2.9 Six of the 27 public sector project teams that commented on construction cost increases were aware that construction costs to the construction company had increased above those estimated when bidding for the contract. In practice, the incidence of construction costs exceeding construction companies' initial budgets may be higher than was reported to us. Unless there are open book accounting arrangements in place, departments may not be aware of increases in construction costs. If these are incurred in fulfilling the original specification, they will not affect the level of payments made by departments. The construction companies we spoke to had all experienced cost overruns on some of their PFI projects.
2.10 Only three public sector project managers were aware of the scale of increases in the construction company's construction costs. Two reported cost overruns of between 11 and 25 per cent, and one reported an increase of less than 10 per cent.
2.11 Reasons for construction cost increases included weather conditions, unforeseen ground conditions, labour problems, and changing building regulations. These are common reasons for increased costs under traditional procurement that historically have been wholly or partly borne by departments. Under the PFI these cost increases have been generally borne by the construction companies. Where there have been price variations in respect of construction cost increases these have mainly related to changes initiated by departments or other parties (paragraph 2.5).
2.12 There have also been media reports stating that some PFI building contractors have suffered financially from the costs of bidding for PFI contracts or from losses incurred on particular PFI building projects. In particular, Laing Construction was sold in 2001 following large losses. The Chairman's statement in Laing's 2001 Interim Report stated that the National Physical Laboratory redevelopment PFI project was a major contributor to these losses (see paragraph 2.24).
2.13 The evidence from our census that construction cost increases were borne mainly by the private sector, and the publicised cases of building contractors suffering financial losses in certain PFI work, is evidence of risk transfer working. Construction companies also told us that, although they had indeed borne cost overruns in some projects, the risk transfer to them inherent in PFI projects was generally leading them to manage risks more effectively. They saw this as further evidence of risk transfer working, in a way which was beneficial to the projects in which they were engaged.
2.14 Where construction companies are able to manage risks and complete PFI projects in line with their initial expectations, they may earn greater profits on PFI construction work than traditional construction work. The Chairman of the Major Contractors Group told the Committee of Public Accounts (PAC) in 2001 that his construction company, the Kier Group, had made returns of 2.5 per cent of turnover on PFI projects compared with one per cent on other contracts.12 But he stressed that the risks were greater in PFI projects as his company had to invest several million pounds before a PFI contract could be signed and there was always the risk that the money would be lost if the deal was aborted. Similarly, Carillion plc told the PAC in 2000 that it expected higher construction profits on PFI work and had been achieving a profit margin of 2.7 per cent against turnover.13
2.15 Construction companies attribute the possibility of better profit margins on PFI construction work to the reward for managing the greater construction risks which are transferred to the private sector in PFI contracts. As we noted in our report on Modernising Construction14, how contractors are remunerated will influence their performance. Careful judgement is needed to ensure that contractors have sufficient financial incentives to perform well, while departments need to be confident that value for money is being achieved. Previous experience has shown that if the price for construction work is too low contractors are likely to seek every opportunity to increase costs through claims often leading to lengthy litigation. In addition to being remunerated for construction services, construction companies may also earn returns on any funds they invest in PFI project companies as part of the financing of the project companies.15 Their overall returns will also be affected by the costs they incur in making bids for PFI contracts.
2.16 This report has focused on the delivery of PFI construction projects to the public sector. On cost issues, the report has concentrated on whether the public sector has been paying the cost it expected to in these projects. The issues of the relationship between the rewards the private sector are earning, and the risks they are bearing, in PFI projects has not been the focus of this report. At present the available information is limited and rather mixed. But these are matters we hope to return to in future reports.
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12 The PAC's report on Managing the Relationship to Secure a Successful Partnership in PFI Projects (HC460, Session 2001-02) Minutes of Evidence paragraphs 148-153.
13 The PAC's report on the Refinancing of the Fazakerley PFI Prison Contract (HC995-I, Session 1999-2000) Minutes of Evidence paragraph 64. This information was based on Carillion's published accounts at that time. Since then, following changes in its method of reporting results, Carillion has not published comparable data.
14 Modernising Construction (HC 87, Session 2000-01) paragraph 3.22.
15 The OGC states that such investments should be considered as a separate arms length use of construction company funds and the returns generated should be considered alongside other sources of equity funding and not coupled with the profits on construction activities.