Failing standards

The private finance initiative is coming of age. Since the growing pains of the 1990s, the number of deals signed, and players that have emerged, are such that there is now a mature and well established PFI market.

Procuring authorities are more experienced and better advised. Many are now procuring their second or third PFI project and have their own specialist PFI/PPP teams in-house.

And the private sector players in the market are more discerning. Bidding consortia and their funders understand the issues better and come to the table with fully developed commercial positions.

Yet paradoxically, at the same time as we are seeing the emergence of a far more sophisticated PFI market, we are witnessing a more inflexible approach from central government.

This is particularly true in respect of the heavy-handed application of standardised drafting. The opportunities for innovation in the PFI market are now greater than ever before, but they are in danger of being stifled.

Draft revisions

The first signs of central government's attempts to drive through standardised positions emerged early in 2002 when the draft revisions to the Office of Government Commerce's (OGC) generic guidance were being circulated to the public and private sectors for consultation and comment.

The preferred position was that, following the precedent set by the NHS, the updated standard terms would become mandatory, unless the sponsoring department could be persuaded that there were deal- or sector-specific reasons that justified a departure.

In the event, a watered-down position was adopted and the revised guidance that took effect from August 2002, while making it clear that advisers will need to make a case for departing from standard terms, only recommends that all procuring authorities adopt the drafting on refinancing as being mandatory.

In practice however, over the past six months, legal practitioners in the PFI market have witnessed sponsoring departments adopting a far stricter approach to compliance. Partnerships UK has been carrying out a detailed audited project agreement, on behalf of the sponsoring department, as part of the clearance of the final business case. It is becoming necessary to anticipate and build-in additional time to allow for this.

Four key policy areas have emerged: refinancing; insurance benchmarking during the life of the project; the definition of what constitutes a liquid market (ie. sufficient market interest to generate a fair price) for the purposes of retendering; and the definition of what constitutes a qualifying lender for the purposes of refinancing (to ensure that the banks that finance the project are regulated by UK banking legislation). A failure to adhere exactly to OGC drafting in any of these areas may jeopardise the award of PFI credits.

Another factor is the apparent change in evaluation criteria - adherence to the OGC guidance is now being ascribed a disproportionate influence on the outcome of the bidding process. For the first time, we have seen procuring authorities advised to give the legal and commercial terms of the bid a weighting of 50% of the marks that are available. Within this 50%, adherence to the OGC standard terms has become the overriding factor in determining the quality of bidders' responses.

Value-for-money considerations

There are a number of dangers in applying the standardised drafting in this way. Aside from the increased bid costs and delays that this approach can lead to, a key consequence is that central government and procuring authorities will lose sight of the fact that risk transfer should be driven by value-for-money considerations.

Bidders are, for example, being asked to price insurance on the basis of the OGC side letter that was issued last year (pending a longer term solution being agreed regarding indexation of insurance costs). Given the sharp increase in insurance premiums in the past couple of years, particularly following September 11th, the private sector is no longer able to accept uncapped liability for insurance costs.

Central government's response to this was to propose a risk-sharing mechanism based on a percentage share of increases in insurance premiums after taking account of indexation. The OGC side letter allocates risk between the public and private sector on this basis.

However, bidders are responding to this requirement by pricing insurance costs on the assumption that they will be 50% higher than the prices available in the market at financial close. It is difficult to see how this can provide value for money for the public sector and the taxpayer.

More worryingly, this flies in the face of conventional PFI ideology that is intended to promote private sector innovation in the interests of finding value for money solutions for the public sector.

Maybe now is the time for central government to stand back and take stock. The overall interests of the PFI market would in the long term be better served by revisiting the guidance on standardised contracts and taking on board the value-for-money solutions that are being developed in the marketplace. n