Q71 Ian Swales: Well, a PFI deal for a school, as I understand it, isn't just about building the school, it's about operating the school. Would it be better to separate the financial costs of building a school to the ongoing operational contract that goes with it in terms of value for money to the taxpayer?
Charles Lloyd: Can I have first go at that? I suppose my answer is I don't think so. One of the underlying almost philosophical points about PFI is you need to have the same party incentivised to both deliver and maintain the asset, so one counterparty to the Government entity that is responsible for minimising the cost of that asset and securing its performance over the whole life of it, or you run risks of building something cheaply and then finding it expensive to maintain in the long term.
Andrew Hudson: Which had been the experience of the public sector over the years. Now, I think we're getting better at managing our own capital programmes and one of the emphases in the spending review capital settlement that was announced last week is to make sure that assets are properly maintained. Not having that link that Charles Lloyd has just talked about was one of the problems that PFI addresses by making the special purpose vehicle and behind them, the banks-
Q72 Ian Swales: My question is about the risk premium that you have to pay for large amounts of finance, given that, as Mr Bacon said earlier, this is only very, very slightly worse than a gilt-edged investment. Are we paying too high a risk premium for these projects? Certainly through this period it appears that we were.
Charles Lloyd: We would certainly do whatever we can to try and reduce the risk premium, both at the construction phase and the operational phase. One way to do that is to try and get these deals refinanced after the construction period at a cheaper rate in the operational period, where I agree with you, the risk has been diminished. That historically has happened a lot. This Committee knows very well the Government have benefitted from that to an extent over the years. I think we are very enthusiastic; we would like to see more refinancing. It is a difficult market for that at the moment.
Q73 Ian Swales: When PFI first started it was legendary how much money you could make by doing a PFI scheme and then refinancing it. What proportion of that refinancing benefit now comes back to the taxpayer?
Andrew Hudson: Well, this is something which has increased over time, so for projects, for the most recent projects reaching financial close since October 2008, the authority share will be 50% of gains up to £1 million, 60% between £1 million and £3 million and 70% of the gain above that. So that has been stepped up over time and, of the projects that the NAO report has talked about where they have quoted this potential extra cost of between £500 million and £1 billion, they also say that some £400 million might be recouped through refinancing-
Q74 Ian Swales: What would you describe as the source of that refinancing gain? Why does it occur?
Andrew Hudson: As Charles was saying, it is at the point where the risk to the lenders reduces, but do you want to explain in a bit more detail?
Charles Lloyd: I think there are two things. One source is the diminution of risk at the point where construction of the asset is completed. The second source is changes in the market. So clearly if rates or margins or loan tenures go down between the point where the deal was signed and the point where refinancing is looked at, there can be a gain. Progressively there's-
Q75 Ian Swales: I've done work in the commercial construction industry and they think a margin of 4% or 5% on a construction projects is fantastic. Would you say that these refinancing gains are of that order or are they much greater?
Charles Lloyd: I think that varies according to what is happening in the market, principally. Historically we have seen substantial gains in refinancing. More recently on the whole it has not been possible to refinance these transactions because many of them were signed at a time when loan margins were 70 or 80 basis points, so less than 1%. Loan margins in the market now are 2.5%, so it's not possible as a general matter to refinance and make a profit at the moment. Obviously, we hope it will be possible in the future and we've increased the refinancing gain sharing to give Government more of that share if it does happen.
Q76 Chair: If we've done that, don't we then make it more difficult for banks to participate in the market, because it's less advantageous? If the Government takes a greater share of the gain out of refinancing, there's less incentive for banks that traditionally participate in that market?
Andy Rose: The banks prefer the shorter-term lending, as articulated earlier. They actually prefer that. The person who's incentivised by the refinancing is the owner of the equity and again, when we came up with the 70:30 balance, we wanted to come up with a balance that recognised that Government had paid more and therefore was entitled to recapture more, but retain the incentive for the private sector to do the refinancing. The banks, frankly, are very pleased to be refinanced as they can recycle their own capital and not be tied into very long-term lending, so striking the 70:30 that Andrew alluded to was an attempt to come up with the optimal balance of recapturing more on behalf of the taxpayer, but retaining the incentive for the private sector to refinance.
Q77 Mr Bacon: Talking about long-term funding, one obvious source of long-term funding is pension funds, who are looking for long-term funds to match their long-term liabilities. Now, what effort was made to start marketing PFI finance deals to those sources of finance or are they only of interest once the risk is reduced, as Mr Rose discussed?
Andy Rose: Well, there has been an active dialogue with pension funds for as long as I've been in the market, which is a very long time. The reality is that pension funds at the moment from a debt perspective do not have the analytical capability to analyse the construction risk, and therefore what they would rather have for their investors and their pension holders is long-term stable cash flows that are more likely in a refinancing-
Q78 Mr Bacon: So a major potential source of refinancing?
Andy Rose: I think it's a terribly important area for us to develop and there is an enormous dialogue with them; I do think it's a very, very important area to develop.
Q79 Ian Swales: We have just established that, as a lender, the track record is that the risk is nil. Financial risk is nil.
Andy Rose: I think Charles-I'm not sure that-
Q80 Mr Bacon: Mr Swales and Mr Lloyd, were the two projects that you were talking about the National Physical Laboratory and the Shrivenham loint Services contract?
Charles Lloyd: No.