Few in the UK – or Europe for that matter – will have escaped news of a shrinking construction sector as public sector cuts across the continent look set to drastically reduce funding for public infrastructure projects. Reuters only last month was reporting a forecast 4% decrease in construction output in 2010 (see http://uk.reuters.com/article/idUKLDE6662B020100708)
In the UK, the head of the National Audit Office (the body scrutinising public spending on behalf of Parliament) has called for a project-by-project review of future private finance initiative contracts, with stricter criteria being employed than in the last two years, to establish the most appropriate funding methods. The “Private Finance Initiative” is the UK’s own version of Public Private Partnerships or PPP and since its inception in the early 1990’s has resulted in over 500 operational projects in England alone with a capital value in excess of £28 billion (according to the National Audit Office Report published 3 November 2009).
Whilst obviously specific to the UK and PFI, the NAO’s report is revealing about the effects of the banking crisis on privately financed projects (PPP) and more interestingly, about the likely prospects for such projects in the future. Its recommendations for how such projects can be more efficient and offer better value for money make interesting reading in light of the UK government plans to put in place “an economic, efficient and effective strategy for financing public services”.
Approval of Treasury response to the credit crisis
The report commends the previous Labour government in its commitment to “reactivating” the financing market at a time when finance became increasingly unavailable, limiting the opportunity for the agreement of sizeable contracts. It also commends the Treasury’s approach at this time and suggests it was successful when establishing the Infrastructure Financing Unit in March 2009 to address the scarcity of debt finance. The Unit was tasked to ensure that 110 privately financed infrastructure projects (exceeding £13billion) would continue by funding any shortfalls in bank finance. For example, this Unit directly assisted the “Greater Manchester Waste Project” in April 2009 providing £120million to the project.
The UK Treasury’s willingness to lend improved market confidence and 35 government infrastructure projects were subsequently agreed without further public lending. However, although banks continued to lend, priority was given to closing deals at prevailing market rates, even if that meant that the public sector was paying more and the private sector was taking on less risk. The total interest cost of bank finance increased by one-fifth to one-third despite the fall in short-term borrowing rates and little change in the risk profile of the projects concerned.
Warning: Change to come
The NAO’s report reveals that higher financing costs added 6-7% to the annual charge of PFI projects. Between £500m and £1billion in higher costs has been built in over 30 years, although this has been partly offset by an increased public sector share in refinancing gains. In October 2008 the Treasury increased the public sector share of such gains from 50% to 70%.
The warning issued by the NAO is that, while the extra finance costs for projects in 2009 were able to provide value for money in the short term and achieve the government’s objective of stimulating the economy, “the Treasury should not presume that continuing the use of private finance at current rates will be value for money”.
Value for Money and Funding Options?
The Report states that the Treasury was justified in not reconsidering the individual business case of projects in 2009 but that in future, there should be “no presumption, based on previous business case analysis, that continuing the use of private finance at current rates will provide value for money”. In addition, the NAO recommends that more exacting and narrower criteria be applied to projects in development than at the height of the crisis. Key recommendations to the Treasury include:
• Analysing the lessons of the last two years with the view to preparing a contingency plan for how government departments should handle future market disruption affecting procurement plans.
• Where there are material changes, such as project costs increasing by 15%, require the department to re-evaluate the project. Such a re-evaluation would “assess all the benefits, and potential loss of benefits, of continuing the project in its current form, compared to other available options, including other forms of procurement”.
The report also highlights a number of alternative funding models for projects that are being developed and that greater emphasis should be placed on assessing the merits of other models when addressing funding issues. These funding models / options have the potential to be key factors in the future implementation and success of PFI projects. Recommendations to the Treasury include:
• During procurement, departments should assess a range of funding options to assess value for money including all public finance or part public and part private finance.
• Government departments should make greater use of sensitivity analysis to inform their decision-making when negotiating small changes in finance rates or considering requests to take on additional project risk.
• Continue to consider how a greater mix of finance sources, with less emphasis on the use of commercial bank loans, can be used to finance infrastructure projects. For example, other options highlighted include the approach of the French government in guaranteeing 80% of debt when a project is operating successfully and loans from the European Investment Bank which is generally able to make funding available on more favourable terms than commercial banks.
• The adoption by the Treasury of a portfolio approach to refinancing, so that individual authorities do not exercise any right to a refinancing on a piecemeal basis. Such an approach would enhance the public sector bargaining position, reduce transaction costs and increase potential gains.
There is a note of optimism in the Report. Infrastructure UK, the new coordinating body established within the Treasury “estimates that the Government needs to continue to encourage substantial investment in new infrastructure, possibly £40-50 billion per annum until 2030”.
Now comes the difficult bit – implementing the recommendations of the Report – and providing structures and funding for PFI projects that secure better value for money. If the private sector’s enthusiasm for PFI was cooling because of high bid costs and lengthy tendering periods, the tendering process will become an even more crucial part of the whole PFI deal, for both the public and private sector. The potential of increased unavailability of government funding will mean that the public sector has few choices outside PFI for the funding of capital projects and a focus and investigation of a variety of alternative funding options will be needed.
Do you have any experience of developments outside the UK for increasing the efficiency of similar projects – and particularly the tender process? If so, your input will be very welcome!