● Design and construction risk. The construction period of a PFI
project is recognised as one of the most critical phases and for this reason often attracts the highest valuation which in some cases can account for 50 per cent of all risk valuation. If for any reason the project is not complete or is late then the service, whether it is healthcare or education, cannot be delivered and the income stream will not be generated. Generally, the design and building of the asset is a risk best borne by the private sec- tor consortium and its financial backers. Because the built asset is being designed to an output/service specification instead of a rigid set of departmental guidelines and there is a commercial
incentive for efficiency right through from initial design to build and operation.
● Commissioning and operating risks (including maintenance or
whole-life costs). It has been estimated that over the 35-year life of a PFI contract, that on average 35 per cent of all costs will be capital cost, while 65 per cent will be running and maintenance costs. In fact, in some projects the split could be as great as 20/80 per cent. The golden rule therefore for consortia is ‘concen- trate on the larger’. As discussed in Chapter 1, the UK con- struction industry has traditionally ignored the influence of whole-life costs in building design; the PFI ensures that they are ignored at the consortium’s peril. Once again this risk is best managed by the private sector.
● Life cycle risks. PFI contracts are long term and therefore SPCs
have an incentive to fully investigate the impact of whole-life costs during the design phase of a project. Whole-life costs are thought by many to lie at the heart of PFI, particularly as stated earlier, when such a high percentage of costs associated with a PFI project are to be found in running and maintenance costs and every public sector comparator is built upon and judged on the basis of the net present value of whole-life costs. This makes sound commercial sense in the context of design, build, finance and operate, where risk is being transferred over a long time pe- riod and it has to be priced at the bid stage. Until comparatively recently, most buildings have been conceived and built on the basis of very simple criteria, fitness for purpose corresponding to the lowest possible construction cost. In addition, in many countries, including the UK, fiscal systems of taxation, tend to favour high running and maintenance costs over low capital costs. Whole-life costs are discussed in Chapter 3. The critical difference between PFI and typical private sector procurement is that the knowledge expertise and control over life cycle risks are in the hands of the service provider, who has a major incen- tive to optimise. Unless the life cycle risks are managed, the price for the job will be wrong. Often, neither the client nor the bidder has been able to pull together all of the necessary infor- mation.
● Demand (volume) risk. The prospect of receiving a stable long-
term income flow that is a major attraction for many private sector consortia that bid for PFI projects. Therefore, demand or volume risk is uncertainty over the level of demand for the service provided by consortium-operated asset. Generally, the
private sector is unwilling to accept volume risk as usually it is the public sector that has control over volume – for example, the numbers of convicted prisoners requiring a place in custody or the numbers of patients requiring a hospital bed.
● Residual value risk. Residual value risk is uncertainty over
what the net value of the asset will be at any time during the contract period. It is highlighted as an issue when a PFI scheme anticipates the transfer or sale of the asset and requires case- by-case consideration. For instance, the procuring entity may no longer require the asset at the end of the service contract. There are two main determinants of residual value; first, the condition of the asset at the end of the contract and second, the demand, if any, for the asset. Some projects, such as prisons, obviously limit the possible alternative uses for this type of proj- ect; however, the private sector take responsibility for main- taining the asset in good condition.
● Technology and obsolescence risks. Technology risk is associated
with the obsolescence of both the services and the function of the assets themselves. It is generally not thought to be signifi- cant outside IT projects; however, it would be a brave person who tried to predict methods of healthcare delivery in 20 years time. Technology refreshment, for example replacing computer networks within a school every 5 or 10 years, is a risk usually transferred and managed by the private sector, but wider rang- ing obsolescence risks impacting on the mode of service delivery would be a matter for negotiation.
● Legislation risks – both UK and EU. Legislation or regulatory
risk is one special aspect of demand risk and is thought to be out- side the influence of the private sector. For example, a reduction in the resources available to the NHS due to legislation passed by either the UK Government, the Scottish Executive or the European Parliament. The test should be one of materiality, with the risk of general changes in the law being borne by the private sector although the way should be open to negotiate possible price adjustments in the event of changes with a major impact.
● Project finance risk. Project finance risk is the risk associated
with the ability to raise finance on the terms suggested by the consortium in their bid. It is a risk retained by the private sec- tor. One of the major criticisms of PFI was that the cost of using private sector finance would always be more expensive than public sector funding. The maturing of the PFI now means that the gap has narrowed.
● Termination risk. Most PFI contracts contain a statement of
the circumstances that would result in the contract being ter- minated. Generally, termination occurs if the consortia fail to provide the level of performance statement in the service speci- fication. Under these circumstances, the public sector would be exposed to taking over the running of the service and paying off any debt associated with the project.
● Refinancing risk. The National Audit Office now recommends
that risks associated with the refinancing of PFI deals is consid- ered at an early stage. Refinancing, which is explained below, can result in the public sector being exposed to an increase of termi- nation risk – that is additional debt that has to be repaid in the case of the contract with the private company being terminated.
Refinancing and clawback
One of the more controversial aspects of PPP deals and in particular the early PFI deals is the ability of the private sector consortia to rene- gotiate their debt during the currency of the contract; a process re- ferred to as refinancing. The practice first sprung into the PPP head- lines in 1999 after the details were made known of the refinancing of any early PFI deal for Frazakerley prison (now known as Altcourse) near Liverpool that resulted in gains of around £10.7 million for the SPC, an increase of 61 per cent on original calculations. At the time of the original deal in December 1995 there was no provision in the con- tract to cover this process except to seek the permission of the Prison Service and only £1 million of the proceeds of the refinancing was given to the public sector. The refinancing process enabled early re- payment of debt and the generation of high dividends for share/equity holders. The refinancing of Altcourse has four strands:
1. An extension to the period over which the SPC, in this case Frazakerley Prison Services Ltd (FPSL), bank loan would be repaid
2. A reduction in the lending margin for the loan
3. An arrangement of a fixed rate of interest of the full period of the loan
4. Early repayment of the subordinated debt invested by share- holders of FPSL.
Other factors particular to this contract were the completion of the facility ahead of schedule and lower construction and commissioning
cost than originally allowed for, which, taken in association with the refinancing costs, produced a total increase in shareholders’ ex- pected returns of £14.1 million, a total of 81 per cent higher than when the contract was awarded.
As a direct result of the Frazakerley deal, the National Audit Office published a report in June 2000 setting out general princi- ples which government departments should apply to refinancing:
● Appropriate benefits should go to those bearing risks
● Benefits from reducing costs in a developing market should be
shared if they have not previously been reflected in the contract price
● Departments that sponsor refinanced projects should seek com-
pensation for any exposure to increased risk
● Substantial refinancing gains may threaten public perception of
value for money
● If the private sector seeks refinancing then it is reasonable for
the public sector to seek a share of the benefits.
Refinancing is still common place for PFI projects, but the degree of transfer of other risks is a matter for negotiation at project level. In addition to the NAO’s report, in July 2001, the Office of Government Commerce issued guidance for government depart- ments when refinancing PFI projects in which it urged caution on departments and suggested that, with regard to any reallocation of risk, any benefits from refinancing should be shared 50/50 with the private sector partner.