AIIP Policy Position Paper: Financial Challenges
March 2024
Issues
1. Contracting authorities are facing increasing financial challenges based on competing budgetary constraints which are, in certain areas, outweighed by inflationary pressures.
2. This Policy Position Note relates to the financial management of Private Finance Initiative (Private Finance Initiative (PFI) contracts within the broad context of value for money as defined by the National Audit Office as “the optimal use of resources to achieve intended outcomes” and HM Treasury Green Book definition of the “balanced judgement about finding the best way to use public resources to deliver policy objectives.”
3. This PPN should be read alongside and in parallel with other PPNs on Management of Change, Relational Contracting, and Financial Challenges
Dissemination and Scope
4. This PPN is applicable to all contracting authorities, including all central government departments, their executive agencies, non-departmental public bodies, local authorities, NHS bodies and the wider public sector (excluding Devolved Administrations). Together these are referred to in this PPN as ‘contracting authorities’.
5. Please circulate this PPN across your organisation and to other relevant organisations that you are responsible for, especially ensuring that it is drawn to the attention of those with direct operational responsibility for PFI projects and those with a commercial or financial role.
Timing
6. With immediate effect.
Background
7. PFI contracts are a form of public private partnerships used in the UK since the 1990s, as a way to finance and provide public sector infrastructure and capital equipment projects, such as roads, hospitals and schools. PFI projects involve the establishment of a new company that delivers the project, commonly referred to as a special purpose vehicle (SPV). The SPV finances, builds, maintains and operates the asset over the contract term, usually 20 to 30 years. During this period, contracting authorities make regular payments to the SPV that comprise debt repayment (covering the cost of building the asset), through-life operation and maintenance costs, financing costs, insurance costs etc, (usually referred to as the Unitary Charge). In many PFI contracts, the SPV is, in addition to delivering the services associated with PFI, are also responsible for reviewing its own performance, and reporting back to the contracting authority.
8. Often, the management of PFI contracts involves different organisations across the public sector ranging from the contracting authority which entered into the original agreement (with primary responsibility for managing the contract, including the expiry process), through to sponsoring Government Departments. The Infrastructure and Projects Authority (IPA), reporting into HM Treasury and also the Cabinet Office, supports Government Departments and contracting authorities as the Government’s Centre of Expertise for Infrastructure and Major Projects. HM Treasury is responsible for PFI policy and fiscal decisions and co-owns the PFI strategy along with the IPA.
9. The Government announced in the 2018 Budget that it would no longer use PF2 (the most recent PFI model) for new government projects, but existing PFI and PF2 contracts did not end because of this announcement. Archived documents including the retired PF2 policy and standardisation of PF2 contracts are available at the National Archive. As a result of both the mass-deployment of PFI during the late 1990s through to 2017, there are 669 PFI projects across the UK with a total Unitary Charge value of £10,193m in 2024.
10. The IPA-commissioned White Fraiser Report, published in 2023, highlighted a range of areas in which some PFI projects were seen by both sides of the partnership to be working ineffectively, in ways which jeopardised value for money, eroded trust, diminished collaborative working and placed expiry and handback at risk. The report called for a ‘resetting’ of the operational basis in the case of these PFIs and the AIIP has responded separately and awaits the IPA’s formal position in regard to the recommendations.
11. One issue that was identified was the financial challenges facing contracting authorities and how this interacts with PFI projects.
Key Considerations
12. When seeking to mitigate cost pressures (which could be as a result of inflation, reduced budgets, or other factors), contracting authorities should consider:
Comparing service needs and service delivery
13. It is possible that over the length of the Project Agreement term what the contracting authority initially required the SPV to deliver changes based on the needs of the end users. This presents an opportunity to recalibrate the scope of services and potentially realise savings.
14. However, in order to strike a balance between immediate cost reductions and the sustained performance of services over the long term, it is imperative to establish and apply a strategic cost-benefit analysis framework. This framework must encompass a thorough evaluation of the potential savings that might be realised by reducing non-essential services or assets against the potential for needing to restore those capabilities in the future (which could be more expensive or complex).
Ensuring the use of mechanisms within the Project Agreement
15. Project Agreements typically include a number of mechanisms designed to ensure continued value for money is achieved throughout the term, for example benchmarking and/or market testing processes; performance-related deductions as part of the payment mechanism; the ability to adjust key performance indicators (KPIs) and the contracting authority's service requirements; and insurance, energy or refinancing gainshare mechanisms.
16. Contracting authorities and SPVs should establish which of these mechanisms are included in their Project Agreements, and ensure these are being used as intended. These are key tools to addressing financial challenges without substantive change to any contractual documentation or ways in which the Project should be functioning.
Ways of working
17. It is imperative that parties seek to work together collaboratively and transparently to avoid misunderstandings.
18. Parties should work from a clear and shared understanding of current costs (including DRAFT
components of the unitary charge and whether they are usage-based and variable – e.g. energy – or linked to user activity – e.g. catering) and jointly identify areas where 'trade offs' can be made to reduce or optimise costs.. Understanding how the cost components may or may not be index-linked may guide the focus of cost optimisation activity.
Actions
Comparing service needs and service delivery
19. The scope of service may be able to be reduced to address cost pressures. Project agreements accommodate changes in Authority Requirements where parties agree. Given the length of concessions it is possible that what was specified at the outset may no longer perfectly reflect the needs of service users so consideration should be given to whether Authority Requirements should be changed. Subject to the extent of the changes being explored technical and legal due diligence and lender consent may be required.
20. Contracting authorities should periodically review all Authority Requirements with end users to determine the ongoing need for the full scope of services. If they are still needed, consideration should be given to whether they could be insourced or absorbed into other contracts to achieve efficiency savings.
21. It might also be possible to address cost pressure through ‘spend to save’ initiatives where an up-front capital investment leads to a reduction in operating costs over the mid to long term. For example, when replacing assets through lifecycle it might be better value for money to spend more than was in the lifecycle profile to upgrade an item of plant or machinery where doing so could lead to a long-term cost reduction (e.g. in energy costs or forecast maintenance costs associated with newer assets that are more efficient to run and maintain). Consideration should be given to where this capital funding comes from, how savings are realised and how and whether they should be shared.
22. To facilitate the development and implementation of spend to save initiatives, contracting authorities should share with SPVs any financial policies or business case templates that detail applicable capital payback periods and develop gainshare mechanisms to encourage savings proposals from SPVs (which could be based on drafting included in Project Agreements for insurance and energy cost savings).
23. Contracting authorities should determine their longer-term needs for facilities and, in this context, review utilisation of PFI facilities and consider whether space can be freed to enable rooms, zones or even buildings to be sub-let on commercial grounds to provide income. In addition, savings might be made possible by stopping or reducing maintenance in areas that are not being utilised. Where entire buildings or areas of land are no longer needed, parties could work together to explore property disposal or development opportunities.
Ensuring the use of mechanisms within the Project Agreement
24. Contracting authorities should use any value testing mechanisms in the Project Agreement that were intended to ensure value for money service provision such as:
Benchmarking and market testing
25. Benchmarking, typically in earlier Project Agreements, is where the provider of the soft services compares its or its subcontractors’ costs of providing the services against the market price of equivalent services. This may lead to an adjustment (which could be upwards or downwards) in the price of the soft services. Market testing, on the other hand, is where the SPV re-tenders the soft services to the open market which may result in a replacement of the provider of some or all of the soft services by the preferred tenderer. For guidance on how to enable efficient and effective benchmarking and market testing see here.
26. Value testing in the form of benchmarking and market testing needs to be executed with discipline to achieve cost optimisation. Contracting authorities and SPVs should work together to plan for these events enabling sufficient time for the processes to be run transparently and thoroughly. Consideration should be given to the creation of a central database of all benchmarking and market testing dates for the benefit of interested parties, thereby maximising market competition.
6.7 Performance-related deductions as part of the Payment Mechanism
27. Contracting authorities have a degree of discretion within the provisions of some Project Agreements to provide relief against calculated deductions for aspects of service failure. This is typically used when the cause of the service failure in question is not the fault of the SPV or its subcontractors, or as part of an agreement or plan to remedy the issue. Any such long-standing periods of relief could be reviewed and, where the relief has not brought about the requisite remediation of the problem, rescinded so deductions to the Unitary Charge are made in respect of that issue, realising a saving.
Adjusting Key Performance Indicators (KPIs) and Authority Requirements
28. Payment for PFI services is based on pre-determined standards and performance. Key Performance Indicators (KPIs) are used to measure this performance. Project Agreements allow for and enable, through clearly defined processes which provide for changes where parties agree, annual reviews of weightings and rectification times. Recognising that PFI services are often ‘golden plated’ there might be grounds for a reduction in service.
29. Full advantage should be taken of the mechanisms available in Project Agreements to change KPIs annually. Whether and how to change KPIs should be determined by contracting authorities in conjunction with service users. Exploring changes in service levels via a contract variation, particularly in terms of response times to service requests, demands a detailed analysis of historical data to understand the actual frequency and necessity of rapid responses. By examining past instances where quick reactions were either essential or could have been avoided, contracting authorities can assess the real impact of these service levels on overall operations. This analysis not only informs more efficient resource allocation but also aids in determining whether maintaining very short response times is truly beneficial or if a approach more reflective of the operational need could lead to significant cost savings without compromising service quality.
Energy, Insurance, or Refinancing Gainshare Mechanisms
30. Gainshare Mechanisms work by dividing between the SPV and the contracting authority any ‘gain’ or saving achieved in a specific area. These gains are split by contractually defined percentages. For example, if a refinancing of remaining Project debt can be done in a way that achieves a positive change in the overall Net Present Value when comparing the pre-refinancing financial model to the post-refinancing model, this positive change is shared.
31. Parties should review which of these Gainshare Mechanisms is in place in the relevant Project Agreement and work together to review opportunities to achieve a gain in any relevant area such that the mechanism can be applied and both parties can realise a saving.
Lifecycle reprofiling
32. Lifecycle profiles in Project Agreements are designed to ensure that assets beyond their economic life are replaced, with lifecycle risk sitting with providers. Contracting authorities could work more closely with SPVs and FM Cos to, by agreement, maintain assets beyond their anticipated economic life (rather than replacing them) and achieve
cost savings. Similarly contracting authorities could change the residual life requirements in project agreements to achieve cost savings in the short term. In order to assess the value for money of this approach contracting authorities should make a case for deferral of lifecycle maintenance or altering residual life requirements in the face of financial pressure in the knowledge that this may result in higher costs being borne later and/or potentially greater risk of assets failing.
Ways of working
33. Contracting authorities and SPVs should begin with a comprehensive cost analysis and forecast to understand the breakdown of current and future costs into unit costs and volumes, considering this outside any contractual benchmarking process if the next benchmarking date is some way off.
34. Contracting authorities should consider how services’ end users can be informed on the costs of using certain items and consumables that are charged for on a variable basis, and how this knowledge can be used to drive long-term behavioural change. In turn, allowing users to consider exactly whether actions are cost effective and building awareness may deliver financial benefits over time.
35. A dedicated joint cost optimisation taskforce (comprising the contracting authority, SPV and supply chain) should be established. It will be accountable to formal project governance and will be responsible for:
a. jointly identifying both cashable and non-cashable benefits of the project (such as enhanced service quality or safety improvements); and
b. making strategic decisions on how to best use these resources.
36. Decisions might include directing funds to enhance frontline services or to strengthen weaker aspects of the project, ensuring its overall effectiveness and sustainability.
