PFI: how the changes effect you

The Public Finance Initiative has, for nearly a decade, been the cornerstone of this government's ambition to upgrade the country's outdated hospitals, schools and roads. At the end of last year, it seemed that the government's grand experiment with this procurement method, which uses private investment to fund public services, was over. Affordability problems with the £1bn St Bartholomew and Royal London hospitals scheme had resulted in the government reviewing the viability of 41 NHS PFI schemes.

However, reports of its demise were premature. Earlier this month, Bart's was finally approved by the Department of Health and the Treasury, although contractor Skanska's annual payments were cut by £20m. And last week, chancellor Gordon Brown confirmed the government's commitment to the procurement method by publishing a document, entitled PFI: Strengthening Long-Term Partnerships, alongside his Budget announcement. This stated that the government was still committed to building the 200 PFI projects that are in the pipeline, which are worth a total of £26bn (see chart, overleaf). Adrian Ewer, the finance director of PFI investor Laing, explained what this meant: "Those that have been knocking the PFI, particularly the media, will now recognise that it remains a key plank of government policy."

At least, that was the immediate reaction. But there is a lot more to this document than simply celebrating the PFI. Within it is a string of recommendations and commitments to improving the procurement method. The aim is to cut costs and reduce the time taken to get on site. At present, a project can take three years to get from initial advertisement to financial close.

A week on, the document has generally been welcomed although concerns remain on specific recommendations and, more broadly, on when they will be implemented. Stephen Ratcliffe, chief executive of the Construction Confederation, said: "To get these statements is good, but they need to be translated into action."

This is Building's guide to eight of the most significant changes, detailing the advantages and potential challenges of each policy.

User satisfaction

• What the document says "[The government will] seek to create an acceptable mechanism for linking user satisfaction with payment under future PFI contracts to align the incentives of service providers more closely with user expectations."
• What this means The contractor's payments will be linked to the client's happiness. At present, the payment system is largely based around inputs rather than results. A well-known example was when CBI boss Digby Jones toured a PFI hospital and admonished the contractor for the poor standards of its toilets. The contractor said it could not be criticised because it had worked to its contract requirements, which were to clean the toilets once a morning. The contract should have just asked for the toilets to be clean at all times rather than prescribing how this should be done. Some service delivery contracts are better drafted, but the government wants these to become the norm. Essentially, it means that if the public sector client feels that the consortium is doing a good job, it will pay it more.
• Advantages This would avoid tying the contractor to tight rules and allow it to raise standards with some private sector know-how. And because it is difficult to define whether something has reached a "satisfactory" standard, it will force contractor and client to develop a more trusting relationship. To implement this, contracts will need to be less prescriptive and the parties to it more honest in assessing their performance. Amanda McIntyre, who was head of modernising government at the CBI until 2004, says: "This will mark a further evolution in public-private partnerships; finding the right payment mechanism will be key."
• Challenges The problem of defining "user satisfaction" could mean that a cash-strapped client could refuse to cough up for perfectly good work. As a board-level director of one leading PFI player says: "That's all very well when you say it out loud, but you try writing that into a contract. These things can't just be opinion."

Public sector skills

• What the document says "[The government should] develop individual and team procurement skills through formal qualification training."
• What this means This acknowledges the lack of project management skills in the public sector. The proposal is to remedy this by allowing civil servants to follow a career in procurement, with the promise of a senior post at the end of it. Peter Stanton-Ife, who set up the Building Schools for the Future programme at the Department for Education and Skills, was rumoured to have left because he could not see how his achievements in managing the procurement process could help him reach a senior grade. Stanton-Ife declines to comment on this, but says: "Any moves to embed and retain programme and project management skills would be very welcome."
• Advantages It will help to recruit and retain procurement experts within the civil service.
• Challenges It is not entirely clear how this programme will be put in place and sceptics argue that it may become a sinecure for older civil servants in the twilight of their careers.

Shortening contract length

You try writing user satisfaction into a contract. These things can’t just be opinion

Director, PFI contractor

• What the document says "[The government will be] setting sector-specific concession length caps to ensure that the length of the contract is appropriate to the nature of the services and assets being provided."
• What this means This is being put in place to ensure that clients aren't tempted to sign 35- to 50-year contracts. Over this length of time, debt financing becomes much cheaper for the PFI consortium. However, it also means the project might provide less value for money, as it commits the public sector to retaining obsolete buildings. As Tim Stone, chairman of global infrastructure at financial adviser KPMG, says: "It is important that deal length is dictated by the needs of the deal itself, rather than extraneous factors such as ultra-long-dated finance."
• Advantages There will be less pressure on the public sector to agree to lengthy contracts.
• Challenges The private sector fears that this could lead to contracts shorter than the typical 25-30 years, which would not provide an attractive return for potential bidders. Sources close to the Treasury, though, insist that such short contracts are unlikely to occur.

Project delivery organisation

• What the document says "[T]he government will be looking to pilot a project delivery organisation."
• What this means This is loosely based on the London & Continental Railways company that built the Channel Tunnel and, more latterly, the Military Flight Training System, a Ministry of Defence initiative. Under the Channel Tunnel system, eight firms, including Bechtel, Arup and Halcrow, held shares in LCR and then dished out subcontracts, such as construction and service provision. Under the MoD scheme, three bidders are currently competing to run the department's pilot training from 2007 onwards.

If this system were to be incorporated into the PFI, this is how a typical teaching hospital scheme would be run. First, the Department of Health would hold a competition to find a private sector organisation to organise all the elements of its life cycle. This company would have no diverting interest in construction or facilities management. Instead, it would run separate design, construction and facilities management competitions. The project delivery organisation would be paid a small fee in the early phases of the project, but its main returns would be gained during the operational phase, which would give it an incentive to get all the long-term aspects right. In effect, this replaces many of the public sector's internal project managers and some of those of a bidding consortium. A pilot scheme is expected to be found in the next few months.

• Advantages The project delivery vehicle can provide the management skills that are currently lacking in the public sector. And because it would be dedicated to seeing the scheme succeed, it would have none of the conflicts of interest that are sometimes found in consortiums made up of firms from different sectors. Paul Livingston is head of customer relations at Ascent, a joint venture between military contractors Lockheed Martin and VT Group. Ascent is one of the bidders for the MoD's pilot scheme and Livingston, who has worked on PFI schemes in the past, says this approach means projects can start more quickly. He explains that once a bidder is chosen, training can start within six months. Outsourcing the project management team means the private sector can be more flexible in reacting to the changing needs of the scheme: "This model is much easier as it means that not all the output requirements are set from day one, and, although we give an indicative price, not all investment commitments are made from the start."
• Challenges Finding the right firms. A senior PFI expert says: "The challenge is, where are the organisations that have the delivery skills?" Realistically, it could not be a constructor, which would now be interested solely in building the infrastructure. The government would be looking to specialists such as Laing and Serco, according to a source close to the Treasury, who admits a market in firms with project delivery skills will have to be developed. Also, as the delivery organisation will probably have the right to provide all the equity, this might annoy financial firms that would usually bid to finance the job.

Design

• What the document says "The government will consult key stakeholders in the private and public sectors with a view to publishing guidance on the design process for the public sector later this year."
• What this means The Treasury is considering the RIBA's suggestion that designs be produced before consortiums bid. At present, architects attach themselves to a consortium, which then has a large degree of control over the design.

This is quite a shift by the Treasury, which last October told Building the idea was "not possible" because it would put too much emphasis on the contractor and price at the bidding stage.

But it has started to listen to the RIBA's claim that it could save £500m a year in wasted bid costs.

• Advantages It is believed that putting a design in position before the project is advertised - "Smart PFI" as Jack Pringle, the RIBA president, terms it - would lower bid costs for consortiums, as design disputes tend to bog down many projects. What's more, affordability tests can be done on the winning design before consortiums are involved, thereby shortening the bidding process. And by making it cheaper and quicker for bidders, it is hoped that more companies will enter what has become a shrinking market.
• Challenges The Treasury is only putting this suggestion out for consultation and it is buried on page 110 of a 128-page document. Pringle insists that the reason it is included towards the back is that he only met the Treasury's PFI tsar, Richard Abadie, a week before it was published, so it was included very late in its drafting.

Pringle says: "We had a very positive meeting with Richard Abadie - he took the point that good design was absolutely important."

Pringle adds that the document also says Treasury Taskforce Technical Note 7, which effectively governs the design process in the PFI at the moment, will be withdrawn. As the RIBA and architectural watchdog CABE will assist in rewriting this, Pringle is confident his vision will be implemented. On the minus side, it seems one of the idea's key supporters in the public sector is cooling on it. Peter Coates, of the Department of Health's private finance unit, was rumoured to have been leading the calls for this approach, as he was fed up with the quality of hospital design. Coates said: "We've been asked to look at this and we're taking the Treasury recommendations and seeing how to meet their requirements." However, he says Pringle's idea is not top of his agenda: "We need to get our existing schemes sorted before we start looking at this."

Debt and equity competitions

The project delivery vehicle model is much easier: not all output requirements are set from day one

Paul Livingston, Ascent

What the document says "To improve further the transparency of private finance within PFI contracts, the Treasury will require debt funding competitions (post the selection of preferred bidder) across all PFI procurements, except where the procuring authority believes that such an approach will unduly increase procurement costs and lengthen procurement times."

What this means This would introduce separate competitions for both equity and debt providers, that is, the banks. The idea is that these are "commodity" services that add little value to a project. The government can set the structure of debt and equity that it wants, such as payment dates, and the banks bid to provide this, with the cheapest rate winning. The banks would no longer be a part of the consortiums. They would join the winning team once it had been selected.

Advantages Supporters of this move argue that with so much surplus equity in the market, competition would lower the amount the banks charge. At the moment, banks have what one PFI expert calls "a lock on the deal", as they set the terms of providing the equity or debt without being rigorously tested against their rivals.

Challenges The banks are angry about this move. Jeff Thornton, managing director of the infrastructure finance group at Royal Bank of Scotland, says equity and debt providers have built up trusted relationships with firms they regularly bid with, and this would be lost. He argues that banks that are thrown in with contractors that they have not worked with before will lengthen the phase between preferred bidder and financial close.

He says: "Our initial view is quite negative. Our business model has always been to partner with people - in some cases we've been worked with these businesses for a decade. Working with a long-term partner, you know what they expect and they know what we expect. Having not worked with a partner before is a recipe for delay as we won't know [exactly how each other works]." Even the supporters of bidding competitions admit that "the $64m conundrum" is that banks typically pay the bid costs for consortiums and contractors will not be able to cover this without them.

Taskforce

What the document says "The government will create a PFI operational taskforce to support contract managers in undertaking variations and improving the flexibility of existing PFI contracts."

Our initial view is negative. Having not worked with a partner before is a recipe for delay

Jeff Thornton, Royal Bank of Scotland

What this means The Treasury-subsidised taskforce is being set up to help PFI managers in the public sector run projects during their operational phase. A helpdesk has already been created and the taskforce should be ready in the next three months. It will be run by PPP adviser Partnerships UK.

Advantages The public sector lacks real management skills, so this will help civil servants run their contracts properly - for example, the taskforce would advise on benchmarking the performance of the facilities management team or market-testing it against their rivals on similar schemes. The taskforce will also advise on how to negotiate contract variations, which are notoriously difficult to incorporate into highly detailed PFI contracts. James Stewart, chief executive of Partnerships UK, says: "We want to create a culture of proactive management both in the public and private sector. There has been a tendency for people to be more reactive and for more investment at the procurement than the operational stage."

Challenges There is a danger that the advice could be "quite stiff", as one of the report's contributors concedes. The team might end up standardising their advice by replicating successful ideas on every project without taking into account the differences between them.

Soft services

What the document says "[T]he government is strengthening its value for money test so that the public authorities must rigorously prove the case for including soft services in PFI projects."

What this means So-called "soft services", such as cleaning and catering, are fundamental to the PFI model. However, Treasury-commissioned research on schools (see chart, left) showed that although most public authorities rated construction and maintenance under PFI highly, most described the quality of soft services as merely "adequate". This is hardly a disastrous result, but it does suggest that there is no great advantage to using the PFI to clean toilets and cook lunch. So, if it is felt that there is no great gain in value for money, soft services will not be provided by the private sector consortium.

Advantages If soft services do not provide value for money, it will strengthen the business case for those contracts without them. It would leave the bidding consortium less likely to be attacked for making too much money out of the PFI. Richard Abadie, head of the PFI team at the Treasury, also suggests that the contracts could be awarded in smaller timeframes. This could raise prices, but again help contractors as they would not be attacked by a hostile media for effectively holding a monopoly on soft services: "If we're saying that soft services shouldn't be awarded on a 25 to 30-year basis but, more appropriately every five years, and prices in the market have gone up, then so be it. At least the government is being transparent."

Challenges Contractors could argue that the reason soft services have not been successful is that the client has been too prescriptive, preventing them from pioneering new ideas.