The government, through the PFI procuring authority, contracts to pay what is essentially a capped price each year for its use of a fully serviced facility.
It enters into a contract with a project company formed by a consortium – which often includes the building contractor, investors and funders – to design, build, finance and operate this facility. The actual construction cost is incorporated into the procuring authority's payment over the life of the project.
The procuring authority usually begins to pay for its use of the facility only after construction is completed, when it is in a position to take up occupation and the project company is in a position to provide its services – although it is not uncommon for payment to commence on a phased basis (after construction) to reflect ramp-up time to the full provision of services.
To cap the amount the procuring authority pays annually, the construction cost must be fixed. This is an embodiment of the risk-transfer approach that underpins the PFI: the risk of construction cost overrun is best managed – and therefore best borne – by the contractor.
To enable the project company to provide this price certainty to the procuring authority, it enters into a fixed-price, design-and-build contract with a construction contractor. The contract obliges the builder to meet the procuring authority's output requirements for a fixed price. It also contains a level of design already prepared by the contractor to achieve that end.
Although the project company does not receive payment from the procuring authority during the construction period, it still pays the contractor in a conventional fashion – either through milestone payments or against the issue of periodic certificates. This payment is traditionally drawn from a funder that the project company has sourced for the project. The only money available to repay the funder's loan will be the income (after construction is complete) to be received from the procuring authority over the life of the project.
To lend on the construction, the funder will require the project company to remain as risk-free as possible. This means a fixed construction cost, with any construction cost increase being either recoverable from the procuring authority or borne by the contractor.
The contractor is liable for any construction cost increase that cannot be added to the procuring authority's payment to the project company. The PFI project could face serious financial difficulties if the project company had to bear these costs. The project company would need to borrow more money to pay the contractor, but it would not have any increased payment from the authority to fund the extra borrowing. The result would be reduced profit margins and the possibility of the loan never being repaid. These risks make a project financially non-viable. Hence, a fixed construction cost.
The circumstances in which costs may be recovered from the procuring authority are set out in the project agreement. They are limited. Any cost increase falling outside the narrow scope allowed for will be borne by the contractor and this will be explicit in the construction contract.
So, by way of example, the contractor must pay if the cost increases because of:
It makes for a tough game but the premium attached to this risk, together with some of the margins that contractors are making in the PFI arena because of their ability to ring-fence the risk through control of the design from the outset, still make it a good game to be in.
Richard Guit is a solicitor at Buchanan Ingersoll.