2.12 A key principle behind PFI is that it encourages the allocation of risks to those most able to manage them. By doing so, PFI hopes to achieve the better management of risk so as to achieve overall cost efficiencies and greater certainty of success. It is not sufficient that risks are transferred. For PFI to work, risks have to be appropriately allocated and better managed once allocated.
2.13 The optimal allocation of risk is a key determinant of the VFM of a PFI project. The standardisation of contracts has embedded a particular allocation of risk that is normally considered good practice. Standardised contracts generally provide a sound basis for the allocation of generic risk in a PFI project, although part three of this paper sets out how this has been influenced by accounting treatment. The allocation of risk is also considered as part of the due diligence work done by lenders, who may resist some elements of the risk transfer.
2.14 Risk allocation requires enforcement through clear reporting structures and penalties if the risk is not managed. PFI attempts to monitor and manage service risks (risks to the satisfactory delivery of the service) through payment penalties for under performance. It enforces construction risk (the risk of not delivering to time and budget) by entitling the contractors to payments only after the asset is provided. Other risks are managed through contractual entitlement and ownership, such as the control of residual risk. Sometimes risk transfer has been curtailed, such as the public guarantee of Metronet's debt (Case study 2).
Case study 2 |
In 2007, Metronet BCV and Metronet SSL - two private infrastructure companies responsible under PPP contracts for maintaining and upgrading sections of the London Underground - went into administration. During the biding stage, the Department for Transport (DfT) gave assurance to Metronet's lenders that 95 per cent of the debt obligations were to be guaranteed by Transport for London (TfL). As a consequence of this guarantee, Metronet's lenders did not protect their investment as anticipated because only five per cent of their investment was at risk. Eventually, when Metronet failed, the DfT had to make a £1.7 billion payment to help TfL meet the guarantee of Metronet's borrowing. We estimated a direct loss to the taxpayer of between £170 million and £410 million1. |
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2.15 Ultimate responsibility for delivery always remains with the public sector. Projects that do not meet the objectives of the public authority are rarely VFM. If risks do materialise, the public authority may have to work with the contractors or lenders to find a solution that delivers the public authority's objectives (Case study 3). We would not regard the enforcement of contractual terms without achievement of the intended benefits of the contract as VFM (Case study 4).
Case study 3 |
National Savings and Investments (NS&I) transferred its operations to Siemens Business Services (SBS) in 1999 under a PPP contract. SBS invested heavily in modernising NS&I's operations, which increased the value of the whole business. After signing the contract SBS discovered that NS&I in house-programme was not good enough to deliver its intended IT system; the contract was far more challenging than originally thought. Soon, key risks accepted by SBS under the contract crystallized, but the contractor and NS&I remained committed to the deal, cooperating to achieve the project's objectives. NS&I realigned contract terms to ensure the contract was clearer, less ambiguous, fairer and was a driver for a low cost operation. We reported in August 2005 that the project was delivering good results. SBS modernised the business to improve customer service by streamlining business processes. SBS also increased productivity and reduced costs. NS&I did not have sufficient resources to achieve the same results within the public sector.1 |
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2.16 Joint ventures have a very different approach to risk than PFI. They pool expertise and resources in a single organisation, which it is hoped, will be better equipped to manage risks. Such PPPs work by the partners working together to manage risks, rather than assigning risks to one side or the other. They require sufficient resources to be pooled to manage the risk.
2.17 The opposite approach to PFI was also taken by the British Airports Authority in its construction of Terminal 5. It decided it was better able to insure against and hold risk than its contractors and thus organised its supply chain to drive out all contingency funding and create open book accounting throughout.18
Case study 4 |
In 1998 the then Department for Trade and Industry (DTI) signed a PFI contract for the building and management of new facilities for the National Physical Laboratory. After significant delays during construction phase it was agreed to terminate the contract. This was the first instance of termination of a major PFI project for serious deficiencies in contractor performance. Our report found that the fundamental reason for the problems was that the original private sector design was deficient, and that the Department did not resolve its concerns about the design of complex units before letting the contract.1 The contract protected the taxpayer effectively from the wasted costs of construction and the termination was value for money. But the project did not achieve the DTI's aims. The subsequent PAC hearing found that the project was 'undermined from the start by a flawed procurement process and naivity by both the Department and the favoured private sector contractor over the technical challenges which had to be surmounted.'2 |
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18 Improving public services through better construction, National Audit Office (HC 364, 2004-05).