5th November 2005

Contingent Risks and Risk Transfer in PFI/ PPP Projects Summary/Key Points •

PFIs were designed to transfer risk from the public to the private sector.

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The key rationale of PFIs should be economic efficiency - the prime assumption being that in the relevant cases, the private sector is better able to manage financial and business risk than the public sector.

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However, the models used to assess the viability of PFIs are typically biased against the public sector comparator. In addition, the economic cost of evaluating PFIs is not accounted for.

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The value for money argument has never been tested. Of the 563 PFIs approved between 1996 and 2002, only 8 have been assessed financially by the National Audit Office.

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In two thirds of all hospital PFIs, the risks associated with the projects could not even be identified.

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There is no reliable data on the relationship between risk and the cost of capital of the private sector concessionaires, making assessment of the success or failure of PFIs practically impossible.

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Contingent liabilities associated with PFIs are long term in nature and heavily dependent on which economic and political scenarios are used.

Conclusions Contingent risks of PFIs are difficult to identify and hence more advanced scenario and probabilistic models are required in order to better assess whether objectives are met and to properly quantify contingent liabilities. Failure to do this has already resulted in a potential future liability for government of up to £200 billion. GENERAL BACKGROUND NOTES:

PFI/PPP Projects •

There are 3 Broad Categories: i.

Free standing;

ii.

joint ventures; and

iii.

services sold to the public sector.

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Free-standing: Costs will be recovered entirely by a charge to the final user – for example the Dartford Bridge. Government often undertakes initial planning and statutory procedures.

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Joint Ventures: Control lies with the private sector - government contribution is well defined and limited, private sector returns genuinely subject to risk.

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Services: For example, where the private sector provides accommodation for the elderly. Public sector should not underwrite the underlying asset’s use by other customers.

Government guarantees are both implicit and explicit for all PFIs. For instance, the Residual Liabilities Act of 1996 guarantees the PFIs of the NHS. The IMF estimates that in the UK, future service payments under PFI contracts amount to an explicit off-balance-sheet liability totaling £100 billion. Other estimates vary between £100 billion and £150 billion but could be as high as £200 billion. The Treasury’s own estimate of future service payments flowing from PFIs already contracted amount to £110bn. The following table from the Treasury shows estimates of payment obligations arising from contracted PFIs:

Key Principles of PFIs •

Must offer cost effectiveness?

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Must use public sector comparator.

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Private sector must assume genuine risk without guarantee against loss.

PFIs should reduce costs, speed up time-to-market and promote innovation. In theory, a model PFI should result in an optimal balance of risk between the private and public sectors. Value for Money This is achieved through the transfer of risk to the private sector. The principle being that the risk is allocated to the party best able to manage it. According to the Modigliani-Miller Theorem, transferring risk should not affect the cost of financing. The cost of capital should depend only on the risk characteristics of the project. However, there is no standard method for identifying risks in PFIs (Problem A). A report commissioned by the Treasury (2003) showed that in over two thirds of hospital PFIs in existence, risks attached to the private sector concessionaire could not be properly identified (Problem B). The Public Accounts Committee in a report in 2004 also pointed out the lack of data on the relationship between risk and cost of private finance (Problem C). Main Financing Routes There are currently three main components to PFI financing: •

The Contractors who build, operate and maintain the projects

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The Banks who provide senior debt to the projects

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And the Specialist Funds who provide secondary financing

Secondary Market The secondary market in PFI financing is in its early stages in the UK and the main players comprise the same group of financiers who provide senior debt, i.e. commercial banks. Private equity firms, pension funds, investment banks and a few specialized funds are becoming more active in packaging and structuring secondary financing for PFI projects. Many in the UK have guaranteed income streams of between 7%-9%. The expected shortfall in secondary financing has piqued the interest of private equity firms, particularly those associated with the large city banks.

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5th November 2005 Key players in Europe •

Barclays Private Equity and SG (SocGen) Corporate and Investment Banking through their joint venture I2 which specializes in PFI financing. I2 has raised £450m and a further £150m from 3i. I2 is estimated to be the largest equity fund currently in the secondary finance initiative market.

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BNP Paribas - through their property venture funds

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Construction and property companies - Laing’s, the largest in the UK, which owns and manages 48 PFIs worth about £335m, Taylor Woodrow, Balfour Beatty and Jarvis.

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Specialist Funds such as Innisfree, which is structured as a private equity group and currently has about £685m of funds under management, with £470m committed to 49 projects.

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Pension Funds

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Investment Banks

Key Types of Projects

BOT: DBFO: DCMF:

Build Operate Transfer Design Build Finance Operate Design Construct Maintain Finance

Types of Government Guarantees •

Guarantee of demand in the long term-usually 20-30 years.

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Indemnities.

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Letters/Statements of Comfort.

The success of a PFI depends to a large extent on a comprehensive contractual framework for the project and the optimum definition of the elements governing its implementation (Problem D). (EU study) However, an EU study in 2002 highlighted the fact that government’s evaluation procedures of PFI proposals do not include factoring strategic behavior by companies designed to improve their position, exploit public sector omissions and failures (Problem E). In other words businesses engage in corruption, secrets and lies. Corruption is notably high in PFI contracts. A global study of infrastructure contracts for railways found that the final actual cost of these contracts was significantly higher than original estimates/proposals (Problem F).

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Performance Measurement Performance measurement of PFIs is notoriously poor. Transaction cost theory, supplemented by resource-based theory is being developed as a way of creating a performance gauge (Problem G). The defense sector has become a key focus for performance measurement as it has been the leading user of PFIs since the year 2000 and by its nature, involves significant problems for long-term contracting given the uncertainties surrounding supply and demand (Problem H).

Common Risk Factors Used in Standardized UK PFI Assessment (Problem I) •

Duration of Contract - normally long term contracts involving cooperation between public sector and service provider.

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Commencement of Service and protection against late commencement, for example: i.

liquidated damages

ii.

performance bonds

iii.

parent company guarantees

iv.

bonus payments for early completion

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Supervening events: Defining compensation.

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Information warranties including latent defect risks.

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Availability of service during term of contract.

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Maintenance issues:

compensation events

i.

Existence of sinking fund.

ii.

Expiry of contract.

iii.

Treatment of assets at expiry.

and

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Performance Monitoring: calculation of performance/objectives.

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Payment mechanism and ability to finance.

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Change in service.

calculation of

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Change in law.

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Indemnities, guarantees and contractual claims: Public guarantees do not constitute effective government liabilities because there is no certainty they will translate into increased debt in the future-only recognized under cash accounting.

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Insurability.

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IPR.

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Dispute resolution.

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Refinancing.

Other Risks •

Costs of assessing PFIs: The Aquatrine project (waste and waste water management across MoD properties in the UK) resulted in more than £37m in legal costs well before the project was approved (Problem J).

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Cost of unwinding complex financing of PFI Special Purpose Vehicles (Problem K).

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The use of subcontractors by the concessionaire increases the complexity of estimating contingent liabilities (Problem L).

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Residual risk, which is the future market price of the asset.

How to Model/ Manage Contingent Risks in the Absence of Data Some ideas from financial modeling world that address the problems outlined above and that do not appear to be widely used by government advisers in the assessment and valuation of PFI deals: Modeling Solutions: A. Accurate identification and valuation of who is assuming what risk. This is relatively easy to standardize provided there is an appropriate evaluation platform and framework. As below. B. This process needs to take place from the point of view of both sides taking into consideration the commercial issues faced by the private entity as well as the view of the public sector administrative framework. C. Appropriate cost of capital (debt/equity) through self-consistent models that incorporate appropriate probabilistically balanced scenarios.

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5th November 2005 D. Proper incorporation of contingent risks into an evaluation process that takes place alongside any contractual negotiation from the early phases. E. It is easy to incorporate various game-theoretic assumptions on negotiation and business motivators into a project model i.e. what-if type scenarios. F. Based on probabilistic drivers of uncertain future outcomes or events it is possible to generate a distribution computation from Monte-Carlo modeling and obtain a better idea of the range of final project costs. G. This is can essentially be done in the context of probability weighted scenario modeling. Risk hedging strategies through novel instruments and secondary market risk transference/ trading. H. Continuous monitoring and hedging of evolving risk - a dynamic and therefore ongoing task. Projects should be structured from the outset to accommodate changing circumstances. I.

Option-based valuation of detailed contractual terms. Proper incorporation of worse-case scenarios and use of worse-case planning.

J. Proper project cost estimates! K. Valuation over a range of residual value and break-up scenarios. L. Appropriate project disaggregating all the way down the supply/contract chain.

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