The public sector also has to radically change how it works with the private sector and chooses partners on new infrastructure projects; its current approach is not sustainable. The approach has transferred too much risk on contractors who are exiting the market. Instead, it should encourage models that attract long-term investors at lower cost, with structures that can absorb risk such as through the introduction of a Regulated Asset Base, and in evaluation it should favour companies with the governance and commitment it wants in the long term; not simply lowest cost. This approach will strengthen not weaken the private sector contracting market.
The Infrastructure Forum's recent paper on alternative models for infrastructure mentioned that history might show that too much risk has been transferred under the Private Finance Initiative. The subsequent demise of Carillion is a demonstration of the point. A large part of Carillion's problems was due to mis-priced construction contracts under PFI in an increasingly competitive market with fewer deals available, as the model has been used less extensively.
The structure of PFI is that government awards a long term fixed price contract to a PFI company to deliver and operate an asset and service. The risk is fully transferred to the private sector as they are the most qualified to price and take the risk. In turn, the PFI has financed itself with relatively high cost finance to be able to absorb this risk and puts in place sub-contracts to pass the bulk of the risk to underlying contractors.
The PFI approach therefore assumes that the private sector has the expertise to accurately price construction risks and by inference that PFI projects inherently can be accurately priced. It encourages contractors to take as much risk as possible to win deals and the PFI companies to use the most aggressive capital structures to reduce costs, which are inflexible and highly geared.
The model absolutely can work, as the success of the PFI programme has proven. But what we have also seen is contractor margins have been progressively falling, the level of risk accepted increasing and large mis-priced contracts have materially impacted contractors. We have seen as a result the demise of both Jarvis and Carillion, Laing exiting the contracting market, and Balfour Beatty sustaining losses.
The number of contractors able and willing to underpin the high risk transfer required under traditional PFIs has diminished; particularly UK contractors. This high risk transfer model no longer seems sustainable if it were to be used widely as it has been in the last two decades.
To give another example where risk transfer is too onerous, in rail franchising, franchises are awarded to the lowest cost bidder (or the one with the highest purchase price where the franchise is revenue earning). The most attractive bidder will be the one with the thinnest equity that takes the greatest risk on future revenue. But pursuing that high risk transfer model has led to an increased number of franchises getting into trouble. Does this demonstrate private sector incompetence or is government simply clinging to a model that encourages high risk taking with low equity, increasing the probability of default? The answer seems self-evident.
Government needs to think about how it procures assets and services and question whether models that have very high risk transfer and where lowest cost trumps all other criteria in bid evaluation, may not be a sustainable approach, nor in their long-term best interest.
Models that share the risk, allow a cost of capital closer to government's and have governance aligned to public sector values would be a far more sustainable outcome for much of infrastructure procurement.
This should impact both how government designs competitions for future infrastructure - is maximising fixed price risk transfer the best approach? - and also the evaluation criteria it uses to choose its partners. Rather than simply lowest cost trumps all, criteria could give equal weight to governance and structures that suggest performance will be sustained, such as financial flexibility, commitment to long term ownership, ability to work with government, representation of government and consumers within governance. In essence, criteria designed to ensure not just lowest cost delivery but a long-term partner with an acceptable cost of capital.