The premise of the discussion in this paper thus far is that the introduction of IFRS may represent an indirect (and unintended) threat to PFI, in the sense that it looks set to remove the accounting driver for implementing capital projects through PFI.
But the introduction of IFRS can also be looked at in a rather different light. If PFI continues to be a mainstream procurement method - and this paper has identified a number of reasons to believe that it should be - could IFRS actually open a way to improvements in the structuring of PFI projects? Specifically, if balance sheet classification is never practically in doubt, could this remove pressures for sub-optimal structuring of projects and barriers to devising new and better ways of allocating risk?
It is unquestionable that some prevalent features of project structuring have been attributable to securing off-balance sheet classification. For instance, a number of projects have had a degree of demand risk injected into them, when this does not seem to make sense in relation to the underlying drivers of demand in the project. Commonsense has steadily reasserted itself in this area with a number of sectors migrating from demand-based to availability-based payment mechanisms over time, roads being the prime example. Artificial structuring of projects is not, however, something characteristic only of the early years of PFI. Many people currently active in the market are aware of examples where aspects of project structuring are back-solved from the intended accounting treatment, notwithstanding official admonitions to the contrary. The removal of this pressure will, frankly, come as a relief.
More generally, there are some chapters in the PFI text book which it has been hard to question in the past, for fear that this would begin the slippery slope down the road towards on-balance sheet classification. But if that classification is all but certain from the outset, that fear is removed, and the debate can be opened up.
One clear example of this is debt underpinning (i.e. the provision of guarantees by the government that a significant proportion (say 90%) of the senior debt will be honoured either by guaranteeing a proportion of the monthly Unitary Charge or through the termination compensation arrangements. This approach has been adopted in a handful of cases, either to make large and difficult projects financeable (e.g. London Underground PPP), or to test whether it offers a value for money benefit (e.g.Skynet5 and the Docklands Light Railway Woolwich Extension). The M25 ring road around London is currently in procurement with bidders invited to offer variant funding proposals which incorporate a partial debt underpin. The results from the closed deals are positive, in that margins have been lower on the underpinned parts of the debt, without increasing the margin on the uncovered portion by a matching amount. There are different views in the market on how the underpinned and non-underpinned tranches should be priced, however, time will tell how effective the underpin structures are.
If the experiments currently under way bear out positive early experience then debt underpinning could become a standard way of retaining the benefits of private finance while reducing the costs involved. And there would be no barrier to wider adoption of this approach for fear of its accounting consequences.
It is, however, important that any moves in this direction should not undermine incentives on senior debt providers to scrutinise projects in advance and to commission rigorous due diligence. In practical terms this means ensuring that the uncovered portion of the debt is sufficiently large in absolute terms to give the senior credit parties a strong financial incentive to get it right. It may require a number of iterations to find the optimum level of the debt underpinning. The guiding principle is that the underpinning should arguably do no more than formalise the de facto reality, to which the ratings agencies have drawn attention, that the current recovery ratings for senior lenders on defaulted projects will be at least 80% and sometimes over 90% (see Exhibit 2, page 8).
An alternative, or additional, way of achieving the same outcome as debt underpinning would be for the public sector to make contributions towards capital costs during the construction period, or in the case of local authorities, to provide a portion of financing through Prudential Borrowing. Again, a balance needs to be struck between decreasing the costs of the project by this means, while not diluting the disciplines exerted by externally provided senior debt.