PF2—the difficult second album

PF2—the difficult second album

Will changes contained in the second private finance initiative (PF2) silence the critics of PF1? Rachel Chaplin, professional support lawyer, and Robert Franklin, legal director at Clyde & Co, look at the evolving landscape of infrastructure financing.

Original news

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The introduction of a ‘control total’ to limit payments under the PFI and PF2 contracts to £70bn over the five years from 2015–16, would not remove the budgetary incentive for individual departments to choose PF2 over traditional procurements, concludes a report from the House of Commons Treasury Committee on how PF2 is working. The Committee expresses concern, among its other conclusions, that the introduction of control total will fail to address the budgetary incentives to use private finance.

What are the key challenges that have beset PFI?

Rachel Chaplin (RC): One of the key challenges for PFI in the UK has been demonstrating that it has fulfilled its original aim of achieving better value for money for taxpayers in delivering infrastructure assets on time and within budget, and maintaining those assets cost-effectively on a long-term basis. In spite of the newspaper headlines decrying the billions spent on PFI as a waste of money, there are well-managed contracts achieving value as originally intended.

Robert Franklin (RF): Supporters of the private finance model would argue that it embodies principles which are sound, but acknowledge that there have been issues when it comes to execution. These have included:

  • inappropriate risk allocation
  • lack of data or inadequate data collection
  • lack of flexibility, and
  • length of procurement process—although the latter two are to some extent constraints inherent within the model

RC: The Treasury Committee has opined in a previous report that PFI has led to ‘sub-optimal value for money’ (Report: Private Finance Initiative) in some cases, but it is worth noting that the National Audit Office (NAO) also concluded in ‘Lessons from PFI and other Projects’ that private finance does deliver benefits, ‘but is not suitable at any price or in every circumstance’.

A further challenge has been removing the politicisation of the original PFI, which forced the creation of PF2—effectively a re-brand with modifications. The modifications espoused by PF2 are intended to remove acknowledged problems.

Interestingly, one of the consistent failings identified by the NAO and cited in the PF2 report—‘problem government projects involving a lack of public sector commercial skills and experience’—is common to all public sector procurement, not just PFI. The Committee does at least acknowledge that the performance of PFI should be assessed in that context. It’s also worth noting that, on a global basis, it has been a hugely successful export.

How does the introduction of a control total expect to set PF2 apart from previous incarnations?

RC: One of the concerns with PFI was that there were clear incentives for public bodies to use PFI rather than capital spending—for example, because it was not used in headline debt statistics and had a smaller impact on current budgets, albeit over a much longer term. It was feared that this might have led to poor investment decisions.

The introduction of a control total limits payments under PFI and PF2 contracts to £70bn over five years, from 2015/16 onwards. This would give an allowance of approximately £1bn a year for new PF2 projects which, once exhausted, would mean additional spending would have to be financed by other means.

RF: The control limit is intended to be a corrective to the continuing difference in balance sheet treatment of PF2 and conventional procurement. It is evident from the report that this measure divides opinion. Chief executive of Infrastructure UK, Geoffrey Spence, views it as a ‘major step forward’, but the Committee considers it an imperfect tool because it doesn’t remove the underlying incentive and may create a counter-productive incentive for investment decisions to be brought forward, in order that they fall within the cap.

Do you envisage the increase in equity proportion under PF2 having a marked effect on the operation/uptake of PF2?

RF: The prescription of reduced gearing, combined with the requirement for equity funding competitions, is clearly intended to attract institutional investor capital both as debt and equity parts of the structure. However, there are different types of institutional investor with different priorities and concerns—direct and indirect investors, insurers and pension funds—which means different risk/reward targets and different demands. This spectrum is reflected in the witnesses who gave evidence to the Committee. They all thought increased government investment is helpful, but have different additional conditions—project risk profile, resolution of regulatory issues, selective de-risking, clarity of pipeline etc—which will need to be satisfied before liquidity will exist.

Reduced gearing is likely to increase the average cost of capital in the short-term, which may affect uptake, but the hope is that bringing new sources of liquidity into the market will reduce pricing in the longer term.

What are the risks/benefits for institutional investors?

RC: The government hopes PF2 will provide an attractive opportunity for institutional investors with an appetite for longer-term investments, because it needs to tap new sources of capital in order to fund its infrastructure programme.

RF: There is a consensus that there is a natural alignment between the demands of long-term institutional investors for relatively low-risk, long-term stable returns and the potential risk profile and revenue-generating capacity of infrastructure assets. Thus the potential exists for mutual benefits to supplier and investor as in other countries, frequently cited where the structure of institutional investment has historically been more conducive.

The project risks for institutional investors are the same as for others. Different investors have different specific concerns as already mentioned. There are also structuring risks and, in terms of asset class issues of transaction, costs and competitive risks. Mitigating these risks is largely a matter of understanding the asset, the asset class, the investment structure and so on, which requires investment in resources. There are also process costs—such as bidding for equity—which means a successful strategy is essential.

What are your predictions for the future of PF2?

RF: Despite being PFI critics, and still having misgivings about PF2, the tone of the report is one of qualified support, and there is recognition that private finance will be needed for infrastructure investment, although clarity of pipeline is an issue.

From the report and the evidence, it is clear that things are moving towards a point where liquidity can be accessed for major new greenfield projects. PF2 contains clear concessions to the demands of institutional investors and the evidence taps into a wider ongoing dialogue between the government and institutional investors. Consider also the other signs—the spate of funds, particularly debt funds—referred to in the report as ‘flavour of the month’, plus activity from those funds aside from new major greenfield projects.

As I said before, different investors have different demands and complex positions, and it is difficult to second guess which of these will be satisfied and when. We can expect some of those to be played out in the context of the relatively small, but still significant, number of major projects currently in procurement. Those who develop a clear and effective strategy which links demands and constraints to a genuine competitive advantage in investment in infrastructure will be the winners.

What should lawyers be considering at this stage?

For lawyers, change creates opportunity, and the focus should be on understanding how the landscape is evolving, anticipating the demands of the client base in that landscape and considering how to develop relationships with new participants and service their requirements.

Interviewed by Duncan Wood.

The views expressed by our Legal Analysis interviewees are not necessarily those of the proprietor.

First published on LexisPSL Banking & Finance. Click here for a free trial.

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