lead to favourable pricing and (within reason) a willingness to accept the next evolution of the PFI regime.”

Guarantees

In terms of helping to kick-start a pipeline, the UK government cannot be accused of standing idly by and doing nothing, however. In September, legislation was passed enabling it to provide guarantees for some £40 billion of privately financed infrastructure projects, with £6 billion allocated to 30 planned PPPs which have struggled to secure funding.

Projects seeking to benefit from the guarantees scheme need to demonstrate that work can begin within 12 months, that they will have a positive impact on economic growth and that they will provide good value for money for taxpayers. The first project to be offered guarantees, towards the end of September, was the £1 billion contract to provide new trains for the huge Crossrail rail link scheme connecting east and west London.

With government guarantees comes the accusation that there is insufficient risk transfer to the private sector and that you undermine the discipline that the private sector should be bringing to the project. However, as Prior point out: “The guarantee scheme means that projects can happen that wouldn’t have happened otherwise. It needs to be of limited duration as the financial markets will develop their own solutions and once this happens one would question if such a guarantee scheme is value for money. It’s a short-term fix for a lack of project finance debt and it’s arguably right for the situation we’re in now – but it’s not a long-term solution.”

The perceived need for guarantees to be introduced underlines that, in times of economic hardship, the private sector will not automatically step up to the plate to compensate for the inevitable shortfalls in public funding. Although PFI’s rationale is bound up with the continuing delivery of infrastructure in hard times – without the government having to pay for it all – it is clear from the austerity programmes that have been implemented across Europe in recent years that PFI and PPP schemes may be as much a victim of recession as a beneficiary. Look at Portugal, for example, where planned PPPs have been shelved and savings sought from existing agreements.

In an introduction to its State of the State report, published earlier this year, Deloitte found that 94 percent of planned spending reductions in the UK were still to be achieved. It said: “Some progress has been made and delivery is on course, but in implementation terms, we are still in the foothills.” With this in mind, and however much hope may be invested in infrastructure as a driver of economic growth, it seems unlikely that the government can increase the pipeline substantially while keeping to its self-imposed spending constraints.

RAB for the roads

Hopes of a significant new source of deal flow may rest with the roads sector. Earlier this year, the Department for Transport and the Treasury jointly announced a study into the feasibility of new ownership and financing models for the UK’s roads network. Media reports have suggested that the study, due to report its findings shortly, may recommend some kind of Regulated Asset Base (RAB) arrangement of the type currently applied to utilities such as water companies. It is expected that the regulator would draw up concession arrangements with private sector operators.

Allison Page, a partner at law firm DLA Piper, advised Birmingham, Sheffield and Isle of Wight councils on their recent highway maintenance PFI projects. She believes there is much scope for investment in highway maintenance, a sector where the private sector tends to be measurably cheaper and more efficient than the public sector according to a 2011 report by the Highways Agency’s Alan Cook. Page says there has been “terrible under-investment” in many of the UK’s highways.

In theory, a shift to ‘user pay’ on UK roads could open up any number of projects but many would say it is likely to remain in the theoretical rather than practical realm. The screaming headlines about road privatisation which greeted the government’s tentative plans for tolling on the A14 road were a timely reminder of the political sensitivity around the subject. And it remains to be seen how much scope there would be for using the PFI model even in an opened-up roads sector where investment was actively being sought.

PFI investors have already developed something of a gallows humour as a result of press criticisms, the lack of debt finance and the long wait for a new model (which they hope will be similar to the one taken away from them). Looking to what lies ahead, they may need to retain that humour to get them through continuing tough times ahead.