The day to day pressures of managing a PFI contract tends to lead one to focus on operational issues, yet the importance of devoting considerable time and energy to keeping on top of PFI costs cannot be undervalued.
Take a short term approach, and failure to keep sufficient PFI financial controls could result in a more immediate issue, such as there being insufficient cash to pay the unitary charge in the current year. But, in the longer term, by taking a short term view, a more likely scenario is that trouble could be being stored up for years to come due to the failure to tackle the affordability issue over the 25-30 year life of the contract. Sadly, it is not uncommon for multi-million pound deficits to accumulate in PFI schemes over the contract lifetime (just one example was Stoke-on-Trent Council’s schools’ PFI finance deal), so keeping control of PFI affordability is essential and is the subject of a separate article – Key Steps to Keep Control of PFI Affordability.
12 Tips to Control and Reduce Your PFI Costs
While this may seem daunting, especially if you are new to PFI contract management, following the list of 12 tips to control and reduce PFI costs in this blog (based on extensive experience of managing complex PFI contracts) will go a long way to putting your contract on a sound financial footing and keeping it affordable for your organisation.
1. Understand the principles of PFI financial monitoring
Monitoring of costs in PFI contracts is a complex and specialised task. Both income and expenditure streams, as well as the payment structure, vary significantly from other public sector contracts. It is therefore critical that the client organisation has staff on board who understand both PFI finance and contractual terms. As a minimum, managers responsible for the financial and operational aspects of the PFI contracts need to work closely together to ensure that costs do not escalate out of control.
To enable effective financial management of PFI contracts, clients should have in place at least the following:
- A robust internal and external meeting structure, covering financial management of the contract. Please refer to our article for further information – 5 Ways to Transform PFI Meetings from a Burden to an Effective Management Tool
- Separate financial control spreadsheets, not relying solely on the client organisation’s main financial system for keeping track of costs
- Monitoring calendars covering monthly, end of year and periodic financial tasks; for further information, see our article on Using a PFI Monitoring Calendar to Reduce Costs and Improve Efficiency
- A good understanding of financial formulas for key PFI transactions (cost sharing provisions, indexation, performance deductions, etc.)
- Common understanding with the contractor of the financial formulas
- Efficient payment process, ensuring the unitary charge invoices are paid on time, while also ensuring that payments are accurate and reflect the services that have been delivered, along with any related deductions.
More detail on financial monitoring tools is provided in the following article focusing on our 7 Recommendations for Establishing Sound Financial Monitoring Systems to Control PFI Costs.
2. Know the PFI cost types
The client pays for a PFI scheme through the unitary charge. This should cover all the costs (fixed and variable) that are envisaged at the time the contract is signed, unless there is a capital contribution at the start of the contract.
Fixed costs are those covered by the unitary charge that do not increase with inflation. The most significant fixed cost in a PFI contract is bank debt, mainly covering the construction costs.
Variable costs are those covered by the unitary charge that do increase with inflation. The most significant of these relate to life cycle (replacement) costs and the facilities management (FM) services that the contractor provides over the operational period of the contract, typically 25-30 years. The mechanism for dealing with inflation in a PFI contract is indexation – explained further in our article 5 Tips for Cost Control by Keeping Track of Indexation.
Ad hoc costs are those that are passed on to the client separately, rather than through the unitary charge. These may include:
- One-off payments for contract variations
- Payments for additional services provided under the contract, such as for use of the asset outside normal hours
- Payments as a result of cost sharing (see tip 11 below).
Understanding the different cost components, what they are made up of, how they are paid for and their values helps the client to establish their relative significance and manage them more effectively. For example, a PFI manager who understands the importance of financing costs will be more likely to explore the option of refinancing (see tip 10 below), rather than focussing solely on FM costs when they need to make savings.
3. Monitor availability and performance deductions
The use of availability and performance deductions in the payment mechanism is the primary means of ensuring the contractor makes the facilities available and performs the services in accordance with the contractual requirements. Experience from many operational PFI contracts shows that this does not happen automatically. Clients, therefore, need to devote considerable time and effort to ensure that the deductions accurately reflect the quality and level of services provided.
Such robust monitoring ensures that the contractor understands that poor performance will not be tolerated, which drives up and maintains service quality. For more detail on this area, please read – Keeping Track of Availability and Performance Deductions in PFI Contracts.
4. Keep track of affordability
Ensuring the project is affordable should be one of the PFI manager’s two key priorities, along with ensuring that the client organisation gets value for money from the contract. Given the complexity of PFI financing and the length of the operational period (typically 25-30 years), this can be expected to take a great deal of time and effort and involve, as a minimum, keeping track of:
- Payments
- Income
- Indexation
- The impact of benchmarking and market testing
- The impact of contract variations, as well as maintaining a sinking fund to ensure that the project is affordable each year and over the whole contract period.
Failure to keep on top of affordability can result in a short-term problem of insufficient cash to pay the unitary charge in the current year. In the long run, deficits of millions of pounds over the life of the contract can accumulate. More detail is provided in this article which looks at the Key Steps to Keep Control of PFI Affordability.
5. Keep an eye on indexation
Indexation is the mechanism for increasing the unitary charge in line with inflation. In a PFI contract, only part of the unitary charge is indexed because only part of the contractor’s costs vary with inflation. Clients need to:
- Know which elements of the contract price are subject to indexation
- Understand how the indexation works
- Check that the contractor is applying indexation correctly
- Monitor actual against estimated inflation
- Take action if an affordability gap arises due to inflation being higher than expected.
More information about indexation is provided in the following article – 5 Tips for Cost Control by Keeping Track of Indexation.
6. Oversee (and guard against) interest payments
All PFI contracts should include provisions for interest on late payments by either party.
The high value of PFI contracts and the related monthly payments mean that the cost of interest on late payments can be prohibitive for the client and add an unbudgeted burden to the already significant PFI expenditure. In order to avoid this, the client needs to:
- Set up a payment profile for the unitary charge invoices at the beginning of each financial year, ensuring that it correctly reflects the indexed payments for the year
- Make arrangements with accounts payable to ensure invoices are paid within the time-scales specified in the contract (which are often less than the standard payment period for other contracts and therefore need to be managed by exception).
In many cases, clients are not aware that interest applies not only to late payments from the client to the contractor, but also to late payments from the contractor to the client. Common examples of where interest applies to late payments by the contractor are:
- Deductions
- Share of refinancing gain
- Payments resulting from income sharing provisions (see tip 11 below).
The contract will specify the date on which the payment should be made and this will determine the date from which interest applies.
Clients need to ensure that where there are such delays in payment by the contractor, interest is charged correctly. This is particularly important where the delay is considerable because in that case the interest due to the client will also be considerable!
7. Understand PFI financing
PFI financing may seem an obscure topic from the client’s point of view, but is at the heart of a PFI contract – the clue is in the name. Knowledge of how the contract is financed and the different stakes held by the lenders and shareholders is, in fact, crucial to understanding the incentives that guide the different private sector players in their approach to the management of the PFI contract. It is also important to understand what their requirements are for financial returns and whether these are being met or not. A client with this knowledge is in a much firmer position to negotiate on costs and performance.
For further information on PFI financing, you can read PFI Financing Explained – Who Owns Your Debt and What It Means.
8. Stay in control of costs relating to contract variations
Contract variations or changes are a key area of risk for the client, as they provide an opportunity for the contractor to rack up its profit. However, this is a risk that the client can and should manage and is another aspect of PFI contract management that merits significant input of time and effort from the client side.
PFI managers need to:
- Ensure the contractor complies with their contractual requirements and agreed protocols relating to variations
- Challenge the cost of the variation proposed by the contractor where appropriate
- Challenge any excessive claims for costs relating to the change process, e.g. for legal fees.
Further guidance on this issue is provided in our article – PFI Change Management: 5 Steps to Cut Costs and Improve Contractor Performance.
9. Be in control of benchmarking and market testing
Benchmarking and market testing can provide another opportunity for a contractor to rack up its profits, but this need not be the case if clients take control of the process. PFI managers need to:
- Understand the benchmarking and market testing provisions in the contract
- Ensure the contractor complies with the contractual provisions, especially those that are there to protect the client
- Actively engage with the contractor to ensure that best value is achieved.
More information about benchmarking and market testing is provided in our article PFI Benchmarking and Market Testing – How to Get the Services You Need at Reduced Cost.
10. Observe refinancing provisions
Refinancing is a change to the terms on which the finance for the PFI scheme is provided. In most PFI contracts, the client is entitled to receive 50% or more of the net gain from any refinancing. For earlier PFI contracts that do not have these provisions, there is a voluntary code of practice under which the client gets 30% of any refinancing gains. As a result, PFI managers need to:
- Understand the refinancing provisions in the contract
- Keep track of whether a refinancing has already taken place or might take place in the foreseeable future
- Make sure the client’s share of any refinancing gain is calculated and paid correctly.
11. Track cost and income sharing provisions
Most PFI contracts include some elements of cost and income sharing. The most common are:
- Share of risk on the cost of utilities
- Share of income from the use of PFI facilities by third parties
- Share of risk on insurance costs
- Share of the refinancing gain.
Although in most cases it is the contractor’s responsibility to inform the client of any amount to which the client is entitled under the cost or income sharing mechanism, the contractor has little incentive to do so. The client, therefore, needs to:
- Have a good knowledge of the cost or income sharing mechanisms
- Keep track of when payments may be due to the client and chase the contractor if payments are not made promptly (see our article on the PFI Monitoring Calendar to help you – click here to read.
- Ensure the contractor is charged interest on any late payments (see tip 6 above).
12. Make operational savings
It is a common myth that once a public body has entered into a PFI contract, it is stuck with the level of service and unitary charge that it originally signed up to. This is not the case at all as detailed in 3 Myth Busters to Help You Achieve PFI Contract Savings. There are many reasons why it may be appropriate to reduce the specification or consider other options for reducing the cost of the PFI contract, including:
- Where operational experience shows that the level of service specified in the contract is higher than it needs to be (e.g. specified hours of availability of a library are more than required)
- The financial climate has changed and the client and/or end users would rather pay less and have a lower level of service.
Please note: It may also be possible to make savings without reducing the specification, e.g. through more effective third party income generation.
Savings can be introduced through the change mechanism in the contract and/or by negotiation with the contractor. It is also likely that the client will need to engage with end users to agree any changes.
Our 12 Tips Summarised…
- Understand the principles of PFI financial monitoring
- Know the PFI cost types
- Monitor availability and performance deductions
- Keep track of affordability
- Keep an eye on indexation
- Oversee (and guard against) interest payments
- Understand PFI financing
- Stay in control of costs relating to variations
- Be in control of benchmarking and market testing
- Observe refinancing provisions
- Track cost and income sharing provisions
- Make operational savings.
For support and advice on PFI financial issues, including how to achieve cost savings, contact us on T. 0845 345 0130 or email: advice@bestpracticegroup.com. Further information on driving maximum performance from PFI contracts can be found by downloading our free white paper.
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