Britain’s next financial model

As PFI crumbles under the weight of soaring debts and political backlash, contractors are developing new ways to raise cash to kick-start public sector projects. Over the next four pages Stephen Cousins looks at these new financial models. Illustration by Shonagh Rae

With the birth of the Private Finance Initiative in the early 1990s, building contractors embraced the role of project financiers on UK public infrastructure projects, providing a much-needed injection of private capital to help remove debt from the Treasury’s books.

Nearly 20 years on, the PFI programme is a shadow of its former self, assailed by a wave of political and media criticism over claims it has failed to deliver value for taxpayers’ money, and created cumbersome, inflexible long-term contracts and poorly constructed buildings.

Two damning reports, published in the past two months by the Treasury Select Committee and the Public Accounts Committee, have dealt yet more blows
to PFI, but that will not mean an end to the key role of contractor-backed finance. If anything, the need for builders to turn money for projects is only going to increase, particularly as central government funds tighten, council budget cuts hit home and the cost of public sector borrowing increases.

Eager to explore alternatives, firms such as Wates, Balfour Beatty, Morgan Sindall and Galliford Try, among others, are exploring new funding mechanisms. These include Local Asset Backed Vehicles, a form of Public Private Partnership (PPP) set up to unlock  value in large areas of council land or building assets; revenue-based schemes such as Tax Increment Finance, which could allow councils to borrow against business rate increases that stem from new development; and other vehicles like the Regulated Asset Base (RAB) model currently used in utilities.

Meanwhile, PFI is expected to be relaunched later this autumn in a leaner, more cost-efficient guise.

In these austere times, new and flexible mechanisms are the way forward, says Richard Dixon, commercial director at Morgan Sindall Investments. “Contractors have to be innovative, flexible and use their skills to make things work for clients’ needs,” he says. “There’s no point waiting for jobs to drop off the PFI production pipeline, you have to go out there, create the work and innovate at source.”

Get a sweat on: the asset-backed model

Whatever the fate of PFI, drastic cuts to public sector grants and capital funding, coupled with the devolution of power to local government under the Localism Bill, will force councils and regional government to seek new ways of delivering infrastructure with their own limited resources.

Since local authority income is capped and council tax or business rates cannot be increased, many are going down the so-called self-help route — sweating value from their estates to help generate funding for development. With the public sector asset base estimated to be worth about £370bn, the concept has legs and the Local Asset Backed Vehicle (LABV) PPP has emerged as the best known of the asset-based models.

LABVs are being used to catalyse regeneration on a large scale, to redevelop town centres or create business parks for example, with councils taking an equal share in development profits in return for bringing land and/or other assets to the table. The scope of development work is longer term under LABVs, which encourages councils and contractors to work in partnership towards a common goal.

The first LABV was set up in 2008 when Croydon signed a 25-year agreement with John Laing to redevelop parts of the town centre and build a new headquarters for the council, which is now under construction. Other councils have followed, including Tunbridge Wells, which announced 37 sites to be developed in partnership with John Laing.

Torbay, meanwhile, has joined forces with Sir Robert McAlpine; the Bournemouth Development Company was created with Morgan Sindall providing finance and construction services; and Thurrock, Slough and Sutton are exploring similar deals.

Other sectors, such as health, education and defence have also shown interest — the £1bn Watford Health Campus being the highest profile project so far.

Despite these early successes, LABVs have their drawbacks. For one, they rely on the public authority having a decent estate portfolio, and while not every site has to be a gem, on balance there must be value to leverage finance against. Councils also need an entrepreneurial bent — rather than simply selling the land and pocketing the cash they must take the risk of putting land into long-term partnerships. And, as with the early days of PFI, LABV contracts are complex and expensive to set up.

Returns for developers can also be quite tight in the short term, says Morgan Sindall Investments’ commercial director Richard Dixon, which is a partner in the Bournemouth LABV: “Returns are a lot tighter than they would be in a traditional development deal. For a normal developer the LABV is a long term play and it could be four to six years before you see any real profit as you’re effectively giving away half of the profits to the council. It has worked better for us in Bournemouth because we are providing investment and construction services, so poor investment return is boosted by the construction return.”

The lack of a pipeline for LABV work is also a difficulty, says Alan Aisbett, head of local government at legal firm Pinsent Masons: “With local and regional government departments having to build up their own projects and go to market with them contractors effectively have to go and track them down... unlike PFI where there was an identified programme and the industry knew what was coming and could align its resources accordingly.”

A taxing situation: the business rates model

A second self-help vehicle carrying councils’ hopes for infrastructure investment and urban regeneration is Tax Increment Financing (TIF). Already widely used in the US, TIFs would allow local authorities to fund infrastructure and other capital projects in a designated TIF zone by borrowing against the future business rate increases they generate.

The government announced definite plans to adopt TIFs in its Comprehensive Spending Review, setting a deadline of 2013, but has yet to demonstrate how the model will be implemented and introduce primary legislation to make it possible — as councils can only currently borrow against their overall revenue stream, not their business rates.

However, three pilot projects have already been given approval in Scotland: Edinburgh’s Waterfront regeneration project; Ravenscraig in North Lanarkshire; and the Buchanan Quarter in Glasgow. Three more are expected to get the green light there early this month (October).

The TIF scheme in Edinburgh will receive £83m of public sector investment designed to unlock more than £600m from the private sector, with initial building work focused on a public esplanade, a new road link and a pier.

If implemented across the UK, TIF contracts could mean contractors financing construction under turnkey deals with councils, and getting paid back on completion, or propping up investments in infrastructure and receiving a percentage return from taxes generated.

Ring-fenced TIFs, which guarantee business tax take for around 25 years, could provide much-needed stability for council planning policy, explains Pinsent Mason’s Alan Aisbett. “It would provide a greater certainty on how much tax income a development will yield due to improvements to infrastructure, allowing councils to go to the public or private sector to raise finance,” he says.

However, he adds that they could negatively impact on current UK equalisation policy that ensures business rates are pooled centrally and distributed to councils based on need, he adds: “It will be difficult to ensure that certain authorities don’t gain or lose out.”

There is also a risk of developments attracting businesses already paying rates in another part of town, says Kevin Bradley, head of Davis Langdon’s PFI/PPP department: “Councils have to be certain that they are getting genuine inward investment and not just shifting businesses from one part of a city to another and robbing Peter to pay Paul.”

A CGI of Bernard Weatherill House, which has started on site and will complete in 2014. The Queen’s Gardens are in the foreground

Croydon council and John Laing

Croydon Council became first council to set up an LABV in 2008 when it entered a 25-year  agreement with John Laing to redevelop parts of the town centre and build new headquarters.

Croydon chief executive Jon Rouse says that to make LABVs work there has to be an underlying proposition based on viability — LABVs are not a magic wand. “They don’t offer a substitute for grants,” says Rouse.

Rouse says it is also vital to choose the right development partner. “Its a good fit in terms of cultures. John Laing has a very strong ethos in terms of corporate social responsibility,” he says.

The first major scheme in the development — Bernard Weatherill House, an office complex to house the new council HQ — is expected to be completed by 2014.

Reducing the cost of capital: the regulated returns model

With the cost of private borrowing higher than ever, the government is now also exploring the Regulated Asset Base (RAB) model, used in the utilities sector, as a possible replacement for PFI. (The Treasury Select Committee’s PFI report cites this along with LABVs as alternatives that should be investigated).

Private investment under RAB can be provided at a cost much closer to the government borrowing rate, because the framework ensures returns to shareholders are protected by regulators. In other words, equity risk for companies in the RAB is zero because it has been transferred to customers or taxpayers, who must pay the returns agreed by regulators.

It’s thought that using the mechanism for forms of development outside utilities could massively reduce the cost of capital. And because the private sector’s returns are regulated, projects could also avoid the extraordinarily high rates currently being charged under PFI.

Hailed by many as a UK success story, the current RAB model is not always suitable for large-scale new build projects and, of course, payment for schemes must ultimately come from the taxpayers’ diminishing wallet.

It’s a well known fact that leaner times help fuel innovation, which is evidenced in contractors’ efforts to devise new partnerships and funding models to get cash-strapped councils building again. It’s a challenging market, but one we’re going to have to live with, says Wates’ Stephen Beechey: “We’re having to take a more innovative approach to the way we deliver projects as traditional forms of funding dry up. It’s a constant dilemma and a challenge, but it’s the future,” he concludes.

RIP: PFI is dead...

Contractor financing of public projects took hold in the UK with the launch of PFI in 1992 under Conservative prime minister John Major. The idea was to fund developments using capital raised on the private market, with developments built and run by private firms. Although the projects cost public authorities little up front, they would pay for them in instalments over the next 25 or 30 years.

In the past, politicians have always stood behind PFI, claiming the public sector lacks the necessary management skills to steer projects. But today’s economic uncertainty makes that position hard to justify.

The Treasury Select Committee’s latest study found that even with the interest rate now at its lowest level for over a century, the extra costs of a private firm borrowing the money to pay for a school or a hospital could add 70% to the costs of a PFI project over its 30-year life. Within the NHS, the effects have been devastating — last month the body admitted spiralling PFI costs running into billions of pounds were jeopardising the future of NHS Trusts with annual bills forecast to rise by 75% to more than £2.5bn in the next 18 years.

The committee’s report slams PFI infrastructure projects as “extremely inefficient” and calls for a more robust analysis of which projects are suitable for PFI to avoid its blanket use. It recommends that PFI debts be brought onto the government’s balance sheet to ensure the mechanism is not used to circumvent departmental budget limits.

Meanwhile, a second report, this time from the Committee of Public Accounts, highlights the excessive profits being made by private firms under PFI and criticises the lack of transparency on PFI deals. It proposes making contractors answerable to freedom of information requests, which, if implemented, could force companies to disclose their profits.

... or is it?

PFI really grew under the Labour government and there are now 700 PFI contracts across the country, with a further 61 in procurement.

Despite a promise to abolish it when in power, the coalition government now seems keen to hold onto it, albeit in a revised form. In fact, it has announced a new schools PFI programme worth £2bn, aimed at addressing between 100 and 300 schools, to be allocated shortly after an application process running between 3 and 14 October.

The government is expected to announce its vision for the funding of major projects during the autumn, but how this “son-of PFI” is to be structured and funded remains uncertain.

“It will have to be a more streamlined and efficient vehicle,” says Stephen Beechey, group investment director at Wates Construction. “The government will be much stricter about what it will be used for, as to date it has been used for almost everything.”

Greater emphasis is likely to be placed on appropriate risk transfer to the private sector, adds Kevin Bradley, head of Davis Langdon’s PFI/PPP department. “Traditionally, risks pushed over to the private sector were charged a real premium, but in many cases it was more appropriate for the public sector to shoulder these, which would have meant better value for money.”

Bradley points to Scotland, where the government has adopted the Non Profit Distributing (NPD) model. NPD uses a similar form of contract to PFI, but caps investors’ returns to prevent excessive profit making. Cutting procurement timetables could also generate savings, he says: “In Scotland, we’re taking reference designs to a much more advanced stage, stage D+ or E, which means bidders have less design work to do, so their bid costs are lower, the procurement timetable is shorter and you therefore make savings.”

He adds that the new PFI could also benefit from greater standardisation of design and expand on government plans for standardised drawings and specifications for school buildings.

The Blueprint LABV has delivered many projects in the East Midlands, including Phoenix Square in Leicester (above), a science park (below), plus eco-housing in Nottingham (bottom)

Igloo, EMRA and the HCA

One of the most successful LABVs is Blueprint, a joint venture set up between developer Igloo, the East Midlands Regeneration Agency and the Homes and Communities Agency in 2005 for regeneration projects in the East Midlands.

So far Blueprint has developed £50m of schemes, among them an arts centre and theatre called Phoenix Square in Leicester, a science park next to Nottingham University, and eco-friendly housing in the Meadows area of Nottingham. 

Blueprint chief executive Nick Ebbs says for LABVs to work scale is important, because of the start-up costs. “I think you need to be thinking about a £100m development plan and a 20-year timescale,” he says.