Another nail has been hammered into the coffin for Public Private Partnerships (PPPs) in the UK with the release of a damning report by the UK National Audit Office. What will this mean for the PPP markets in Australia and elsewhere?
The UK PPP market, known there as the Private Finance Initiative (PFI), has been in the doldrums since the GFC hit in 2008. The total investment in PFI deals has fallen from an annual average of £5.5 billion (~A$10 billion), in the five years to 2007-08, to less than £0.5 billion (~A$0.9 billion) for the last two years, down from a peak of £9 billion (~A$16 billion) in 2007-08.
PPPs have also become political poison in the UK. The model has been slammed by the UK press over the last 10 years. Deals that were done in the heyday of UK PPPs are now seen many as a terribly expensive way for government agencies to borrow money for infrastructure that they can’t afford from their capital works budget.
How does the UK model work?
Most UK PPPs involve the delivery of schools, hospitals and other public buildings under a contract that:
- bundles the obligation to design and construct the building together with obligations to provide various services – such as maintenance, janitorial services, cleaning, patient meals etc. – over a long term period (usually 25-30 years); and
- allows the government to pay the cost of constructing the building and providing the associated services over the 25-30 year operation phase of the contract.
The private sector raises finance (mostly debt) to pay for the construction of the building. The cost of this finance is ultimately paid by government through the long term service charge. The private sector enters into the PPP contract through a special purpose vehicle (SPV), which subcontracts the design, construction, maintenance and other obligations to contractors.
Why was it favored, despite the higher finance costs?
Even though government can raise its own finance at a lower cost than private finance, the PFI model was preferred over conventional procurement methods because of other benefits that were considered to outweigh the additional financing costs, principally:
- additional risk transfer to the private sector; and
- reduced operation and maintenance costs, and higher quality, well maintained assets, as a consequence of bundling operation and maintenance services into the same contract as the design and construction services.
Also, in the UK, most PFI debt is off-balance sheet for National Account purposes, and budgeting rules allow government agencies to spread the capital costs of a project over its operation phase. This creates a short term incentive for UK government agencies to prefer PFI procurement over conventional procurement. Different accounting and budgeting rules in other countries mean these incentives don’t necessarily apply in other PPP markets.
Why has the NAO changed its tune?
In its 2009 report on PFIs, the UK NAO concluded that “private finance can deliver benefits, but it is not suitable at any price or in every circumstance.”
The NAO now considers there is little evidence that the benefits of PFI outweigh the additional cost of private finance. In particular, the NAO says:
- while there is some evidence that PFI projects are less prone to construction cost blow-outs, and therefore provide greater cost certainty than non-PFI projects, this additional cost certainty does not necessarily mean lower costs for the public sector. Indeed, the NAO makes the obvious point that builders who commit to a fixed price will typically charge a higher price to cover unforeseen costs;
- for hospitals, there is no evidence of lower operation costs; rather, the evidence suggests that operational costs are similar or higher under PFI; and
- budgetary pressures have caused government agencies to reduce maintenance expenditure on non-PFI assets, but this is more difficult under PFI contracts (because the private sector bears the risk of inadequate maintenance under the PFI model).
The NAO also says:
- the construction cost certainty and higher maintenance standards achieved under PFI can be achieved without the use of a long-term private finance contract; and
- while PFI increased the spending power of government agencies in the short term, the longer term commitments to pay services fees (including private financing costs) has now significantly reduced their budget flexibility.
The NAO also points to a number of additional costs associated with PFI deals including:
- government paying for insurance for risks that it would self-insure under conventional procurements;
- government paying for the cost of funds held in cash reserves by the SPV that would not be held by the government agency for conventional procurements;
- higher adviser costs that would not be incurred under less complex conventional procurements;
- arrangement fees charged by lenders and fees paid to credit rating agencies; and
- costs associated with the SPV (e.g. company management and production and auditing of accounts) that don’t apply to conventional procurements.
The NAO suggests that these additional costs, when added to the higher cost of private finance, can result in the cost of PFI schools being 40% higher, and PFI hospitals being 70% higher, than non-PFI equivalents.
Finally, the NAO points to:
- the additional costs that the SPV and its lenders charge for variations under PFI contracts, and instances where government has had to continue paying for schools that it no longer needs;
- the prices that government agencies pay to transfer the risk of future costs, such as lifecycle costs and insurance premiums, being higher than anticipated; and
- numerous instances where equity investors have generated excessive returns.
All in all, a very negative picture.
Is the NAO criticism fair?
The NAO’s core criticism is that there is a lack of data evidencing that the benefits of PPPs outweigh the additional financing and other costs. This is true, but there is also a lack of data evidencing otherwise. Much of the evidence presented by the NAO is anecdotal, or based on the unsubstantiated opinions of government agencies contained in survey responses.
No one can ever know with certainty what a particular project delivered as a PPP would have cost if delivered via conventional procurement, or vice versa. And while data sets for “equivalent” projects delivered under each model continue to grow, it takes many decades to generate statistically significant sample sizes, and there are always circumstances unique to each project that make comparison difficult.
It’s true that a fixed construction price, and higher maintenance standards, can be achieved without private finance, as there’s no reason why the government agency couldn’t contract directly with the SPV’s builder and/or maintainer under identical terms. But can a government agency administer such contracts as effectively as a SPV that is subjected to the oversight of lenders? For instance, the lending documents will typically require the SPV to obtain lender consent before ordering variations or exercising other contractual rights that entitle the builder to claim extra time or money. This restriction doesn’t apply when a government agency administers a publicly funded construction contract. Any builder will tell you that claiming extra money from a SPV client is more difficult than claiming it from a government client. The Australian evidence bears this out, with post award construction cost and time blowouts being considerably lower for PPPs than for conventional government administered construction contracts.
It’s also true that some of the additional costs identified by the NAO are unique to privately financed PPPs, such as the SPV costs and the extra adviser costs attributable to the added complexity of private finance. But others are not necessarily unique to PPPs – for example, government could avoid the cost of insurance premiums, and achieve the same self-insurance risk profile, by agreeing to effectively act as the insurer to the SPV. And there is an opportunity cost to government of using government funds to cover risk events that the SPV’s cash reserves cover under a PPP deal.
The NAO report understates the additional risk transfer that is unique to PPPs, such as the risk of contractor insolvency, and default for which the contractor’s liability is capped or excluded. Government is partially protected from these risks under a PPP, because the SPV’s investors and lenders are motivated to invest additional funds to solve problems caused by contractor default or insolvency provided the cost of doing so is less the reduction in value to their investment or loan if they don’t. It is only when the investors and lenders are unable or unwilling to provide additional funds to solve the problem that the risk shifts back to government. Under conventional procurement, government bears this risk without any buffer from the SPV’s investors or lenders.
Will the NAO criticism affect the Australian PPP market?
The NAO report won’t go unnoticed in PPP markets beyond the UK. However, the Australian PPP market differs from its UK counterpart in many key respects:
- Australian governments have long been more circumspect in their use of the PPP model than was the case in the UK pre 2008. It has never been the ‘default model’ in Australia (i.e. to be used unless it can be demonstrated that another model would deliver better value for money), as was once the case in the UK. And the capital works budgeting requirements of most Australian governments have meant PPPs can’t be used as a mechanism to buy capital works that an agency can’t otherwise afford from its capital works budget. Consequently, the primary motivation for using the PPP model in Australia has been its ability to deliver a better value for money outcome to any alternative model, on suitable projects. The ‘gold-plating’ that occurred on many UK projects hasn’t been a dominant feature of Australian PPPs.
- Australian governments have taken steps to reduce the private finance costs associated with PPPs whilst maintaining the risk management disciplines that private finance brings. By providing a portion of the government funding earlier, Australian governments have been able to reduce the amount of private finance required, or the period for which it is required, and thereby reduce the associated financing costs.
- The UK PFI market is dominated by ‘accommodation’ projects, where the risk of public demand for the service provided from the building is retained by government. The Australian PPP market, on the other hand, has seen more ‘user-charge’ PPPs with demand risk transferred to the private sector. Australian taxpayers have benefitted significantly from the transfer of demand risk on several toll road and rail projects.
- Australian PPPs are less constrained by standard form PPP contracts than UK PPPs, which has allowed greater risk transfer to the private sector, and consequently greater value for money.
- High levels of competition for Australian PPP projects, and contractual regimes for the sharing refinancing gains, super-profits and the like, have resulted in few instances of excessive returns to equity investors.
As such, the NAO report won’t resonate in Australia the way it will in the UK.
 Duffield C, “National PPP Forum – Benchmarking Study, Phase II – Report on the performance of PPP projects in Australia when compared with a sample of traditionally procured infrastructure projects”, University of Melbourne, 2008.
Owen Hayford is a Partner at PwC Legal, specialising in infrastructure, transport and procurement.