The complexity and length of PFI contracts and the upward pressure on the unitary charge (due to inflation, the cost of contract variations and the contractors’ desire for profit, among other things) mean that multi-million pound deficits can accumulate if PFI affordability is not managed properly.

Ensuring that the PFI scheme remains affordable is, therefore, one of the two key issues for the client (along with ensuring the contractor performs). This is a never-ending task that merits a great deal of time and effort.

The financial and operational sides of PFI contract management are inextricably linked, so those tasked with the management of PFI contracts must keep track of PFI affordability; it cannot be left to the finance department.

PFI Affordability: 6 Steps to Keep Costs Under Control

Step 1: Keep track of payments

Payments to the contractor need to be checked carefully. Indexation, benchmarking/market testing and contract variations, which we deal with separately below, all make the calculation of the unitary charge complicated. In addition, there will be ‘below the line’ adjustments, such as performance and availability deductions (for further information, see our article – Keeping Track of Availability and Performance Deductions in PFI Contracts), which will affect the amount of the monthly invoice.

It is, therefore, easy for mistakes to be made. The client will of course not want to be over-charged, but equally needs to ensure the contractor is not inadvertently under-charging, otherwise there may be a nasty surprise in store when the contractor eventually realises this and puts in a big retrospective claim.

In order to keep track of payments you need to:

Make sure you have the definitive version of the contract showing the original unitary charge
Keep track of indexation (see step 3 below)
Keep track of the impact of benchmarking/market testing (see step 4 below)
Keep track of the impact of variations on payments (see step 5 below)
Keep track of deductions
Keep track of any ad hoc payments (i.e. those outside the unitary charge)
Carefully check the contractor’s invoices each month, taking into account all of the above
Ensure invoices are paid on time and keep track of any interest charged on late payments.

Step 2: Keep track of income

The regular income to cover the unitary charge typically comes from the following sources:

The government grant linked to the PFI credit
Contribution from the client organisation’s revenue budget
Contributions, if any, from end users, e.g. schools.

Money received back from the contractor – including performance and availability deductions and any credits resulting from income sharing provisions – cannot be relied on as a regular source of income, but may be used to help boost the affordability of the project. In some cases these receipts, particularly payment mechanism deductions, are passed on to end users and are not therefore available to the client. Where this income is retained by the client it should be paid into the sinking fund (see step 6 below). In either case, careful track needs to be kept of these amounts to ensure that the full amounts are received and recorded.

The client needs to ensure it maintains good records of the originally agreed amounts of each source of income and keeps track of any changes, e.g. as a result of indexation or contract variations initiated by the end user.

In some cases there may be a capital contribution, either to fund a contract variation or to reduce the unitary charge. The client needs to keep track of these too, otherwise it may end up paying twice, e.g. if the contractor ‘forgets’ to reduce the unitary charge following a capital payment.

Step 3: Keep track of indexation

Let’s start by defining some terms:

Base prices – prices at the base date in the contract, e.g. if the base date in the contract is April 2010, sums of money specified in the contract will be expressed at April 2010 prices

Current prices – prices at the current time, e.g. if it is now April 2014, we would expect a sum expressed at April 2010 prices to have increased to reflect four years’ inflation

Out-turn prices – what we expect prices to be in future, e.g. if we’re estimating what something will cost in five years’ time, we will normally include an estimate for inflation over the next five years, e.g. 2.5% per year.

Variable element or indexed element – part of the unitary charge that increases with inflation.

In the contract, the unitary charge will be expressed at base prices. The variable element will then be increased with inflation each year, or indexed. The purpose of indexation is to reflect increases in costs (such as wages, supplies and services, etc.) as a result of general inflation. The other part of the unitary charge remains fixed, mainly because it relates to the bank debt which is not affected by inflation; click here for further information.

The contract will specify the index that is to be used, e.g. RPIX, and the base date, e.g. April 2010. It will also specify how the increase in the variable element is to be calculated, often including a formula. The calculation may not be quite as straightforward as you might expect, e.g. because RPIX for April is not published until some time after the beginning of the financial year.

The client’s PFI manager and finance staff need to understand all this.

PFI companies often make mistakes in how they apply indexation. The client should, therefore, carefully check the contractor’s invoices to make sure it has been applied correctly. Particular things to watch out for are:

The correct index, e.g. RPIX, has been used
The correct base and current values of the index have been used
Indexation has been applied only to the variable element, not the whole unitary charge
The correct formula has been used
There has been no double-counting with increases following benchmarking and market testing
There has been no double-counting with increases due to contract variations
There is no confusion between base, current and outturn prices.

If there is any ambiguity in the contract, e.g. in the formula used for calculating indexation, it may be appropriate for the client to propose a change to rectify this. The same principle applies to calculation of indexation for any end user contributions, as not indexing these properly can also contribute to an affordability gap. For more information see our article – 5 Tips for Cost Control by Keeping Track of Indexation.

Step 4: Keep track of benchmarking/market testing (value testing)

The benchmarking and market testing process is explained in our article – PFI Benchmarking and Market Testing: How to Get the Services You Need at Reduced Cost. Here we are concerned with the impact of value testing on the unitary charge. This is a minefield. The calculation of the change to the unitary charge is never straightforward. Both clients and contractors get confused. Clients therefore need to invest time in:

Understanding the principle behind the calculation, i.e. what is being compared with what and how this affects the unitary charge
Understanding how the calculation is supposed to be done/how the formula works
Checking that the contractor has done the calculation correctly
Checking that the contractor has made the correct adjustment to the unitary charge.

It’s useful at this point to define the following terms:

Value testing – the shorthand we use in these blogs to mean both benchmarking and market testing

Base cost – the assumed cost of the service when the contract was signed, which is the starting point for value testing

Current cost – the contractor’s cost of providing the service, immediately prior to value testing

Revised cost – the revised cost that emerges from value testing

Base, current and out-turn prices – see step 3 above.

The biggest pitfall is double-counting of indexation and value testing increases, especially if the increases are expressed at current, instead of base, prices. If the cost of the service increases from, say £100k to £110k at current prices, but there has already been an increase of £5k through indexation, the value testing increase should be no more than £5k. It is, therefore, safer to express all figures at base prices.

Other things to watch out for are:

Determining the base cost – the lower the base cost the bigger the value testing increase. The base cost may not be clear in the contract and it is in the contractor’s interest to make it as low as possible. Clients therefore need to make sure that the contractor is not understating the base cost, e.g. by hiding costs in other parts of the unitary charge. This involves looking at the financial model and understanding it, as well as the relevant clauses in the contract.
The right comparison is being made – value testing should compare revised cost with base cost, not with the current cost. Clients need to check this is in fact the case, otherwise the contractor could be rewarded for failing to control costs after the contract is signed. The contract may not be clear about what comparison is being made, in which case it may be advisable for the client to try and negotiate an amendment to the contract to rectify the problem.
Like for like comparison – the onus should be on the contractor to demonstrate that a like for like comparison of costs is being made, but the client needs to keep an eye on this and challenge the contractor if necessary.
Double-counting with previous value testing adjustments – if the current round of value testing shows that the base cost has increased by 9%, for example, but there has already been a 10% increase resulting from the previous round of value testing, then the unitary charge at base prices should go down, not up. Clients therefore need to keep track of what has happened in previous rounds of value testing.
Savings are fully reflected – clients need to be just as rigorous when value testing results in a decrease in the unitary charge. Remember that in this case the decrease is the client’s right, not a privilege. Bearing in mind all the other affordability pressures, it is essential that clients ensure they get the full amount of the decrease to which they are entitled.
End user contributions are adjusted – in some cases end user contributions may need to be adjusted following value testing. It is important to ensure that provisions for increases to be passed on to end users are implemented. If there are no such provisions, but the client considers that there should be, then the client should try to negotiate an amendment accordingly.

Step: 5 Keep track of contract variations

Guidance about the process for dealing with variations is provided in a separate article on PFI change management. Here we are concerned with the impact on affordability. Depending on whether the variation results in an additional cost or a saving, the financial effect could be:

An increase in the unitary charge
A decrease in the unitary charge
A one-off payment to the contractor
A one-off payment from the contractor.

The same key principles apply as for variations, namely:

No double-counting of inflation – e.g. by adding the cost of a variation at outturn prices to the unitary charge at base prices. Again, calculating everything at base prices will help to avoid this
Getting the full benefit of any decreases in costs.

In addition:

Where there are one-off payments, the client needs to check that the correct amounts are added to, or deducted from, the monthly invoice and to take them into account in keeping track of affordability
Where the client pays fees to the contractor related to the variation (e.g. for legal costs) these may need to be passed on to end users.

Step 6: Keep track of the sinking fund

The usual method for keeping track of the affordability in a PFI project is the sinking fund. This is useful if the profile of payments and/or income is uneven, which will normally be the case. Where there is a surplus in one year, this is carried forward and used to help pay the unitary charge in future years. The finance director may agree that interest can be applied to surpluses, in which case the amount carried forward will be enhanced, but this is less likely in the current economic climate with interest rates as low as they are.

A typical sinking fund looks basically like this:

Period	Year 1	Year 2	Later year	Final year
Value	£000	£000	£000	£000
Unitary charge	1,000	1,060	1,300	1,400
In-year income (government grant etc)	1,100	1,110	1,200	1,250
In-year surplus (deficit)	100	50	(100)	(150)
Interest on balances	2	1	0	0
Balance brought forward	nil	102	300	150
Balance carried forward	102	153	200	0

The client needs to:

Regularly update the sinking fund to keep track of affordability
Check that there is enough cash to cover the unitary charge in each financial year
Check that there is no overall deficit (i.e. a negative balance in the final year)
Take action to deal with any affordability gap: either an overall deficit or a deficit in a particular year.

PFI managers also need to make sure that all relevant parties within their organisation understand the purpose of the sinking fund and the need to ensure the PFI scheme is affordable throughout its life. In the current financial climate client organisations may be tempted to raid the sinking fund to support the corporate budget in the short-term, but this creates a long-term problem.

As is so often the case in PFI, it is important to understand the difference between base, current and outturn prices. If the sinking fund is expressed at out-turn prices, then a projected deficit in future years may appear bigger than it really is. A good way to understand the deficit is to work out what additional annual revenue contribution at today’s prices would be required to bring the sinking fund back into balance. This is particularly important when presenting the affordability position to senior management or politicians.

Where there is an affordability gap, action will of course need to be taken to deal with it and it will be the PFI manager’s responsibility to initiate this. The options are:

Checking that the payments are not higher than they should be (see step 1 above)
Checking that the correct amounts of all income (including the government grant related to the PFI credit) are being received – this may require going back to original sources and making sure that any provisions for increases, e.g. due to indexation, have been properly implemented
Negotiating increases in income from other parties, e.g. increased contributions from end users if they can be persuaded that the revised contributions would represent value for money
Negotiating with the contractor to make operational savings or other changes to the contract, e.g. passing back of insurance premium risk
As a last resort the client organisation putting its hand in its own pocket, one option being to make a capital payment (to reduce the ongoing unitary charge) if capital budgets are not quite as tight as revenue budgets.

For more information about what action you can take to reduce costs see our article – 12 Tips to Control and Reduce Your PFI Costs.

For support and advice on PFI affordability issues, including an affordability health check, please do not hesitate to contact us.

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Key Steps to Keep Control of PFI Affordability