2 Relationship between the returns which contractors earn and the risks they actually bear

6. We have sought on a number of occasions to gain an understanding of the relationship between the returns which contractors earn from PFI projects and the risks they actually bear. At present the available information is limited and rather mixed. A study of contractors' returns initiated by the OGC, which it told us about over a year ago,7 had yet to reach any conclusions. There has been some publicity about individual cases in which heavy losses have fallen on construction companies in PFI deals, and to that extent risk transfer has worked. Yet there have also been indications that construction companies can hope to earn substantially more from PFI projects than from conventional building work (Figure 2).8

7. More thought needs to be given to the most appropriate measures for monitoring the returns of private sector participants in PFI projects. In many PFI projects construction companies are both investors in the project company set up to manage the PFI contract and suppliers of construction services to the project company. The limited information we have been given previously has either been the contractors' returns on turnover for providing construction service to PFI projects or the separate rate of return equity shareholders are expected, at contract letting, to receive on their investment (a rate which is often understated as it does not include the benefits of subsequent refinancings). We have not seen information to show the total expected return which construction companies will make from PFI projects taking account of both their remuneration for construction services and their investment in the project company (including the benefit of any refinancing).9

Figure 2: Information on PFI returns previously given to the PAC

Sources: The Committee's reports on the Refinancing of the Fazakerley PFI Prison (HC 372, Session 2000-01) and Managing the relationship to secure a successful partnership in PFI projects (HC 460, Session 2001-02)

8. With more transparency on the returns which construction companies earn from PFI projects it would be possible to consider further the reasonableness of those returns compared with the risks which the companies are actually bearing. Construction companies may be earning over twice the rate of profit for construction services compared with what they earn from conventional projects, before taking account of the additional dividends or capital appreciation they will receive on any investment they have in a PFI project. The construction industry attributes the need for better profits as a reward for bearing the greater construction risks which are transferred to it in PFI contracts. It also considers the previous problems on building work were related to poor profitability, which had led to a lack of investment in people, research and development. Projects had been delayed and had not been value for money. The low level of profitability had also encouraged adversarial relationships between departments and contractors, litigation and arguments over money due for contract variations. The CIC said the better rewards from PFI projects would enable the construction companies' investment programme to be improved and the public sector would get better value for money. The CIC would not speculate on the extent to which the scope for additional work during a thirty year contract would provide construction companies with additional profits. But it expected the prices offered to the public sector to come down as more PFI projects were repeated.10

9. Construction companies are able to manage their risk exposure through due diligence and insurance. Due diligence is the process which the construction companies and their funders carry out to clarify the nature and extent of risks in the project. After due diligence some of the risks can then be insured against, which helps the private sector to price the project with greater precision. The OGC told us that the timing of due diligence is up to the private sector project company but is supposed to be completed before best and final offers are submitted by competing bidders, as an offer from this point is potentially binding. In practice, however, a significant amount of due diligence is completed after the preferred bidder is selected, because funders will not want to commit large resources to due diligence unless they have the certainty that their client will be awarded the contract for the project. Insurance of risks, where this is possible, will also often take place in the closing stages of the negotiations. It is not clear what effect due diligence and insurance has on the expected costs of the project and whether any benefits that it may create are passed back to the public sector in the final pricing of a PFI contract. The CIC considers that due diligence and insurance provide PFI project companies and their funders with greater certainty over costs but do not necessarily reduce costs. In theory insurance could be sought for risks in conventional procurement, but the OGC doubted whether in practice external parties could be found to offer insurance at economic rates.11

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7 42nd Report from the Committee of Public Accounts, Managing the relationship to secure a successful partnership in PFI Projects (HC 460, Session 2001-02), Ev 16 (Q 178)

8 C&AG's Report, paras 5, 2.16; Qq 88-91, 135-136, 184-185; Ev 22

9 C&AG's Report, paras 2.14-2.16; Qq 7-12, 64-70, 152-158, 184-185, 198; Ev 23-29

10 C&AG's Report, para 2.15; Qq 7-12, 49-56, 64-70, 95-104, 108-111, 141-142, 193

11 Qq 98-105, 159-162, 187-198; Ev 23-29