The Fundamentals Of Pfi Construction Essay

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This section of my dissertation will provide the reader with an understanding to the Private Finance Initiative and also an insight into the Building Schools for the Future Programme. The Key points to consider with PFI including risk allocation will be identified, along with critical appraisal of the advantages and disadvantages of this particular type of procurement method. In addition to this, a review of the BSF programme will be carried out to see if this government policy had a positive impact that the Labour Party envisaged.

Public Private Partnership (PPP)

Public Private Partnerships (PPP) are partnerships held between government bodies and private companies. The government hoped that by bringing the public and private sectors together "the management skills and financial acumen of the business community will create better value for money for taxpayers" [1] . The Labour Government under Tony Blair promoted PPP's as they believe that these were the best way to fund and upgrade various public facilities such as hospitals and schools.

There are other various forms of PPP available such as;

Conventional Procurement

Outsourcing & FM

Strategic Partnering

Leasing

GOCO

Joint Ventures

Full Privatisation

However, Private Finance Initiative (PFI) is the most commonly used form of PPP used throughout the UK.

Fundamentals of PFI

PFI is the preferred choice of procurement method which has been adopted by the United Kingdom (UK) government. The main objective of PFI since 1992 is to encourage the investment in public construction projects, i.e schools and hospitals by private businesses as public expenditure was continuing to fall year on year. "Public Sector gross capital formation as a percentage of GDP fell almost continuously between 1975 (8.9%) to 2000 (1.7%)." [2] 

Private companies, historically, have been favoured by the UK government to build hospital, schools and roads etc; however, PFI brings the fundamental change that is, the Contractors are paid in instalments throughout a period of time (usually between 25 - 30 years), and they also bare the cost of the initial expenditure. Reports have shown that due to the transfer of risk, PFI projects can be uplifted by as much as 25% above other procurement methods. However, the treasury has argues that "evaluations show that 88% of PFI schemes are delivered on time, whereas 70% of non - PFI schemes are delivered late and 73% over budget" [3] 

PFI is supported by the Office of Government Commerce (OGC) "Since April 200, government policy has been that projects should be procured by one of these three recommended route" [4] 

Foundation of PFI - The Ryrie Rules

Following an evaluation of various ways in which private finance could be introduced into nationalised industries, the Ryie Rules were established in 1981 by the NEDC (National Economic Development Council) headed by Sir William Ryrie. The main objective of this review was to illustrate that private investment for public projects can be managed successfully. The two main rules that were the foundation of this report were;

Such projects should yield benefits in terms of improved efficiently and profit from the additional investment commensurate with the cost of raising risk capital from financial markets. [5] 

Decisions to provide funds for investments should be taken under conditions of fair competition with private sector borrowers; any link with the rest of the public sector, Government guarantees or commitments, or monopoly power should not result in the schemes offering investors a degree of security significantly greater than that available on private sector projects. [6] 

The Ryrie Rules were revised in 1988 to allow, contracting out, opting out, mixed funding and partnership schemes to be considered. Two principles arising from the review were;

Private finance could only be introduced where it offered cost effectiveness. [7] 

Privately financed projects for public sector programmes had to be taken into account by the Government in its public expenditure planning. [8] 

The retirement of the Ryrie Rules were announced by then Chief Secretary John Major in 1989 as he stated that the rules had "outlived their usefulness." [9] His belief was that this action would promote "the private sector to bring forward schemes for privately financed roads, which offer value for money for the user and the taxpayer" [10] 

PFI has grown from the foundations laid out by the Ryrie Rules. The key principles stated above have been carried forward and are used throughout PFI today.

The Inauguration of PFI

Norman Lamont, Chancellor of the Conservative party in 1992 was the first to announce the use of PFI "The Primary objective of PFI was to encourage private investment in major building projects like schools, prisons, hospitals and roads" [11] Norman Lamont announced that "any privately financed project which can be operated profitably will be allowed to proceed". [12] The announcement of the use of PFI was strongly opposed by the Labour Party at the time it was introduced by the Conservative Party but would then be used by the Labour Party when they came to power in 1997 under Tony Blair.

A fundamental change to procurement endorsed by PFI, is that the government is being provided with a service and not an asset by the private company. The PFI procurement method differs from conventional procurement methods, as the contractors have a duty to maintain the project long after its completion in line with the requirements of government authority.

Allocation of Risk

It is extremely important that all risks that are identified on construction projects are mitigated to ensure that the project is successful. The choice of procurement method and contract can prove to be vital in mitigating risks on a project. ISO 31000 also advises on how projects can approach risks as it is "utilised to harmonise risk management processes in existing and future standards" [13] 

As previously highlighted PFI procurement enables the transfer of risk from the public to the private sector if the Contractor carrying out the works is in a stronger position to manage, control and monitor the process. Allocating risks to the best suited party will effectively "lead to better management of risk overall which should be more cost effective." [14] 

A common misunderstanding with regards to PFI risk is that all the risk associated with the project will be covered by the private sector. The private sector may not be in a position to manage and control the risks as the cost of the project could be considerably higher. It is therefore important that it is understood which risks both parties can manage and control.

To ensure that financial and programme difficulties are kept to a minimum with regards to risk on projects, the government has outlined three general principles that must be adhered to when allocating risk. They are as follow;

The Government underwrites the continuity of public services, and the availability of the assets essential to their delivery;

That the private sector contractor is responsible, and at risk, for its ability to meet the service requirements it has signed up to. Where it proves unable to do so, there are a number of safeguards for the public sector and the smooth delivery of public services in place, but the contractor is at risk to the full value of the debt and equity in the project;

The full value of that debt incurred by the project, and the equity provided by contractors and third parties, is the cap on the risk assumed by the private sector. [15] 

Risks which would be retained by the public sector and not transferred to the public sector would constitute as;

The need for the facility on the end date given and the adequacy of its overall size to meet public service needs;

The possibility of a change in public sector requirements in the future;

Whether the standards of delivery set by the public sector sufficiently meet public needs;

General inflation risk. [16] 

There are, however, a number of risks that are usually transferred to the private sector. They are;

Meeting required standards of delivery;

Cost overrun risk during construction;

Timely completion of the facilities;

Underlining costs to the operator of service delivery, and future costs associated with the asset;

Industrial action;

Physical Damage

Market conditions [17] 

Distributing risks within the private sector

A Private Finance Project (PFP) commonly brings together several consortiums which each provide their own expertise on matters such as finance, facilities management and construction; these are referred to as Special Purpose Vehicle (SPV).

Insert Diagram

SPV Relationships

One of the many benefits of companies coming together to construct a PFP are that the risks can be separated and spread across the companies, to whom the risks are best suited. For example;

A Facilities Management Contractor would be allocated the risk that comes with providing a timely and effective service.

A Design and Build Contractor would be responsible for the risks that come with the designing and building of a project.

A Parent Company would be responsible for the financial risks that would occur if the SPV suffered any financial problems.

Key Landmarks throughout PFI history

As many local authorities and private companies failed to implement this new procurement method of PFI, a decision was made in 1993 to create a Private Finance Panel (PFP) that would;

Encourage the greater participation in the initiative by both public and private sectors;

Stimulate new ideas;

Identify new areas of public sector activity where the private sector could get involved;

Seek solutions to any problems that might impede progress. [18] 

In 1994, during a speech given by the then chancellor of the Conservative Party Kenneth Clarke at the annual CBI Conference, he outlined the two leading principles of PFI which are;

The private sector must genuinely assume risk without the guarantee by the taxpayer against loss;

Value for money must be demonstrated for any expenditure by the public sector. [19] 

Further to these comments, Kenneth Clarke went on to state that "Private sector finance would be the main source of growth in public investment projects." [20] The 1995 Budget that followed this statement re-launched the PFI initiative, meaning that projects with an initial capital expenditure of £9.4 billion would be prioritised. Following these comments there was a dramatic rise in PFI projects as "in 1995, projects amounting to £668.9 million were signed, whereas PFI investment from 1997 to 2001 has averaged £2.6 billion a year." [21] 

Bates Review

The Labour government decided that at the process of procurement within PFI contracts was to be reviewed to enable improvements to be made. A quick review of the entire PFI procurement system was carried out by the Chairman of Pearl Group and Premier Farnell, Mr Malcom Bates.

Following his review, Bates published 27 recommendations on 26th June 1997 which outlined improvements and increased the effectiveness of PFI projects.

One of the more notable recommendations that escalated from the Bates Review was the creation of the Treasury Taskforce. This idea would be based on a central authority which would excel in procurement and project management therefore reducing delays leading to savings in cost. The Standardisation of PFI contracts version 4 (SOPC4) was created to ensure that the Treasury Taskforce were able to provide expertise across these areas.

Following his 1997 review, Bates conducted a second review in 1999 to analyse whether the first review had made a positive impact, and to also make further recommendations. Following this review, Bates decided that it was necessary to install a permanent organisation to continue the excellent work of the Treasury Taskforce.

Under the Government Resources and Accounts Act 2000, in June 2000, Partnership UK (PUK) was created to take over control of projects that had been controlled by The Treasury Taskforce. A major difference between The Treasury Taskforce and PUK, was that PUK became a Public Private partnership company with 49% Public and 51% Private. It was described by Alan Milburn (Chief Secretary to the Treasury) that by creating a Public Private Company it "would provide the public sector with the key commercial skills to forge increased and better partnerships

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