The media portrayal of PFI projects may be of contractors pocketing fat profits at the expense of the public purse, but in reality the risk of taking on work is rising, profits are falling and the pipeline of promised projects has yet to materialise. Is the fate of the funding mechanism up in the air?

PFI

Those working on PFI schemes - or PF2, as it was rebranded in 2012 - are used to their projects being a political punchbag. While the Conservative Party dreamed up the funding mechanism in 1991, and New Labour turbocharged it to fund a new generation of schools and hospitals after their 1997 victory, media and politicians from all parts of the political spectrum now happily line up to give it a kicking.

Alongside accusations of contractors’ superprofits from PFI have come reports of £300 charges for changing a lightbulb, horror at the interest payments for PFI buildings and huge concern over the £10.5bn annual cost of PFI payments on a cash-strapped public sector. It was inevitable then that last year’s revelation over construction failures at a host of Scottish PFI schools led to calls for the financing mechanism to be scrapped - despite the fact an independent inquiry didn’t find PFI was the reason for the failure.

Politically it’s very sensitive; the public don’t like the model - there’s an antipathy to PFI

Stuart Burr, Pinsent Masons

But if public outrage at PFI has become expected, revelations in recent months over how these public-private deals are working out for contractors themselves are perhaps much more surprising. Following on from the disclosure that contractor Laing O’Rourke was writing off £93m related to a Canadian hospital PFI scheme, came the news that Carillion was taking a £375m hit in its UK business, which it said was primarily related to three (unnamed) PFI contracts.

And while many in the industry are still disappointed that the pipeline of PF2 projects promised by chancellor Philip Hammond last November has not yet emerged (see box “So where’s the pipeline?”), there is also evidence of a change in the industry’s attitude to it. Increasingly, the opinion in the industry is that rather than the fabled gravy train of popular perception, the public sector’s fear of being taken for a ride has put such pressure on PF2 deals that contractors are concluding it is not worth the trouble.

PFI - What is it?

PFI and its successors - PF2 in England and Wales and NPD in Scotland - are deals in which the private sector funds up front the cost of designing, building and operating new public buildings, with the costs paid back over time - commonly 30 years - via an annual unitary charge. Critics say it doesn’t offer value for money because the private consortiums delivering PFI projects borrow money at a much higher rate than the public sector, and take large profits in return for their risk. Defenders say it enables the public sector to pay for infrastructure without incurring additional borrowing.

Midlands Metropolitan hospital

Source: Jon Lewis / Alamy Stock Photo

Midlands Metropolitan hospital is a PFI scheme that has been hit by delays

Fat margins

It is not hard to see why accusations of contractor profiteering on PFI projects were made. When the financing was first used, contractors priced in margins fat enough to make them comfortable with the novelty of the system and the risks attached to operational performance over 30 years.

This was not surprising, given that construction contracts sitting under PFI vehicles commonly include heavy penalties for delays to the programme. Stuart Burr, partner in the projects group at law firm Pinsent Masons, says these can add up to millions of pounds a month in the largest schemes, and mean a large degree of risk transfer to the contractor.

Mike Peasland, former UK chief executive of Balfour Beatty Construction Services, says: “Like any new contract style, people are a bit nervous at first and put in bigger margins. Commonly, contractors would make a 15% margin and then add a risk premium on top, meaning total return could be 20%.”

However, the way deals were structured also meant problems were much less likely than on traditional contracts. Alastair Stewart, analyst at Stockdale Securities, says: “Standard PFI new-build is simply not meant to go wrong. Everything should be designed to the nth degree in the preferred bidder stage with back-to-back fixed price supply chain agreements.”

Mark Baxter, managing director of investments at contractor Galliford Try, says: “The perception at first was of the big bad contractor walking off with a sack-load of money, pricing in risks that didn’t manifest themselves.”

Pinsent Masons’ Burr says this has fed into its political unpopularity. “There’s a general view of concern about complex projects taking ages to come through. Politically it’s very sensitive; the public don’t like the model - there’s an antipathy to PFI.” From the height of PFI use in the early 2000s, when more than 60 deals were being signed every year, just six PF2 schemes have been signed since the revamp was launched in 2012.

But they remained popular with the industry. With builders both contracted by the special purpose vehicles set up to deliver these projects and being an investor in them, they got a double benefit when lucrative building contracts delivered buildings that became solid investments yielding good returns. Hence in the summer of 2014, when contracting giant Balfour Beatty was in the depths of financial woes brought on by dozens of failing contracts, it was largely the £1bn value of its portfolio of operational PPP projects that enabled it to keep the wolf from the door, giving it the balance sheet strength to absorb repeated profit warnings cumulatively worth hundreds of millions of pounds.

But fast forward three years and the situation is flipped on its head. Carillion - ironically the firm trying to buy Balfour back in 2014 - is now in trouble, in large part because of problems on three PPP contracts responsible for more than half of last month’s £375m UK writedown.

Royal Liverpool hospital

Source: Kevin Walsh / Alamy Stock Photo

Royal Liverpool hospital

Heavy penalties

So how has this happened? Peasland says: “As the market matured then naturally it became more commoditised as contractors got more comfortable. The government side also got more attuned to the wrinkles in the contracts.” As a result, he says, margins are down to more like 7% including risk - which leaves little room for error if problems arise. But rather than just correcting earlier high profits, Burr says there has been a “race to the bottom” in terms of pricing.

Galliford Try’s Baxter says: “The pendulum has swung too far away from the contractor. These recent jobs have obviously got too much risk in them. While the man in the street thinks the private sector has the government over a barrel on PF2, the reality is now the other way round.”

However, the new contract form following the coalition government’s revamp of PFI in 2012 is not seen as responsible for the problem. Mark Elsey, partner at law firm Ashurst, says the wider issue has been primarily commercial: “There has been some very aggressive construction pricing with resultant financial hits for some of those companies. And we can see that those who say there is no risk transfer in PFI are clearly wrong.”

Of the three projects widely suspected as being behind Carillion’s recent woes, only one - the £430m Midland Metropolitan hospital scheme - is a PF2 deal, with one other being a Scottish roads PPP and one other - the £335m Royal Liverpool hospital - being a classic PFI project.

Philip Hammond

Source: Philip Hammond

So where’s the pipeline?

Since the 2012 revamp, which saw the replacement of PFI with PF2 in England and Wales, only six PF2 projects have been signed: five batches of the Priority School Building Programme, and the Midland Metropolitan Hospital. Together, they have a capital value of £1bn.

In his Autumn Statement last year, chancellor Philip Hammond promised to develop a pipeline of PF2 projects to be published in “early 2017”. The industry was briefed to expect PF2 to be used to fund hospitals, schools, prisons and Ministry of Defence estate redevelopment, plus a few other large projects, and that it would update the PF2 standard contract set (called SoPC - standardisation of PF2 contracts).

However, while the £6bn Lower Thames Crossing and the £1.4bn A303 Stonehenge tunnel are progressing, no pipeline has been published and the only other sign of progress has been publication by Calderdale and Huddersfield NHS Foundation Trust of a business case for a £300m PF2 transformation of its estate. KPMG’s Richard Threlfall concedes that while expectations of a much bigger pipeline may have been “overstated”, the government has “now stopped talking about publishing a pipeline full stop”.

Instead, PF2 schemes are thought to be likely to come forward on a much more piecemeal basis. Ashurst’s Mark Elsey says this is despite the fact the Treasury itself is in favour, as evidenced by Hammond’s original announcement. “The Treasury doesn’t wield the same influence as it did, and it has faced kicks from government departments who say PF2 is too complex and lengthy to procure and too politically toxic, and that the public sector can borrow more cheaply anyway,” he says.

Clyde & Co’s Meakin says: “It is driven on a department by department basis now. Given a choice, most departments would seemingly rather have their projects centrally funded than have to engage with lots of bankers and investors.”

However, despite this, the Treasury is understood to be pushing ahead with its plan to update the SoPC. Pinsent Mason’s Burr says the Treasury has a draft of the new standard contracts, which is being reviewed by external lawyers prior to consultation.

[The Treasury] has faced kicks from government departments who say PF2 is too complex and lengthy to procure and too politically toxic

Mark Elsey, Ashurst

A spokesperson for the Treasury declined to answer whether the government still expected to publish a pipeline of PFI projects. However, he said PF2 remained the government’s “preferred model of public-private partnership”, as it was value for money and reduced procurement times.

“The government is committed to increasing spending on infrastructure, including the use of private finance where appropriate,” he said.

Stonehenge

Source: Shutterstock

Some have questioned whether PF2 is suitable for a major public project to build a tunnel under Stonehenge

Risky business

Nevertheless, those pushing for a more collaborative industry where contractors and clients work in partnership see a contradiction with the degree of risk transfer expected under PF2. While PFI is ostensibly a form of public-private partnership, this partnership occurs primarily between the ultimate client and the special purpose vehicle (SPV) set up to deliver the scheme. The relationship between the SPV and the contractor is not so cosy. “There’s collaboration around the SPV,” says Burr, “but the contractual risk position is very old-school.” Baxter says: “At the moment, the partnership bit is missing from some PPPs. They just want a price and if it’s not realistic, it’s not their problem.”

Richard Threlfall, head of infrastructure and construction at KPMG, says: “Creating a bidding war on price for contracts where you have to give an absolutely fixed price over a 30-year period puts enormous pressure on the construction side, and is what sows the seeds of destruction. It is set up to create maximum financial exposure to the contractor at the thinnest possible margin.”

And any assumption that being equity holders in the PFI special purpose vehicle might insulate contractors from losses has not proved correct. “Quite often the equity-holding contractor has been pushed to take more of the pain than other subcontractors,” says Burr.

In addition to these concerns, there is also the spectre of the ultimate public clients to PFI contracts attempting to use contractual conditions, in an age of public spending austerity, to reduce their payments, and even force PFI vehicles back to the negotiating table long after deals have been concluded. This hits the value of the projects once construction has been completed.

Meanwhile, other potential bidders for PFI work are concerned that the strictures of the PF2 model - which works best to deliver programmes of projects such as schools, hospitals or prisons that are well-understood and have replicable elements - are not suited for the huge one-off schemes that have recently come forward: a tunnel under Stonehenge, and two new crossings under the River Thames. Ashurst’s Elsey says: “PF2 is quite a purist model - it’s not suitable for all clients and projects. You may need something more flexible depending on the particular challenge you’re facing.”

Tilbury

Source: Shutterstock

The site of the Silvertown tunnel beneath the River Thames

The final challenge is that, with a lack of a significant pipeline or prospect of one, many firms have shed their PFI expertise. Robert Meakin, partner in the projects and construction group at law firm Clyde & Co, says: “People have retired or moved. You can’t keep highly skilled and expensive people hanging around, given the hiatus.” This makes it less likely firms will bid.

Baxter says Galliford is “one of the few” to have held on to a reasonable-sized team by finding other things for people with PFI knowledge to do. But others have not. “As a company we’d very rarely bid on a project if we didn’t have an expert in-house,” he says.

All of this adds up to a much less attractive prospect than the lucrative PFI contracts of old. Carillion, which has taken forward two of the six PF2 deals signed, has now announced it is withdrawing from bidding for PFI projects. And while Galliford’s Baxter says he would be interested in bidding on any forthcoming pipeline of school or prison projects, he has not bid for the A303 PFI tunnel under Stonehenge or the Silvertown tunnel under the Thames. “The risks in construction and bid costs for PFI make it internally quite a hard sell to go for. It’s certainly going to make some less keen. The market’s saying it still has appetite - but only at the right level of risk,” he says.

He is not alone in thinking that. Burr says: “There’s a real sense that people are saying the risks aren’t commensurate with the rewards. Some massive PFI schemes are potentially group-threatening if they fail. You always get some companies who are more bullish, but across the piece I wouldn’t be surprised if a number of contractors are changing tack.”

Despite all these challenges from both the public and private sides of the equation, there are still many who are worried about what seems to be the slow death of a model that has funded more than 700 projects worth nearly £60bn since the 1990s. Elsey says the market will still bid for properly structured deals. “There’s no alternative to private sector finance if we want a serious programme of infrastructure investment in this country,” he says. “The UK can’t afford this current round of projects to be the last throw of the dice.”