2.4 Almost all investments government makes involve the private sector in some way. Where government is procuring infrastructure at the complex end of the spectrum, the private sector may be involved simply as a supplier of goods to an input-specified project managed by the public sector. The private sector may, in other cases, be involved in designing the project to respond to the public sector’s output specification, raising finance for the project, building it and managing the provision of the resulting service either to the authorities or to the consumer.
2.5 All infrastructure projects are subject to risk. There are, for example, risks that the project will cost more to build than anticipated and there are risks associated with its operation and maintenance, as well as with the possibility that it may attract fewer users than planned.
2.6 Project risks should be borne by those best able to manage them and to shoulder them. There are fundamentally only three classes of party to whom the risks can be allocated: consumers, investors (usually through private sector companies) and taxpayers (through the authorities). Risk does not disappear through contractual structuring, it is simply allocated differently.1
2.7 Appropriate risk allocation and associated contractual incentives are essential for cost-effective and efficient project delivery for the public sector. This was illustrated by a National Audit Office (NAO) study2 which found that in only 8 per cent of major PFI investment projects was the delay more than two months and in every case the public sector paid what it expected to pay. By contrast, in traditional procurement, 70 per cent of projects were late and 73 per cent were over budget.
2.8 Management of risk is important in the process of reducing the likelihood of projects underperforming. Many of the changes over the past 15 years in procurement, such as an integrated project process and partnering the supply chain, discussed in the Egan Report3 , involve the reduction of risk, and hence cost, by changing the relationship between the parties involved in the project. Indeed, some new approaches to delivering complex projects, such as alliancing, are largely conventional procurement combined with an intensive approach to identifying and managing risk through all tiers of the supply chain.
2.9 Delivery models are distinguished by how they apportion and manage risk. If construction costs on a public sector infrastructure project overrun under a cost-plus arrangement, the additional cost to complete the project is usually borne by the authorities. Under a PFI arrangement, the additional cost is borne by the private sector contractor and shared with its subcontractors in accordance with the subcontracting arrangements. Ultimately, losses arising from the additional cost are borne by the investors in the contracting and subcontracting entities (and in more extreme cases by those who have provided debt finance to the project concerned). They bear risk up to their capacity or their limit of liability. Beyond that point, residual risk in an infrastructure project is generally borne by the authorities to the extent they regard the service derived from the infrastructure as essential.
2.10 Procurement approaches and contracting structures other than PFI can also be used to shift the risk of construction cost and time overruns to the private sector contractor, for example through a fixed-price, date-certain turnkey contract. From the 1990s, a number of contractual structures were developed involving the private sector in project delivery and risk sharing beyond the construction phase. These structures were known by various acronyms, such as BOO (Build Own Operate), BOOT (Build Own Operate Transfer), DBMO (Design Build Maintain Operate), DBFM (Design Build Finance Maintain) and DBFO (Design Build Finance Operate). In the UK, these types of delivery models, usually involving a performance-related payment which begins after construction and only once the project has demonstrated that it is fit for purpose and has entered service, coalesced into PFI. Under PFI, the private sector is involved not only in operating and maintaining the asset and providing the service, but it is also amortising its cost of constructing the assets over their life, which may be 25 years or more. This requires the private sector contractor to raise long-term finance at risk. Chapter 3 considers the role private finance can play in public infrastructure provision.
2.11 In return for bearing and managing the risks inherent in a project, private sector investors expect a return. The more risky the project or the portfolio of projects in a programme the higher the required return. If the public sector is, through the chosen contract structure, bearing some or all of the project risks, it too should, notionally at least, take account of the higher required rate of return implied. Access to cheap funding is in itself not a good reason for an entity to assume more risks. Indeed, cheap funding can encourage ill-judged and ill-managed risk taking.
1 Ownership, Utility Regulation and Financial Structures: An Emerging Model, Dieter Helm, 2006
2 PFI: Construction Performance, NAO, 2003
3 Rethinking Construction: the report of the Construction Task Force, Department for Trade and Industry, 1998