Behnam Sarani - MSc Dissertation - Risk Management in PPP PFI Projects - 2010

Risk management and sharing in PPP/PFI projects
A dissertation submitted to the University of Manchester for the
degree of MSc in Engineering Project Management in the Faculty
of Engineering and Physical Sciences
2010
Behnam Sarani
School of Mechanical, Aerospace and Civil Engineering

Behnam Sarani, University of Manchester
Risk Sharing and Management in PPP/PFI projects
2010 Page 2 of 129
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Table of Contents
1.0 Introduction...................................................................................................................... 7
1.1 Background .................................................................................................................. 7
1.2 Aims ............................................................................................................................. 8
1.3 Objectives..................................................................................................................... 8
1.4 Research questions ....................................................................................................... 9
1.5 Scope and limitations ................................................................................................. 10
2.0 Research methodology................................................................................................... 11
2.1 Introduction................................................................................................................ 11
2.2 Approach to Research ................................................................................................ 11
2.3 Report structure.......................................................................................................... 12
2.4 Data Collection........................................................................................................... 13
2.5 Research Strategy....................................................................................................... 14
2.6 Summary .................................................................................................................... 16
3.0 Overview of PPP/PFI procurement systems .................................................................. 16
3.1 Introduction................................................................................................................ 16
3.2 PPP/PFI Procurement origins..................................................................................... 16
3.3 Government commitment to PFI procurement........................................................... 19
3.4 PFI Project structure................................................................................................... 21
3.5 PFI tendering process................................................................................................. 25
3.6 VfM determinants ...................................................................................................... 29
3.7 Financing PFI projects................................................................................................ 33
3.8 Payment mechanisms in PFI projects......................................................................... 36
3.9 Summary .................................................................................................................... 38
4.0 Critical review of PPP/PFI procurement........................................................................ 39
4.1 Introduction................................................................................................................ 39
4.2 Utilising the efficiencies of the private sector............................................................ 39

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4.3 Risk allocation strategies............................................................................................ 42
4.4 New Risks being introduced to the public sector....................................................... 47
4.5 Is the transfer of risk feasible ..................................................................................... 50
4.6 Evaluating the robustness of the Public Sector Comparator ...................................... 53
4.7 Determining the value of risks transferred................................................................. 55
4.8 Refinancing of PFI projects and the secondary equity market................................... 61
4.9 The impact of the recession and change in government............................................. 67
4.10 Summary .................................................................................................................. 72
5.0 Case Studies................................................................................................................... 73
5.1 Introduction................................................................................................................ 73
5.2 Norfolk and Norwich University Hospital care Trust ................................................ 73
5.2.1 Background to project......................................................................................... 73
5.2.2 The Project structure........................................................................................... 74
5.2.3 Value for money analysis.................................................................................... 76
5.2.4 Financial restructuring of the PFI Project........................................................... 78
5.3 HMP Altcourse (Fazakerley)...................................................................................... 82
5.3.3 Financial restructuring of the PFI Project........................................................... 86
5.3.4 The Secondary Equity market............................................................................. 89
5.3.5 Risk Transfer....................................................................................................... 91
5.4 Queen Elizabeth II Bridge, Dartford crossing............................................................ 93
5.4.3 Risk transfer to the private sector ....................................................................... 98
5.5 Summary .................................................................................................................. 101
6.0 Conclusion ................................................................................................................... 102
6.1 Introduction.............................................................................................................. 102
6.2 Discussion ................................................................................................................ 102

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6.2.1 Research Question 1 ......................................................................................... 103
6.3 Ensuring PFI project success.................................................................................... 113
6.4 Final Conclusion ...................................................................................................... 116
6.4.1 Aims.................................................................................................................. 116
6.4.2 Objective One ................................................................................................... 117
6.4.2. Objective Two.................................................................................................. 118
6.4.4 Objective Three................................................................................................. 119
6.4.5 Objective Four .................................................................................................. 120
6.4.6 Objective Five................................................................................................... 121
6.5 Limitations ............................................................................................................... 122
6.6 Recommendations .................................................................................................... 122
7.0 References.................................................................................................................... 123
Appendix A........................................................................................................................ 127
Appendix B........................................................................................................................ 128
List of figures
Figure 1 - Research Structure............................................................................................... 13
Figure 2 - Number and value of PFI projects (HM-Treasury, 2006a) ................................. 20
Figure 3 - Proportion of Projects by capital value (HM-Treasury, 2006a).......................... 21
Figure 4 - Adapted from Fox 1999 ...................................................................................... 22
Figure 5 - Features of SPV (Saunders, 2010a)..................................................................... 23
Figure 6 - Timing of payments under the PFI and conventional procurement adapted
from(PAC, 2003a)................................................................................................................ 29
Figure 7 - PSC comparison with the PFI option (Canadian-Council-for-PPP, 2003).......... 31
Figure 8 - Typical sources of Finance for PFI projects, Adapted from (Fox, 1999)............ 34
Figure 9 - Unitary payment components (Hogg, 1996)....................................................... 37

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Figure 10 - Metronet Consortium, adapted from (Kellaway and Shanks, 2007)................. 51
Figure 11 - Cost elements in public sector comparators and PFI (Broadbent et al., 2008).. 56
Figure 12 - Project risks, financial costs and return based on phase of project (Finlay, 2003)
............................................................................................................................................. 62
Figure 13 - Real quarterly GDP growth (ONS, 2010a) ....................................................... 68
Figure 14 - Public spending and taxation % GDP (HM-Treasury, 2010b).......................... 71
Figure 15 - NNUH trust aerial photo and Hospital main entrance (NNHU, 2010) ............. 73
Figure 16 - NNUH Trust PFI project structure (Partnerships-UK, 2010b).......................... 75
Figure 17 - NNUH Trust termination liabilities post and pre refinancing (PAC, 2006)...... 81
Figure 18 - HMP Altcourse Prison aerial photo and main entrance (Google Images) ........ 82
Figure 19 - FPSL project structure (Partnerships-UK, 2010a) ............................................ 85
Figure 20 - How the HMP Altcourse refinancing increases, and brings forward, the returns
to the shareholders of the consortium (NAO, 2000)............................................................ 87
Figure 21 - Changing shareholder profile of HMP Altcourse PFI project (Partnerships-UK,
2010a) .................................................................................................................................. 89
Figure 22 - Queen Elizabeth II Bridge - Dartford crossing ................................................. 94
Figure 23 - Queen Elizabeth II Bridge PFI Project Structure. Adapted from (Saunders,
2010b, Highways-Agency, 2010) ........................................................................................ 97
Figure 24 - One of FSD’s buses during the Dartford Crossing installation (FSD, 2010).. 100
Total Word count inclusive of references of Appendix: 27,900

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1.0 Introduction
This chapter will cover the background of the project and the
relevance and importance of the topic investigated. The aims of the
research project are outlined and defined through a set of research
questions.
1.1 Background
Until the late 1980s the provision of public service infrastructure was
funded by a strong tradition of public sector procurement. All associated
costs were placed on the government balance sheet due to strict rules in
involvement of the private sector, meaning works were placed to
competitive tendering. However increasing pressure on the government
budget and an ever growing population led to a lack of available funding for
the development of critical public infrastructure (Fox, 1999, Mackie and
Smith, 2005, Dixon, 2005).
The Conservative government of the time introduced new guidelines
such as the Ryrie rules to encourage funding from the private sector to fund
major road infrastructure projects (Carlile, 1994). This led to initiatives such
as PFI (a type of PPP) which would allow private funding to design, finance,
build and operate public infrastructure projects in return for a regular
payment from the government, also known as the unitary charge.
This allowed for major infrastructure spending to be taken off the
government balance sheet with private sector expertise and innovation
being utilised to deliver projects on time, on budget and to a higher standard
(Mackie and Smith, 2005, Dixon, 2005). The private sector also gave

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projects further credibility as their involvement would ensure commercial
viability and remove the possibility of projects being sanctioned for political
reasons. It was stated that these arrangements could be used to transfer
risk away from the public sector and provide Value for Money (VfM) for the
taxpayer (Akintoye et al., 1998).
The PPP/PFI market has evolved, with the private sector participants
introducing innovation to maximise profits. Initiatives such as refinancing of
PFI Projects to take advantage of lower interest rates and the emergence of
thriving secondary and tertiary markets, trading in equity, have raised
concerns about the risk management process in PFI projects. It is the aim of
this research to investigate the critical issues that need consideration in
PPP/PFI projects.
1.2 Aims
To complete qualitative research into the academic and government
literature on PPP/PFI procurement methodology.
To review the risk management and transfer process in PFI projects
to critically review the wider VfM objective of PFI projects.
1.3 Objectives
1. Determine the extent to which risk transfer is central to the
development of PPP initiatives and whether the government’s
justification of such initiatives has changed.
2. Critically review government guidelines on the successful
implementation of PFI procurement

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3. Examine the extent by which government objectives of risk transfer
are realised in operational PFI projects
4. Critically review the VfM appraisal process and the method by which
valuation of risks transferred is carried out
5. Determine the future implications for PFI procurement methodology
1.4 Research questions
From the objectives above, a number of research questions have
been created to provide a focus for the research study. Upon completion of
the literature survey, these questions will be used to analyse and evaluate
the information gathered.
1. To what extent do government regulations stipulate risk transfer and
management as a requirement of PPP/PFI procurement and whether
implementation of PFI project shows evidence of this occurring?
2. Is the transfer of risk to the private sector feasible?
3. How accurate is the VfM appraisal process and does the transfer of
risk to the public sector represent VfM for the taxpayer?
4. What have been the major developments in the PFI procurement
method and how have government guidelines adapted accommodate
these?
5. What has been the positive impact of transferring risks to the private
sector and the benefits realised through their involvement?

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1.5 Scope and limitations
With PPP/PFI initiatives being used more widely to provide
infrastructure and services in the health, prisons, education and transport
sectors, it is important to gauge whether the transfer of risk is being realised
and whether these initiatives offer VfM for the tax payer in comparison to
those procured through traditional methods.
The debate for and against using private funding to provide public
service infrastructure has been ongoing ever since its inception. This debate
provides valuable literature (reports and journal publications), that can be
used to complete a qualitative literature-based research project to take into
account arguments for (Forshaw, 1999, Partnerships-UK, 2008, HM-
Treasury) and against (Pollock et al., 1999, Froud, 2003) the use of
PPP/PFI procurement.
This research however has limitations that affect the extent of works
carried out. PPP/PFI projects are typified by contracts over a lengthy period
of time (30 to 60 years). This means that only a few projects have
completed the operational phase and been handed back to public
ownership. Therefore an analysis of long-term effects of new developments,
such as equity markets and refinancing, cannot be fully investigated.
Also the model of PFI procurement has been exported with an
overwhelming number of projects worldwide and copious volumes of
information relating to these projects available. For the purposes of this
research, UK projects will be the primary focus, as PPP/PFI procurement
was pioneered in the UK along with Australia and the USA.

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2.0 Research methodology
2.1 Introduction
This section will outline the structure of the dissertation and the approaches
implemented in collecting the required information. Also the method by
which analysis of the information gathered is carried out and its relevance to
the objectives of the report are discussed. Furthermore the justification of
the research methods utilised will be established.
2.2 Approach to Research
The relatively short history of PFI projects coupled with long-term
concession agreements has resulted in the majority of projects not
completing the operation phase. This however has not deterred extensive
research and analysis of the PFI procurement methodology by both
regulatory bodies and academia. There are also increased levels of
transparency in the PFI market as this type of procurement is carried out in
the public domain, with extensive data from PFI projects being made
available from government sources. This transparency has led to multiple
books and journal publications in support of and against the government’s
ever increasing reliance on procuring major public infrastructure projects
using PFI methodology.

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Qualitative desktop research was carried out to gather the required
information for the purposes of this postgraduate dissertation. A qualitative
research methodology as defined by Naoum (1998) is the subjective
assessment of a situation or problem and takes the form of an opinion,
perception, view or attitude towards objects (Naoum and Coles, 1998). The
use of qualitative research methodology will allow for exploratory research
with an emphasis on description and discovery rather than on hypothesis
testing and verification (Harake, 2006). This research approach is
implemented to subjectively evaluate the situation, evaluate different
perspectives and discover new ideas with regards to the workings of PFI
projects.
2.3 Report structure
The section of this report have been categorised, as per guidance of
Maxwell (2005), into four main section (Maxwell, 2005). Initially the purpose
of this research is outlined by stipulating the aims and objectives. the
methods applied for the collection of data and its relevance are explained in
the second section. The final two sections relate to identifying the relevant
literature to research project and critically reviewing these findings to
present a discussion in the effectiveness of risk management and transfer
within PFI projects. The structure of the research project can be seen
overleaf in figure 1.

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Figure 1 - Research Structure
2.4 Data Collection
The two main methods of data collection are fieldwork and desktop
study approaches. Fieldwork is regarded as the collation of primary data for
the purposes of research, whilst desktop research is the analysis of data
from a secondary source such as government reports, journal publications
and text books. Findings from the literature review can be reinforced or
proven using case study information highlighting practical evidence of the
theory highlighted (Naoum and Coles, 1998).
Galliers (1992) defined case studies as “an attempt at describing the
relationships which exist in reality, usually within a single organisation or
organisational grouping” (Galliers, 1992). The use of case study information

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is beneficial as it captures in detail the specifics of PFI projects and
analyses the various aspects of an often complicated process. Both Galliers
(1992) and Bell (2005) point out a weakness in case studies being
susceptible to generalisation as they tend to be restricted to a single event
(Bell, 2005, Galliers, 1992). Furthermore case studies are susceptible to the
interpretations of events by various stakeholders and researchers, who may
derive dissimilar conclusions from the same set of data (Galliers, 1992). To
minimise these obstacles, case study information from various sources
(such as government commissioned reports from various sectors) will be
used to support findings (PAC, 2006). These will in turn be compared to
findings of independent case study reports done by academic research
(Edwards, 2009).
2.5 Research Strategy
For the purposes of this dissertation, the literature review is centred
on existing work on risk management methods used within PFI and PPP
projects and how the process has developed in line with evolution of the PFI
procurement methodology. This will include:
• Investigating the critical role risk management plays in PFI
projects,
• Reviewing how risks are identified, quantified and allocated to the
various parties involved in typical PFI projects,
• Identifying and critiquing the contractual mechanisms that
facilitate the transfer and sharing of risk and

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• Completing a review of the risk transfer process and any
identifiable shortfalls in this process.
The main source of secondary data will be government
commissioned review reports sourced from respective websites of the
departments and public bodies involved. These include:
• National Audit Office (NAO)
• The Office of Government Commerce] (OGC)
• HM Treasury Taskforce – PPP Projects (up to 2000) (HM-
Treasury)(HM-Treasury)
• Partnerships UK (Partnerships-UK, 2008).
Non-governmental sources include literary publications on the subject
with prominent publications by Fox, Pollock and Boussabaine. (Fox, 1999,
Pollock, 2005, Boussabaine, 2006), in addition to journal publications and
web publications. E-journal databases will be used to collate journal articles
on the subject. Initial searches will utilise Science Direct and Compendex
databases.
The argument for and against PPP/PFI projects has led to the
publication of many sources of literature that are related to the subject. It is
the aim of the search strategy outlined above to ensure that all viewpoints
are considered in the final dissertation report.

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2.6 Summary
In this section the proposed research methodology was outlined and the
qualitative desk top research methodology justified against the aims and
objectives of the research project.
3.0 Overview of PPP/PFI procurement systems
3.1 Introduction
In this chapter the theoretical background to PFI procurement methodology
will be investigated. This will include a brief history of PFI projects and the
analysis of the reasons behind the government’s decision to involve private
sector participants in the provision of major infrastructure projects. An
analysis of government guidelines of what is required for effective PFI
procurement is also carried out.
3.2 PPP/PFI Procurement origins
Until the 1980s major infrastructure projects were completed using
traditional public procurement with all funding placed on the public sector
balance sheet. There was a strong tradition of public sector procurement
with works being placed to competitive tendering and strict rules with
regards to the involvement of the private sector. The lack of available
funding led to neglect of many of the UK’s essential infrastructure such as
hospitals, schools, prisons and the road network. This coupled with growth

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in the economy and population increases led to increased demand for
provision of new infrastructure (Heald, 1999).
The need for major investment meant that the Conservative
Government introduced new guidelines such as the Ryrie rules to promote
funding from the private sector (US-DoT, 2007). The Ryrie rules meant that
private sector investment could be utilised to fund major infrastructure
projects. These privately sourced funds were to be used in place of, rather
than an addition to, public funds whilst all risks had to be genuinely
transferred to the private sector (Mackie and Smith, 2005).
In the UK the involvement of the private sector was implemented
through Public Private Partnerships (PPP). PPP can be defined as a long-
term contract between public and private sector parties for the design,
construction, financing and operation of public structure by the private
sector party (Yescombe, 2007). Payments are made over the life of the PPP
contract to the private party for use of facilities by the public sector parties or
the general public. The facility remains in public sector ownership or reverts
to public ownership at the end of the PPP contract (Yescombe, 2007).
The PPP option of procurement is distinctive from traditional public
sector procurement. The traditional procurement method involves the public
authority taking full responsibility for operations and maintenance of the
facility. Payment is made using funds from taxation or public borrowing
(Fox, 1999).
In a PPP project, the public authority stipulates its requirements in
terms of output, but does not specify how these are to be achieved. It is left
to the private body to design, finance, build and operate the facility. The

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private party receives regular payments known as “unitary charge” aimed at
repaying the borrowed finances for the project and give a return to the
investors (Yescombe, 2007).
The PPP procurement approach did not require increased taxes and
meant that infrastructure spending was taken off the government’s balance
sheet. The use of PPP procurement is not exclusive to the United Kingdom
with similar schemes in North America (P3) and Australia (Privately
Financed Projects (PFP)). In the UK, PPP procurement is done primarily
through Private Finance Initiatives (PFI) a type of PPP (Yescombe, 2007).
For the purposes of this research project, the focus will be on PFI projects to
reflect the government’s preference in using the PFI procurement model.
Another feature of PPP/PFI projects is that by allowing the private
sector to determine how to deliver the service, the awarding authority is able
to transfer some risks to the private sector. This risk transfer is integral to
the contracting of any PFI project (Fox, 1999). This includes the transfer of
design, construction, finance and operational risks to the private sector,
which would otherwise be borne by the public sector under typical capital
asset procurement (Hogg, 1996). If a traditional procurement process was
used, all risks from the project and consequent effects on project costs and
schedules in case of failure, would be accountable to the public sector
(Perez, 2006).
The use of PPP/PFI method of procurement also allowed the
government to bring forward capital expenditure and enable major projects
to be completed in the healthcare, education, corrections and transportation
sectors. Furthermore with a lack of sufficient public funding being available,

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some argue that without the introduction of initiatives such as PPP/PPP,
many essential infrastructure projects would have not been financed (Heald,
1999).
Unlike government projects which were susceptible to late
completion and above budget, the involvement of the private sector
introduced much needed technical expertise and project management
capabilities to ensure that projects were delivered on time, on cost and to
the desired quality (US-DoT, 2007). Furthermore in traditional procurement,
there is no incentive for the contractor to choose the best construction
materials or ensure optimal performance during the operation phase due to
financial restraints and need to maximise profit. This is not an issue in PFI
procurement where it is in the interests of the private consortium to
complete the construction, operations and maintenance of the facilities to a
good standard for the entirety of the project (Mackie and Smith, 2005).
3.3 Government commitment to PFI procurement
Government guidance and statistics in PPP/PFI projects show that it
plays an increasingly pivotal role in delivering much needed public
infrastructure in the health, education, defence, transport and prison
sectors. There are currently 920 PPP/PFI projects in the United Kingdom
that have achieved financial close (Partnerships-UK, 2008), of these
projects 668 are PFI projects with a total estimated capital value of £56.5
Billion (HM-Treasury, 2010d). The increasing trend in total number and
value of PFI deals since their inception in the early 1990s can be seen in
figure 2.

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Figure 2 - Number and value of PFI projects (HM-Treasury, 2006a)
PFI procurement has been used in twenty different government
departments with the Department of Health (DoH) and Department for
Education and Skills (DfES) being the largest of PFI users. Figure 3
represents the breakdown of these projects according to the various
departments.

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Figure 3 - Proportion of Projects by capital value (HM-Treasury, 2006a)
The increasing trend in number of PFI projects was set to continue
with the outgoing Labour government supporting PFI procurement. A further
116 PFI projects with a total capital value of £14.4 Billion are currently in the
tendering stage (HM-Treasury, 2010c). The effect of the new Coalition
government on the future of PFI projects will be discussed in detail in
section 4.9.
3.4 PFI Project structure
PFI projects involve numerous parties whose relationships are
governed by various contracting agreements. Central to the structure of a
PFI project is the Special Purpose Vehicle (SPV). The SPV, also known as
the project company is a central feature of PFI projects and an essential risk
transfer mechanism. The SPV lies in the centre of the PFI project structure
in between the main parties involved. These are the awarding public

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authority, the private parties chosen to design, build and operate the project
and the debt funders financing the project (Fox, 1999).
The typical structure of a PFI project and the parties involved can be
seen in figure 1.
Figure 4 - Adapted from Fox 1999
The SPV lies at the centre of all contractual and financial
relationships within a PFI project as a separate legal entity with sole
responsibility for the project (Yescombe, 2007). The SPV ensures that there
is limited or non-recourse to sponsors of the project and that SPV is not
affected by any unrelated businesses. An SPV will typically have no assets
or liabilities other than those contained to the project (Gatti, 2007). The use

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of an SPV also has further features which can be seen in figure 5.
Figure 5 - Features of SPV (Saunders, 2010a)
The relationships between the various parties involved are governed
by contracts which stipulate the rights and obligations of the parties
involved. These include the concession agreement, shareholder agreement,
construction contract, operations contract and the loan agreement. These
contracts are the mechanisms by which the SPV transfers risks to parties
best able to handle them (Grimsey, 2007).
The operating contract for example governs the business relationship
between the SPV and the party that manages the facility or structure. The
aim for this contract is to mitigate risk by transferring it to the party which
can best evaluate and handle it. The operating party takes an agreed sum
of money or percentage of profit from the SPV in exchange for their
expertise or services provided (Gatti, 2007).
SPV
Non-
recourse
funding
Off-balance
sheet
transaction
Sound
income
stream of the
project
Allocation of
risks
Complex
Contractual
Arrangement
s

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The loan agreement is used to create a business relationship
between the SPV and the banks or lenders. The purpose of a loan
agreement is to help the SPV secure the financial resources required to
carry out the tasks. Within the contract, lenders would have agreed on terms
such as:
• The amount of funds made available to the project company
• The interest rates and repayments schedule
• Protection to banks against increased cost
• Representation and warranties - actions that the banks are allowed to
take in the case of project failure.
It is in the lenders interests to limit the amount of risk they are being
exposed to, as they cannot reclaim money from the sponsoring company
assets in case of failure of the project (Gatti, 2007).
Construction contracts such as a Turn-key contract or an
Engineering, Procurement and Construction (EPC) contract are used to
legally bind the Contractor to the SPV. The construction contract is a
standard requirement by banks or lenders as a large proportion of risk will
be transferred to the contractor. The Principle Contractor (usually a
reputable organization) is legally bound to all operations relating to the
construction of the project. This type of structuring allows the SPV to only
deal with one principal contractor for the entire duration of the project. This
can often lead to fewer conflicts between the parties involved which can be
costly and adversely affect the project schedule. In effect, the SPV would
deal with “one single point of responsibility” (Gatti, 2007).

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The Concession Agreement is a contractual agreement which
governs the relationship between the government and the SPV. It allows for
all required permits and authorisation to be acquired and stipulates the
rights and obligations of the sponsors and the government as well as the
technical and financial requirements for the length of the project.
A Shareholders Agreement is used to govern the relationship
between different shareholders and makes provisions for percentage share
of ownership, voting rights and distribution of profits.
3.5 PFI tendering process
The use of PFI procurement has been facilitated by the government
through the use of standard contracting. Guidelines on the application of PFI
procurement are published to ensure VfM for the taxpayer by focusing on
the delivery of a service rather than the acquisition of an asset (HEFCE,
2004). This included guidance on the critical tendering process for a PFI
project and the various stages compulsorily involved, 14 stages in the case
of an example from the Higher Education Funding Council for England.
These stages were: (adapted from HEFCE 2004)
• Stage 1: Establishing the business need
o Once the business needs have been established, outline how
these needs might best be met, and identify those areas
where the principles of PFI could be applied
• Stage 2: Appraising the options and choosing procurement
route

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o Specifics of service to be provided and cost of transfer
analysed to determine whether PFI procurement is relevant.
Original project criteria based on assumptions of what could
be delivered.
• Stage 3: Assessing VfM for taxpayer
o Compare funding projects by public or private commercial
sources. Often the Green Book Appraisal and Evaluation in
Central Government guidelines, published by HM treasury, is
used during this process.
• Stage 4: Creating the project team and advisors
o Project team is chosen to deal with project on behalf of public
body. External project management advisors often utilised as
it is often new territory for the public body project team
• Stage 5: Decide tactics on pre selections
o Involves creating a shortlist from 30 possible bidders and
choosing negotiation tactics
• Stage 6: Official Journal of European Union notice (OJEU)
o Projects above a threshold must be advertised in a specific
way in OJEU to invite expressions of interest
• Stage 7: Pre-qualification
o The public institution establishes relevant criteria to ensure all
bidders are capable of carrying out the project
• Stage 8: Short listing
o Applying the pre-qualification criteria to reduce number of
bidders and invite remainder of parties to negotiate

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• Stage 9: Refining original appraisal
o Reassess original appraisal during negotiations to refine what
can be accomplished according to project specifications
• Stage 10: Invitation to negotiate
o Formal document known as “Invitation to Negotiate” issued,
setting out detailed framework within which commercial
organisation can make their offers
• Stage 11: Evaluation of bids
o Carried out according to criteria set out at initial stages of
project
• Stage 12: Selection of a preferred bidder
o Further investigation into the preferred organisation to
ascertain their capability, given that they will be investing in a
medium to long term relationship with the commercial body.
• Stage 13: Contract award
o SPV established as a contractual company between the public
and private body. Design, construction and operation
agreements signed
• Stage 14: Contract management
o Management of the relationship between public and private
bodies - essential to ensure project is run in a cooperative
rather than combative environment
As outlined above, the PFI tendering process is complex with many
stages that need to be completed. This can result in a lengthy and often

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costly tendering process which introduces barriers to entry for new private
sector participants. This is reflected in government figures that show that for
PFI projects between 2004 and 2006 there were two or fewer bids per
project (NAO, 2007). Fewer bidders means that the public sector is at a
disadvantage and susceptible to opportunistic behaviour, a point
documented by the NAO and Public Account Committee reports (PAC,
2003b).
Further research by Akintoye and Dick (1996) identified the ‘PFI
bidding process and costs’ as an 8 out of 10 on the PFI unattractiveness
scale (Akintoye and Dick, 1996). This is also evident in PFI projects in the
Department of Health with academic research highlighting significant
barriers to entry for new consortiums entering the bidding phase (Pollock et
al., 2002, Froud, 2003).
Further justification is also required for the often high costs paid by
the tax payer for legal and financial services, £445 million in the case of the
PPP project for the London Underground (Committee-of-Public-Accounts,
2005). Across PFI projects the average total costs of tendering for private
contractors was 3% of the overall project costs, this is in comparison to just
1% in traditional procurement (Allen, 2001). The increased costs of the
bidding process and the barriers to entry that are introduced cast a shadow
over its effectiveness in ensuring maximum VfM for the taxpayer.

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3.6 VfM determinants
PFI funding benefits the public sector as the money needed to
acquire an asset can be made available immediately even at a time when
public funds are scarce (Fox, 1999). Often the repayments are spread long-
term, easing the burden on public sector funds. This is a disguised form of
borrowing known in the commercial sector as ‘buy now pay later’. Although
this method of procurement allows faster access to much needed funds, the
long-term nature of concession period in PFI contracts, often 30 years, can
result in the overall cost of the private sector option proving to be more
costly for the taxpayer (see figure 6).
Figure 6 - Timing of payments under the PFI and conventional procurement adapted from(PAC, 2003a)
An additional long-term cost of the PFI procurement method can be
attributed to the higher rate of interest for private companies compare to the

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government’s ability to secure funds at a lower interest rate. This
differentiation in costs also needs justification if PFI projects are to go
ahead.
As discussed previously, one main benefit of PFI is the transfer of
risk away from the public sector, as discussed in section 3.2. Other benefits
include the private sector’s ability to deliver projects on time and to budget,
in contrast to traditional public procurement. An HM treasury publication
(1999) found that the first Design, Build, Finance and Operate (DBFO) road
projects delivered average savings of 15% (Fox, 1999). These savings were
realised in decreased construction durations and lowering costs by bringing
together the previously separate design, construction and operations
phases of a project (PAC, 2003a). The full list of benefits and related
disadvantages for PFI projects as listed by committee of public accounts
can be seen in appendix A.
To ensure VfM for the taxpayer, it is essential that other possible
procurement options are fully considered before a PFI project is approved.
This will ensure that the option which delivers the best VfM for the taxpayer
is in the short and long term is chosen. To enable this comparison, a Public
Sector Comparator (PSC) is often used to determine whether PFI
procurement offers VfM when compared to the traditional public sector
procurement (Yescombe, 2007). The methodology for the calculation of the
PSC is stipulated in the HM Treasury’s Green Book (HM-Treasury, 2010a).
The Green Book defines the PSC as a “hypothetical risk adjusted costing,
by the supplier to an output specification as part of a PFI procurement
exercise”. The calculation of the PSC is a hypothetical, whole of life, risk

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adjusted cost of the government delivering the project and in addition to the
costs of retained and transferred risks, includes costs of construction,
operation and maintenance (HM-Treasury, 2010a). The use of the PSC
allows for financial comparison to be made to the Net Present Value of the
PFI option, as can be seen in figure 7.
Figure 7 - PSC comparison with the PFI option (Canadian-Council-for-PPP, 2003)
Government guidelines stipulate that a PSC should only be used when
the public sector finance option is a genuine alternative to the PFI option
and should be utilised at the outset of the project (PAC, 2003a). The use of
the PSC is beneficial as exact figures are given for often unquantifiable
aspects of a project, such as the value given to risks transferred to the
private sector. Other benefits as highlighted by the British Columbia council
for PPP guidance (2003) include:

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• Financial and cost disciplined approach to PFI project evaluation
• Full consideration of risks in a project and the threats and
opportunities to the project
• Encourages competition and consideration of management
(Canadian-Council-for-PPP, 2003)
There are however limitations to the use of the PSC which will be
discussed in chapter 4.6.
The monetary value for the PSC is calculated by determining the
value of the project income in future rates discounted at the cost of money.
This Net Present Value (NPV) or discounted cash flow is calculated by
using the following formula:
𝑃𝑉 =
𝐹𝑉
(1 + 𝑖) 𝑛
Where: PV = present value, i.e. money of today
FV = future value, i.e. money of the future
i = interest of discount rate and
n = number of periods
A Discount Cash Flow (DCF) is the NPV of a series of future cash
sums and is calculated as:
�
𝐹𝑉 𝑛
𝑛(1 + 𝑖) 𝑛
∑ is the sum of the net cash flow for each period, usually
semi-annually in PPP/PFI projects. (Yescombe, 2007)

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In addition to comparison of the PSC and PFI bids, the VfM process
also requires critical analysis of the received bids to ensure the optimum
blend of financial and non financial benefits for the public sector. In order to
determine the financial benefits, the public sector uses an Economic Rate of
Return (ERR, a type of Internal Rate of Return) to measure the return of an
investment over it’s lifetime before deciding to proceed with the procurement
of a PFI project (PAC, 2003a).
The cost of financing infrastructure development often represents a
significant proportion of the costs of a PFI project. Government guidelines
stipulate that the benefits of using private finance must outweigh the costs
of using such a method to ensure VfM. In order for the government to
maintain a strong negotiation position it is also essential that competition
exists between a number of bidders for a PFI project during the tendering
process (PAC, 2003a).
3.7 Financing PFI projects
The main difference between PFI and the traditional procurement
process is that in PFI projects the private sector finances the project upfront
and only receives remuneration by ensuring the capital asset adheres to the
performance criteria set by the government (Fox, 1999).
The scale of funds required often results in project sponsors
approaching third party sources for the sums required. The third party
involved, often a commercial bank will often require evidence of commercial

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viability of the project and the robustness of cash flows before the decision
to lend can be made. This is due to the third party funders being limited to
having recourse only to the assets and cash flows of the project and not the
project sponsors (Yescombe, 2007). The various potential sources of
finance for PFI projects can be seen in figure 8.
Figure 8 - Typical sources of Finance for PFI projects, Adapted from (Fox, 1999)
Equity funding is commonplace in PFI projects and is provided
through investment by the private consortium in return for shares in the
SPV. It is possible for the awarding public authority to require a certain level
of equity funding as part of the PFI contract. Increased levels of equity
represent a greater commitment from the project sponsors, therefore
commercial banks evaluating a proposed project often review the equity to
debt ratio in order to assess their exposure to risks in a project (Gatti, 2007).
Sources
of
Finance
Bond issues
Bank DebtEquity

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There are rare cases where funding for PFI projects occurs without any
equity from the project sponsors. In the case of the Queen Elizabeth II
bridge, the project was deemed to have minimal risks associated due to the
inelasticity of demand of road users and lack of alternative routes that could
threaten the project’s cash flow (US-DoT, 2007).
The majority of funding for PFI projects is done through commercial
Bank Debt, also known as senior debt. The funds are drawn with
commitment from commercial banks for the term of the project with a
structured drawdown and repayment profile in place (Fox, 1999). Often a
number of banks are recruited by a lead arranger bank to form a syndicate
that will provide the total funds required. This syndication allows for funds to
be drawn as and when necessary allowing for repayments to be linked with
anticipated cash flows. The covenants and warranties required by the
syndicate is often dependant on the nature of the project and its risk profile
(Yescombe, 2007).
The third source of funding available is Bond Financing of PFI
projects. This is often prevalent following the completion of the construction
phase where the risk profile of the project has changed. The sponsors often
refinance a project by issuing bonds to take advantage of the high credit
ratings the bonds will receive due to the low risks and the guaranteed
income stream of the project. Furthermore bond refinancing in the UK is well
regulated and a buoyant bond market offers a cheaper source of finance
post-construction in comparison with bank debt. The use of bond financing
allows for the involvement of a broader investor base with less stringent
covenants (Fox, 1999).

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Although equity, bank debt and bond financing represent the majority
of funds for PFI projects, there are additional sources that can be utilised.
These are lease financing, investment from the European Investment Bank
and in some cases government grants.
Regardless of the funding combinations used, all funds for a project
are raised through limited recourse financing, with financers of the project
still having recourse only to the assets of the SPV established for the project
(Fox, 1999).
3.8 Payment mechanisms in PFI projects
PFI projects are financed using funds from the private sector with
commercial lenders providing the majority of this funding through senior
loan debt. The repayment of this debt is via payments from the government
to the SPV. The timing and amounts of these payments are stipulated in the
concession agreement between the SPV and the awarding public body.
The payment mechanisms stipulated in PFI procurement allow for
risks to be shared in two distinct ways. The first is that the PFI operator is
partly paid for services it provides, i.e. number of available beds in a
hospital or cells in a prison project. The second performance related portion
of payment allows for the incentivisation/disincentivisation of the operator for
poor performance, e.g. escaped prisoners in the prison service or extended
waiting times in a hospital. In essence in a PFI project, the public authority is
not concerned primarily with the ownership of assets, but more with the

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quality of services provided for the general public (Hogg, 1996). This
requires the public sector to specify both the quality and quantity of services
required and also to have the ability to measure them correctly in order to
utilise the risk sharing capability of the payment mechanism.
The overall unitary payment is often made following the initiation of
the operation phase of the project and is comprised of elements relating to
various attributes of a project. These various elements as described by the
PFI panel can be seen in figure 9.
Figure 9 - Unitary payment components (Hogg, 1996)
The first payment component relates to the minimum levels of
capacity available for the service being provided. The second relates to
measurement of the performance of a particular support service against
preset minimum levels required. The third component relates to the future
usage of the facility where it is anticipated demand will increase or

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decrease. The final component relates to any particular incentives agreed
with the operator regarding service provision.
3.9 Summary
In this chapter the objectives of the government to take major
infrastructure spending off the government balance sheet was identified as
the major reasons why initiatives such as Ryrie rules were introduced.
These initiatives led to the involvement of the prvate sector in the form of
PPP/PFI projects which have become an important part of public
infrastructure provision in the UK and other countries around the world.
The implementation of PPP/PFI procurement was made possible
through various government guidelines such as the tendering process, VfM
appraisal process and the various participants involved were also
discussed. Furthermore PFI theory on the payment of the unitary charge
and the various sources of finance were discussed.

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4.0 Critical review of PPP/PFI procurement
4.1 Introduction
In this section a critical review of PFI theory will be carried out. Examples of
operational PFI projects will be used to analyse the success by which risk
transfer to the private sector has been realised. The potential benefits of
private sector involvement are discussed before a review of the
government’s VfM appraisal procedure is carried out. An investigation will
be carried out on recent developments in the PFI market and their
implications on the risk management process. The final section will review
the impact of the recent global recession and comment on the impact of the
recent change in the UK government.
4.2 Utilising the efficiencies of the private sector
One of the benefits of PFI procurement has been the use of expertise
in the private sector, meaning public authorities are more efficient in
procuring major public infrastructure projects. The traditional procurement
approach was often associated with time and budgetary overruns. The
introduction of expertise from the private sector in PFI projects and efficient
project management procedures have resulted in increasing number of
PPP/PFI projects being delivered on time and to agreed budget. This was
evident in the NAO (2003) report which found that up to 2002, 89 per cent of
PFI construction projects were delivered on time or early, whereas 75 per

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cent of traditionally procured hospitals were delivered late (NAO, 2003b).
The report also highlighted price certainty and the achievement of good
quality assets as major advantages of utilising PFI procurement.
There are also benefits to the public sector during the operational
phase of PFI projects. A report by HM Treasury (2006) found that in PFI
projects:
• Users are satisfied with the services provided
• Public authorities report good overall performance and high levels
of satisfaction against contracted levels of service
• The services contracted for are appropriate
• The incentivisation within PFI contracts is working (HM-Treasury,
2006a).
Further benefits for public authorities come from PFI projects having a
knock on effect on facilities still operated by the public sector. This was
evident in the NAO (2003) report into prison operations which found that
when PFI prisons were created, the public sector managed prisons began to
compete, which resulted in them often outperforming PFI prisons (NAO,
2003a). The positive impact of PFI projects is also evident in staff turnover
rates, which was 12.4 percent in the public sector, compared to a
significantly lower PFI staff turnover averaging 7 percent (BERR, 2008). It
can be deduced that the lower staff turnover rates are a result of a more
satisfied workforce in PFI operated facilities.
Analysis of PFI project performance in the education sector found that
PFI funded schools achieved educational improvements 92 percent faster

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than those rebuilt through traditional procurement (KPMG, 2009). The report
by KPMG (2007) identified increased innovation, thorough assessment
methods and benchmarking to be behind improved contract performance in
the majority of projects in the education sector (KPMG, 2007).
A further consideration is that the long-term unitary payment
mechanisms implemented in PFI projects provides incentivisation for the
private sector to provide high quality services for the entire length of the
contract (Grout, 1997).
The private sector participant is also incentivised to design and monitor
the facilities to a high standard to ensure payments are continued by the
public authority. There is a contractual guarantee that the ongoing
maintenance of the infrastructure is maintained, with funding ring-fenced for
the entirety of the concession period, a lesson now being implemented on
publicly procured projects (SCEA, 2010). This transfer of operational, design
and constructions risk to the private sector was one of the core objectives of
PFI contracting.
The use of PFI procurement provides the public body with the
additional financial diligence that is provided by the commercial lenders of
the PFI contract, this in essence reduces financial risk to the project (Gatti,
2007). It also ensures that projects are successful and loans are repaid with
the private operator incentivised to work though problems (SCEA, 2010).
Initial investigation into PFI procurement methodology has
demonstrated private sector efficiencies to be utilised in large scale public
infrastructure projects, efficiencies which in some cases are transferred to
publically operated facilities. There is also evidence of risk transfer to the

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private sector being realised to the benefit of the tax payer. A number of
critical issues were also highlighted for consideration to gain a holistic view
of PFI project performance. These will be discussed in the remainder of this
chapter.
4.3 Risk allocation strategies
As discussed in section 3.2, the transfer of risk to the private sector is
one of the most important features of PFI contracting. The monetary value
given to the risks transferred is often the critical factor in deciding whether
the public or privately funded option is chosen. Moreover it was
demonstrated that risk transfer is facilitated through contracts between the
project company (SPV) and the party best able to handle them. Although
the transfer of risks to the private sector is desirable, government guidelines
suggest that it is not feasible to transfer all risks to the private sector (Hogg,
1996).
In order to achieve the optimal VfM for the tax payer, government
publications stipulate the preferred risk allocation strategy in PFI projects.
These principal risks and government guidelines on preferred allocation are:
Principal Risk Allocated party
Design and construction risk Private sector
Commissioning and Operations risk Private sector
Availability and Performance risk Private sector
Demand for Volume risk Public sector

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Residual Value risk Not of concern for public sector
Legislation risk Public sector
Adapted from (Hogg, 1996, Yescombe, 2007)
A principle of PFI contracts is that since the public sector is
purchasing delivered services at pre-agreed prices, any increase in project
costs or consequence of delays will be borne by the private sector.
Furthermore the provision of services will remain the responsibility of the
private sector for the entirety of the concession period with a whole-life
approach to the construction and maintenance of the facility (Fox, 1999). It
is for these reasons that the operational risks are transferred to the private
sector. Yescombe (2007) states that since the private sector has the ability
to manage the aforementioned risks, the price will represent VfM
(Yescombe, 2007).
Contrary to this, if the private sector has no control over risks
transferred, then the price given to these risks represents poor VfM for the
taxpayer. For example, the Home Office is responsible for determining
which prison an occupant is allocated to, therefore the cost of transferring
demand or volume risk to the private sector would be too high as they have
no control over the number of prisoners in the country (Clarke, 2010). The
trend is now for the usage risks in the Prison Service to be retained by the
public authority (Yescombe, 2007). Risks often retained by the public
authority are the legislative and regulatory risks as they are best placed to
handle them by acquiring necessary permits or licences for completion of
works (Hogg, 1996).

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Some risks that are retained by the private sector are availability and
performance risks and a percentage of the unitary payment is made only
when the facility is available. The public authority is able to alter the
payment of fees dependant on performance or availability of services.
Yescombe (2007) draws on examples of various PFI projects to point out
that this risk transfer has ensured that levels of availability once the PFI
facilities are built are high, since the operators rely heavily on full unitary
payments in order to repay debts secured on the project (Yescombe, 2007).
Having considered government guidelines on risk allocation, it is also
necessary to consider the risk allocation preferences of other parties
involved in PFI projects. Research by Akintoye et al (1998) into risk
allocation in PFI projects found that the parties involved rank those risks
paramount to their business needs as most critical. Whilst the private
consortiums focus on design, construction and budgetary overrun risks, the
public authority is more concerned with availability and performance risks.
The commercial lenders were mostly concerned with capital and interest
risks as well as those associated with payments under the unitary charge
method (Akintoye et al., 1998). The various parties involved also bring to
the table various risk management techniques and approaches which can
lead to conflicting outcomes between the parties. Although the risk
allocation preferences of the private sector are closely matched to those
stipulated by the government, the different risk management approaches
means that coordinated efforts between the parties are required for a risk
management methodology to be applied effectively.

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One such method proposed by Bing et al (2005) is a result of
research using questionnaires to study PFI/PPP project professionals to
gauge their preferences in risk allocation strategies (Bing et al., 2005). The
aim of this research was to classify risks in order to aid contract negotiations
(Bing et al., 2005) and was a continuation of previous research which had
identified risk allocation as one of three critical success factors for the
implementation of PFI/PPP projects (Bing, 2003).
Bing et al. (2005) stated that the initial aims of PPP/PFI projects, to
remove infrastructure project costs from the government balance sheet, had
a lower than expected impact on government borrowing. This resulted in
public authorities using PPP/PFI projects as a new approach to risk
allocation (Bing et al., 2005). One of the major issues with PFI/PPP projects
to be discussed in section 3.5, was the complicated tendering process
which can be time consuming and costly and result in barriers to entry being
introduced (Bing et al., 2005). A risk allocation scheme as proposed by Bing
et al (2005) can be used to assign risks to the party best able to manage
them with any agreements stipulated in a binding final contract. Bing et al
(2005) drew on earlier research which stated that to ensure success; the
public authorities should identify risks before transferring them to the private
sector. This will allow for analysis of potential costs and allow for other
stakeholders such as the end user to consider other risk allocation
processes (Grant, 1996, Al-Bahar and Crandall, 1990). Furthermore for the
risk allocation strategy to succeed it is important to understand the various
perceptions of risk by public and private sectors and how they prefer to

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allocate them. The aim of their paper was to propose a matrix which would
provide this information to aid the contracting process.
In their previous work, Li et al. (2003) had begun to categorise risks
into three meta classification categories (Bing, 2003). These were macro,
meso and micro categories which were concerned with risks outside project
boundaries, risks inside project boundaries and risks found in stakeholder
relationships respectively. Each category was also given subcategories to
further differentiate the risks involved (Bing et al., 2005).
The method used by Bing et al. was to send out 600 questionnaires
to organisations/professionals in PFI/PPP projects. The results were
analysed to give risk allocation preference tables which allocated risks into
four main categories. These were risks that should be allocated to public,
risks that should be allocated to the private sector, risks that should be
shared between both sectors and finally a group of risks whose allocation
depended on the circumstances (Bing et al., 2005).
This comprehensive list of risks and the recommendations into which
party should manage them should help both public and private parties agree
to a risk allocation scheme, which can aid in a smoother and more efficient
contract negotiation process. Although the relatively small number of
respondents is not fully representative of PPP/PFI projects as a whole, it
provides valuable information to aid the risk allocation and contracting
phase of projects, an issue highlighted as critical by Akintoye et al (Akintoye
et al., 1998).

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4.4 New Risks being introduced to the public sector
Transfer of risk away from the public sector is a key benefit of PFI
procurement with robust risk transfer methodology used to ensure VfM for
the public sector. Academic research into the transfer of risk has however
identified new risks being introduced to the public sector through the use of
PFI projects.
Cooper et al. (2005) critiqued the robustness of the Scottish Prison
Estates Review which was carried out by Jim Wallace (Cooper and Taylor,
2005). Wallace’s report (2002) on the Scottish Prison Service identified a
need to build three new prisons in order to meet the demand caused by the
closure of older facilities. In the Wallace report it was recommended that the
new prisons should be built using private finance via the PFI procurement
method (Wallace, 2002).
The Wallace report (2002) identified a potential saving of £700 million
when comparing private to public sources of finance. This was based partly
on the transfer of risks to the private sector as well as savings to be realised
by the projects being completed on time and on budget. In addition it was
argued that the private sector would introduce innovation into the PFI
projects during the design and construction phases due to the expertise of
the personnel they had onboard. The aforementioned savings were
confirmed by the a report by the accounting firm PriceWaterhouseCooper
(2002) and as such were quoted as fact in government discussion on the
subject (PricewaterhouseCoopers, 2002). The report also highlighted as a
benefit the government’s ability to ensure the provision of superordinate

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services in the long term through the use of incentivisation and penalisation
mechanisms linked to the payment of the unitary charge.
In their publication, Cooper et al. (2005) analysed the underlying
assumptions used to determine the savings figure of £700 million which was
calculated by comparing Net Present Value (NPV) figures for both public
and private procurement options. Cooper et al (2005) argue that using this
accounting figure alone does not take into account all the factors that should
be considered and is therefore inherently inaccurate.
Cooper et al (2005) pointed out that new risks to the public sector,
such as lower staffing levels and inferior build quality were not fully
considered for the purposes of cost comparison in the private option.
Furthermore they go on to comment that regardless of contractual
provisions, the government will remain as the ultimate risk bearer. This is
due to the fact that if the private sector company were to fail, the
government would have to step in to take over the provision of such critical
services with any additional costs borne by the taxpayer (Cooper and
Taylor, 2005).
The exposure of the public sector to new risks through PFI
contracting is also commented on by Pollock et al (1999) in their findings on
PFI projects in the National Health Service (NHS). Pollock et al (1999)
highlighted that for projects up to the turn of the millennium, the level of
service provided by private funded hospitals was lower than those publically
funded (Pollock et al., 1999). Furthermore the long term nature of
concession agreements was identified as the cause of inflexibilities for local
hospital trusts in coping with the ever changing demands of the health

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sector. Pollock et al (1999) also highlighted poor contracting strategies as
the reason why NHS Trusts were not able to be compensated for poor
hospital design. This would introduce long term operational risks for the
public sector bodies (Pollock et al., 1999).
The needs of the taxpayer change over time, therefore public
infrastructure must also adapt to adhere to these needs. Also hospitals,
schools and prison facilities need to adapt to take advantage of
technological advances in order to introduce efficiencies. Pollock et al.
(1999) and Cooper et al (2005) indicate a flaw in the PFI procurement
method in that although long term contracts allow for project debts to be
repaid over a number of years, it prohibits public bodies from adapting
assets to meet the ever changing needs of critical public infrastructure. This
contradiction between the need of the public for adaptable infrastructure and
the inflexible nature of PFI contracts was also raised in recent research by
Professor Corrigan (2010) who was advisor to the previous Health
Secretaries for the Labour Government (Davies, 2010).
The above inflexibility inherent in PFI projects can introduce the
public sector to operational risks, risks that would not have been borne if the
infrastructure was funded using traditional public procurement. The only
solution to this inherent inflexibility is for the public authority to buy-out the
PFI contract if needs change. However this is not guaranteed to ensure
savings for the public sector, as was the case of Norfolk and Norwich
University Hospital Trust PFI projects which found that the predicted savings
of £217 million were overshadowed by the £300 million cost of a buying-out
the private sector (Edwards, 2009).

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4.5 Is the transfer of risk feasible
The transfer of risk to the private sector is one of the fundamental
objectives of PFI procurement. However academic research has raised
questions of whether this transfer of risk to the private sector is feasible.
The point raised is that the critical nature of public infrastructure funded
means that should these PFI projects were to fail, the government would be
forced to bail out the project and bear the resultant costs (Akintoye and
Dick, 1996, Pollock, 2005, Hogg, 1996, Ball et al., 2003).
An example of this is the Balmoral High School project which was
completed in 2002 by the Northern Ireland NAO as a pathfinder PFI project
(N.I-National-Audit-Office, 2004). However the school was closed in 2007,
only five years after its opening due to as lower than forecasted number of
pupils. The severe penalties for early termination of the concession contract
however meant that although the school was no longer feasible, the
education board was still committed to pay the unitary PFI payments for the
remainder of the concession agreement (CONNOLLY et al., 2008).
There are further examples public sector having to bail out failing
operators at an additional cost to the taxpayer (SENATE, 2000). Arguably
however, the most high profile PPP/PFI project to fail was that of Metronet.
In 2002 the government announced that the maintenance and renewal of
the London Underground infrastructure would be undertaken through a PPP
project (Kellaway and Shanks, 2007). The PPP consortium consisted of five

2010 Page 51 of 129
companies, all of which held equal shareholding in the new SPV. The five
companies involved can be seen in Figure 10.
Figure 10 - Metronet Consortium, adapted from (Kellaway and Shanks, 2007)
In July 2007 Metronet went into administration with significant debts
and having failed to meet its obligations for network improvement (HOUSE-
OF-COMMONS, 2009). In this case the government was forced to bail out
the company by financing the £2.6 billion of debt owed by Metronet which
was guaranteed by the government (Kellaway and Shanks, 2007). This
guarantee, written into the original concession agreement meant that in
essence, the government bore the risks of the project in the case of failure,
irrespective of the public authority’s risk transfer objectives at the outset of
the project. This was in spite of the government spending £500,000 in the
negotiation phase on lawyers and advisory fees alone (Edwards, 2009).
Metronet
Electricite
de France
W.S Atkins
Balfour
Beatty plc
Bombadier
Kemble
Water Ltd.

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The cases of Balmoral High school and Metronet demonstrate the
fact that due to contractual obligations, the government is the ultimate risk
bearer should the PPP/PFI project fail. The private sector can be seen to be
reaping large returns without carrying substantial risks., a statement
supported by Edwards et al (2004) who draw on the findings of the financial
service company, Standard and Poor’s who found that in their analysis of
the PFI capital market, PFI consortiums carried little risk (Edwards et al.,
2004).
The aims of risk transfer to the private sector may also be
undermined by further practices. In section 3.7 it was demonstrated that
often equity requirements stipulated by public authorities were used to
ensure commitment by the private consortium and transfer risk however
findings by Froud (2003) demonstrated that the equity requirements
stipulated were often financed through loans and bonds, decreasing the
efficiency of any risk transfer (Froud, 2003). This was further supported by
the National Audit office’s findings that in the majority of projects risk
transfer was not being realised (National-Audit-Office, 1999). However we
must note that a more recent NAO publications has noted some
improvement in the risk management process (National-Audit-Office, 2006).
Another consideration is that the transfer of risk may not be ideal
from the outset. Pollock et al. (2002) refer to contract theory findings which
suggest that the public sector may be better suited to bear the risks
associated with NHS projects (Pollock et al., 2002). This point of view was
supported by Froud (2003) who questioned the wisdom of transferring risk
away from the public sector and argues that governments with numerous

2010 Page 53 of 129
activities should be risk neutral and are best placed to deal with the various
risks and uncertainties. Instead Froud (2003) suggests a post-modernist
approach be taken to allow uncertainty to positively affect the provision of
public services, with the risk agenda widened to include public infrastructure
projects (Froud, 2003).
4.6 Evaluating the robustness of the Public Sector Comparator
As discussed in chapter 3, the value for money process often
involves the use of a PSC to determine whether the PFI or public funding
option is chosen. It is therefore critical that the calculation of the PSC is
highly accurate to give the evaluation process any validity. Recent
Government reports however highlight that the accuracy of using this purely
accounting tool alone can limited (PAC, 2003a). The increasing complexity
of PFI transactions with uncertain forecasts are quoted as reasons why the
decision on whether to choose the PFI route must not depend solely on this
calculation. Given the central role the monetary value of the PSC often
plays in public authorities’ choice of whether to go ahead with a PFI or
public funding option, the government’s own admission of the PSC’s
inherent inaccuracies may be a cause for concern.
The problems that may arise from the public authority’s over reliance
on the PSC calculation were further analysed by Shaoul et al (2005) who
stated that since the PSC is often a hypothetical and by definition a rough
estimate, its only use may be to ensure that the PFI option is chosen. This is
supported by evidence that since adequate public finances are often not

2010 Page 54 of 129
available, prospective projects will not receive the go ahead unless the PFI
option is chosen. This creates a bias towards approving the PFI option in
order to make sure that the project is given the go ahead and the much
needed infrastructure is procured (Shaoul, 2005). The existence of this bias
will result in the public sector approaching the negotiation phase of projects
with a weak bargaining power, as there is a distinct lack of an alternative
option. The findings of Shaoul et al (2005) and the weak bargaining position
of the public sector authorities is supported by the governments own
findings into the negotiation phase of various PFI projects (PAC, 2003a).
The findings by Shaoul et al (2005) are mirrored in research from
other public sectors. Broadbent et al (2008) concentrated their research on
PFI projects in the Health sector. Their research pointed to the NAO findings
that described the use of the PSC as prone to error, irrelevant, unrealistic
and based on pseudo-scientific mumbo-jumbo (Broadbent et al., 2008). The
authors also found that in the case of the Dartford & Gravesham and West
Middlesex hospitals, the public sector comparator was often overestimated
to ensure the PFI project was cheaper.
Across the Atlantic, the Canadian council for PPP found that the use
of the correct discount rate and value given to risks transferred often
resulted in inaccuracies within the PSC option. Moreover they highlighted
that PSC calculations did not address long term affordability issues for the
public sector (Canadian-Council-for-PPP, 2003). Their research surmised
that the use of the PSC alone would result in further decision factors being
ignored during the decision making process. These decision factors were:
• Service quality & market innovation

2010 Page 55 of 129
• •Broader economic benefits
• •Public Interest
• •Access, safety, privacy issues
The general consensus of both government sponsored and academic
research is that the presence of an over reliance on the PSC in deciding
whether to go ahead with the public or private option can result in a one
dimensional comparison based solely on accounting figures, ignoring many
issues beneficial to the public (Clifton and Duffield, 2006). Government
guidelines aim to remedy this over reliance by placing emphasis on the
need for continued review of the choice to procure projects through the PFI
route after the initial decision to go ahead has been made (PAC, 2003a).
This approach will allows for the various technical solutions available
and the long term benefits of the procurement options to be considered as
the project progresses. For this to be effective however there is a need for
the existence of a realistic public alternative available throughout.
Further critical issues with the PSC are the accuracy by which the
various components, namely the value of risks transferred, are calculated.
This will be discussed in detail in the next section.
4.7 Determining the value of risks transferred
A critical part of the VfM appraisal process in PFI procurement
determining the monetary value of risks that are transferred to the private
sector. This criticality arises from the fact that it is often this figure that

2010 Page 56 of 129
determines whether the public or private procurement option is chosen. (see
figure 11).
Figure 11 - Cost elements in public sector comparators and PFI (Broadbent et al., 2008)
To determine the accuracy of the methodology utilised to determine
the monetary value, a review of HM Treasury publications is required. HM
Treasury (2006) publications emphasise a strict and effective risk transfer
process as central to the justification of individual PFI projects. This is done
through clear and concise guidelines with the calculation of the monetary
values divided into three stages. These were programme, project and
procurement level assessment (HM-Treasury, 2006b).
Given the government’s attempts for a clear and concise approach to
the valuation of risks, it is interesting that the findings of academic research
into existing PFI projects found the process to be far from clear (Froud and
Shaoul, 2001, Froud, 2003, Pollock et al., 2002, Nisar, 2007).

2010 Page 57 of 129
This academic research was carried out on projects in various public
sector departments over a number of years. For example Froud (2003)
attempted to analyse the ability of PFI projects to transfer risk away from the
public sector and deliver better managed facilities at lower service costs
(Froud, 2003). Froud (2003) pointed out that proposed government risk
management methodology, entitled optimal allocation, conflates risk and
uncertainty in order to be able to assign a probability to all factors.
For PFI projects justification of risk transfer away from the public
sector requires for risks to be quantified to allow for the NPV to be
calculated. Froud (2003) however states that uncertainty by definition
cannot be scientifically calculated and as such, any calculation of risks using
absolute figures to represent uncertainties is narrow and inaccurate. The
author goes on to draw on earlier work which stated that risk perception and
the subjective manner in which it is calculated can lead to significant
variances.
Froud (2003) also alluded to the public bodies’ use of this inaccurate
and often vague approach to ensure the PFI option was chosen. This was
demonstrated in analysis of PFI projects which that found that although the
PSC option was often more cost effective, the addition of the value of risks
transferred would invariably leave the PFI option as the cheaper of the two,
often with negligible difference. (See Table 1).
Table 1 - Risk transfer and value for money in new hospital projects – adapted from (Froud, 2003)
Hospital – NHS
Trust
Public sector comparator
NPV £m
Private finance option
NPV £m
Carlisle Hospitals
NHS
Without
risk 151.1 167
Trust Risk 21.8 0

2010 Page 58 of 129
Financial close:
5.11.97
Risk
adjusted 172.9 167
North Durham
Health
Without
risk 157.3 173.9
Care NHS Trust Risk 23.6 3.12
Financial close
31.3.98
Risk
adjusted 180.9 177
South
Buckinghamshire
Without
risk 161.6 163.3
NHS Trust Risk 7.6 -1.7
Financial close
16.12.97
Risk
adjusted 169.2 161.7
Taking into account Froud’s (2003) finding on the conflation of the f
risk and uncertainty in valuating the risks transferred casts further doubt on
the accuracy of the PSC calculations and the VfM decision making process.
These inaccuracies are also supported by findings of Broadbent et al (2008)
who looked at eight PFI projects in the health sector (Broadbent et al.,
2008). Their investigation found that in PFI project appraisal process,
quantitative risk estimation superseded the qualitative risk estimation of
uncertainties. This was due to the fact that the quantitative approach better
suited government decision to use the NPV method for the purposes of
comparison. In essence, although risks and uncertainties are identified at
the pre-decision stage, the majority of uncertainties are ignored. Broadbent
et al (2008) suggest the removal of the dominance of accounting logic to
ensure better consideration of risks and uncertainties during the initial
decision making processes.
Further research by Pollock et al (2002) found that in two thirds of the
PFI projects analysed, the risks being transferred could not be identified
(Pollock et al., 2002). Therefore any value given to risks transferred was

2010 Page 59 of 129
inherently inaccurate. The ambiguity of the method used by the public
authority to calculate the value of risks transferred and the fact that this
figure was always almost identical to the figure required to close the gap
with the public option, led the Pollock et al (2002) to deduce that it was
being use as a tool of ensuring that the private option was cheaper. The
results of the analysis from four NHS trusts can be seen in Table 2.
Table 2 – Differences between NPV costs of a publicly funded scheme and those of a PFI scheme (Pollock
et al., 2002)
Trust
Cost advantage to publicly financed
scheme before risk Transfer (£m)
Value of risk transfer to
the PFI scheme (£m)
Swindon and
Marlborough 16.6 17.3
Kings
Healthcare 22.9 23.8
St George's
Healthcare 11.9 12.5
South Durham 6.1 9.1
In their paper, Pollock et al. (2002) brought attention to the vast
difference between the proportions of total expenditure allocated to risk at
the various hospitals as further evidence of the use of risk valuation to
ensure the PFI option is chosen. They argued that given the above
inaccuracies in determining the value of risk transferred, using private
finance to provide NHS infrastructure will turn out to be more costly, a view
contrary to government justification of the funding methodology. In fact
drawing on their earlier publications, this increased costs over the life of a
PFI project is coupled with lower levels of services provided by the private
funded hospitals when compared to those facilities which were publically
funded (Pollock et al., 1999).

2010 Page 60 of 129
The inaccuracies in the determination of the value given to risk
transferred are not exclusive to health sector projects. Khadaroo et al (2008)
examined three PFI projects procured the Department for Education and
Skills (DfES) in Northern Ireland. An section of the published results can be
seen in Table 3.
Table 3 - Calculation of the risk-adjusted PSC for PFI school projects (Khadaroo, 2008)
Net Present Cost (discounted at 6%)
School 1
£000
School 2
£000
School 3
£000
Capital costs 12,008 6,025 15,993
Operating costs 5,543 2,692 3,943
Total costs before adj. for risk transfers 17,551 8,717 19,936
Risk transfers (e.g. construction, time 1,420 877 1,526
overrun, site, obsolescence,
planning, maintenance, insurance,
operating and maintenance,
regulatory and force majeure risks)
Total risk-adjusted PSC 18,971 9,594 21,462
PFI price 17,193 9,711 21,500
Difference = financial VFM
benefits/(disadvantage) 1,778 -117 -38
Khadaroo et al (2008) found that in a number of cases, if the private
option was found to be more costly, the private consortium was advised to
“work down” their bid in order to ensure parity with the PSC. From Table 3 it
can be seen that schools 2 & 3 represent a disadvantage if the PFI
procurement option was chosen. Nevertheless these PFI projects were
given the go ahead as they were deemed “pathfinders” by the public
authority. These pathfinder projects were undertaken to overcome a major
capital and maintenance backlog in the education estate and lack of

2010 Page 61 of 129
available public funding (N.I-National-Audit-Office, 2004). Considering the
observations in section 4.6, it is clear that the lack of realistic alternative will
create a bias towards the PFI option and devaluating the VfM appraisal
process.
The bias towards the PFI option was demonstrated further in the
research by Froud (2003) who ascertained that ambiguous projects with
many bundled services were often proposed over a long term project.
Therefore the value given to the numerous risks involved would ensure that
the PFI procurement option would be chosen.
4.8 Refinancing of PFI projects and the secondary equity
market
As discussed in chapter 3.7, PFI projects are financed using a
mixture of equity and loan debt sourced from the private sector. An analysis
of PFI projects post construction has shown that often these projects are
refinanced, changing the debt profile of the project. To understand the
various methods of refinancing it is advisable to consider the two distinct
phases of a PFI project, the construction and operations phases.
The refinancing of PFI projects often occurs after the initial
construction phase has been completed successfully and the risk profile of
the project has changed significantly (PAC, 2002). Moreover having
successfully completer the construction phase of the project, the consortium
operating the PFI contract is deemed to have demonstrated robust risk
management techniques. The increased maturity of the PFI procurement

2010 Page 62 of 129
methodology and the guaranteed unitary payment from the public sector
have also resulted in commercial lenders being more receptive of PFI
projects and as a result offering better terms for finance (Finlay, 2003).
It is for these reasons that the consortium are able to approach
commercial lenders and secure funds at lower lending charges and interest
rates, reflective of the lower risks now inherent in the project (Finlay, 2003).
The changes to the project risk profile and the resulting financial costs and
return can be seen in figure 12.
Figure 12 - Project risks, financial costs and return based on phase of project (Finlay, 2003)
As it can be seen, following the refinancing of a PFI project there is
an increase in returns for the private sector. For example in the case of
HMP Altcourse project, expected returns increased from the 16% originally
planned to 39% following refinancing. We must consider that since financial
costing for a PFI project are carried out at the inception of a project; any

2010 Page 63 of 129
increased returns for the private sector that are not share with the public
authority, will represent lower VfM for the taxpayer. A 2002 NAO report into
refinancing found that of the twelve audited projects, only 2 had shared 50%
of the gains with the public authority, whilst 4 did not share any of the gains
(PAC, 2002).
The bad press that a number of high profile PFI refinancing deals
received and the consensus that following refinancing, the taxpayer was
losing out led to the government introducing mandatory requirements in
2002 which entitled the public sector to receive 50% of any gains from the
refinancing of projects (OGC, 2002a). The report produced in 2002 by the
Office of Government Commerce (OGC) also recommended a voluntary
30% share of gains for the public sector for projects that had been signed
prior to July 2002 (OGC, 2002b).
It was reported by the regulatory bodies that the new mandatory and
compulsory codes would result in the public sector receiving between £175
and £200 of additional funds (NAO, 2006). A later report by the NAO
carried out in 2006 found that the government had secured £137 million of
funds from refinancing of PFI deals. The gains realised can be seen in table
4 (NAO, 2006). This £137 million figure was lower than original estimates, a
shortfall that was attributed to a lack of refinancing activity since late 2004.
Table 4 - Public sector gains from refinancing of projects adapted from (NAO, 2006)
Number of
refinancing
Actual gains of the
public sector (£m)
OGC estimate of
gains (£m)
Norfolk and Norwich
Hospital 1 34
Bromley Hospital 1 14

2010 Page 64 of 129
Darent Valley Hospital 1 12
Other deals 17 12 175-200
Total 20 72
Other refinancing:
London Underground 1 42
Other deals 26 23
Total Gains 47 137 no estimate
Refinancing of projects such as the Norfolk and Norwich NHS Trust
PFI project where the private consortium increased its returns from 19% to
60% following refinancing, led to greater public scrutiny of PFI project
financing. The subsequent government reports raised concerns of the
refinancing method which often accelerated the benefits to the private
sector consortium by increasing the debt ratio of the project. Reports in
2006 for the NAO and PAC also pointed to increased liability of the public
sector in event of contract termination and extension of the concession
period as new risks that the public sector was now exposed to (PAC, 2006,
NAO, 2006).
A report for the Scottish Parliament Finance Committee (2008) also
questioned the justification for new risks being borne by the public sector.
Cuthbert and Cuthbert (2008) found that in the case of the HMP Altcourse,
in addition to new termination liability risks introduced, the refinancing of the
project had allowed the private consortium to take out of the project the NPV
of future profits, therefore if the maintenance costs were higher than
expected, the project would not have sufficient reserves to cover the costs.
Cuthbert & Cuthbert (2008) quantified the costs of new risks borne by the
public sector to be £47 million for the entirety of the project, a figure

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