Most PFI contracts contain the following key features:23
- an initial construction of some physical asset, eg a school or waste treatment facility;
- a subsequent "operational" period, which might last 25 years making the total contract length 25 years plus the construction period;
- a "unitary charge" becomes payable once the asset is available for service, and continues throughout the operational period, usually on a monthly basis;
- if the asset never becomes available, no payment is made by the authority;
- if the quality of the service fails to meet the "output specification", there are deductions levied from the "unitary charge", by the operation of the "payment mechanism". The output specification and the payment mechanism lie at the heart of the contract and deliver the risk transfer;
- deductions can be made for failures relating purely to services delivered during the operational phase, or can relate to failings which reflect shortcomings in the initial design or construction, or both;
- because of the long-term nature of the payment obligation on the authority, ie over 25 years, but a requirement for the contractor to pay for the initial asset at the time of its construction, there is typically a significant requirement for long-term finance. In the majority of PFI contracts this is provided from the banking market as that has proved to be the best value-for-money source of finance for most projects;
- the involvement of lenders serves an additional purpose: the best that can happen for lenders is that they get their money back and therefore their "due diligence" analysis is focussed on downside risks. This helps ensure project robustness as lenders are independent of both the procuring authority and the providers of the construction and operational services;
- the type of lending involved is often described as "project finance", because the lending is normally to an entity set up specifically for the project in question and lenders' risks relate purely to the performance of that project;
- as well as bank funding, some larger projects have accessed the bond market;
- moreover, the standard PFI contract guidance does not actually require any particular finance model. It is not necessary to involve third-party finance at all although it does bring certain benefits. Some sectors of PFI have used corporate finance fairly extensively, for example the housing or waste sectors;
- typically there are two key elements to the financial appraisal of proposed PFI transactions: "value for money" and "affordability". Value for money refers to the overall cost-benefit analysis of PFI as opposed to alternative procurement routes. Affordability refers to the impact of a PFI project on the procuring authority's budget and accounts. The two are related but the former is an economic appraisal whereas to assess affordability the authority needs to understand matters of accounting presentation such as the balance sheet treatment of project assets, and
- important caveats to the fixed nature of the unitary charge are (a) an element of indexation to inflation and (b) benchmarking or market testing arrangements for the costs of certain ongoing service elements. These arrangements avoid transferring risks which the private sector cannot control or easily price whilst maintaining the integrity of the original packaging of design and construction risks and responsibilities.
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23 Further guidance can be found on the HMT and PUK websites. For example the standard contract guidance, SOPC, is at: http://www.hm-treasury.gov.uk/ppp_standardised_contracts.htm.