Background to PF2

It is now nearly two years since the Government published its wide-ranging reforms to major public infrastructure and services projects under the Private Finance Initiative (PFI). However, the new approach, known as “PF2”, has been slow to get off the ground. Due to the shrinkage in the UK PPP market over recent years, there has not been the steady pipeline of projects that potential bidders may have hoped for. The first projects to be procured under PF2 are under the Government’s Priority School Building Programme (PSPB), although only a proportion of the total programme will now be procured by PF2. As successful tenderers have now been selected for the North East, North West, Yorkshire, and Hertfordshire, Luton and Reading PSPB batches (with the Midlands due to follow this month), it seems a good time for a reminder of the key differences between the old PFI and PF2.

PF2 was introduced to address concerns that PFI did not deliver value for money, was inflexible, lacked transparency, provided excessive gains for private sector equity providers, and took too long to reach financial close. Despite these concerns, it was acknowledged that aspects of the existing PFI approach worked well, such as delivering innovation and offering a reasonable level of risk allocation. Whilst the reforms are significant, many of the existing PFI principles were retained.

How does PF2 differ from PFI?

The key changes introduced by PF2 were:

  • Government Equity Stake: The Government will take a minority equity stake (around 30 per cent) in the special purpose vehicle (SPV) responsible for delivery for each project. This is intended to encourage greater collaboration between the private and public sectors, increase transparency through increased access to SPV information, and allow the public sector to share in some of the SPV gains. The Government’s equity stake is in addition to the usual 10 per cent private sector equity stake, so will reduce the overall debt to equity ratio to around 75:25, providing additional comfort to senior lenders.
  • Greater transparency: The public sector will have increased access to SPV information as a result of the Government’s equity stake. In addition, there is now a requirement for the private sector to provide details of actual equity returns and proceeds from equity sales.
  • Funding competitions: There were concerns that equity returns on PFI projects were often too high and that some investors made unacceptable windfall gains. The Government is keen to see more long term investment at an earlier stage (eg, by pension funds) and is proposing to introduce funding competitions for a proportion of the private sector equity funding.
  • Centralised procurement: To deal with concerns regarding public sector organisations’ expertise and experience in PFI procurements, there is to be greater centralisation of project procurements under PF2. The first projects under PF2, the PSBP schools projects, are being procured centrally by the Department of Education’s Education Funding Agency.
  • Removal of Soft FM Services from PF2: “Soft” FM services, such as catering and cleaning, have been removed from PF2 contracts. PFI projects had traditionally included both hard and soft FM services. However, there were concerns that including soft FM services did not provide value for money, operational flexibility or transparency. In recent years, many contracting authorities had, therefore, decided to exclude soft FM services from their PFI projects. Under PF2, soft FM services will be procured separately, under short term contracts with the private sector or other public sector bodies. While this will address the concerns previously expressed, it will raise various interface issues, which will need to be addressed contractually.
  • Lifecycle: There were concerns that, under PFI, the private sector was able to make windfall gains at the end of the contract by the build-up and management of the lifecycle fund. Under PF2, lifecycle spend in the financial model is compared to actual lifecycle spend every five years, providing the public sector with greater transparency. There will also be the opportunity for the public sector to share in any lifecycle surplus.
  • Ambitious project timetable: One of the criticisms of PFI (by both the private and the public sectors) was the time it took projects to reach financial close, resulting in increased costs for both sides. Under PF2, the time taken from issuing the Invitation to Participate in Dialogue/Invitation to Negotiate to appointment of preferred bidder cannot exceed 18 months. After that time period, funding will not be approved by the Treasury, unless an exemption has been granted by the Chief Secretary. In addition, the Government will adopt a streamlined approach to the procurement in accordance with its Lean Sourcing principles.
  • Suite of new standard documentation. The Government is issuing a suite of standard documentation for PF2 projects, including procurement and contract guidance, a shareholders’ agreement, an FM service output specification and a payment mechanism for accommodation projects. A revised guidance document (to replace the Treasury’s “Standardisation of PFI Contracts version 4” or “SOPC4”) has been issued, entitled “Standardisation of PF2 Contracts”.

As the first PF2 projects have not yet reached financial close, it still remains to be seen how the new approach works in practice and whether it achieves the Government’s aims of greater value for money, transparency, flexibility and speed.

Choice of procurement procedure for PFI/PF2/PPP projects

In the early days of PFI/PPP, projects were procured under the EU procurement rules using thenegotiated procedure. However, there were concerns in other EU member states that the negotiated procedure was being used inappropriately and that it should not be used for PFI projects. Following the introduction of the Public Contracts Regulations 2006 (the “2006 Regulations”) (implementing a 2004 EU Directive), contracting authorities were required to use the new “competitive dialogue” procedure for most PPP projects. Since then, use of the negotiated procedure has only been permitted in exceptional circumstances and the majority of projects have been advertised under the competitive dialogue procedure. Following initial doubts and concerns, particularly amongst the private sector, regarding the time it would take to reach financial close and the potential for substantially increased bid costs, competitive dialogue has worked reasonably well, particularly when the process has been well structured and carefully managed.

Following the adoption of a new EU procurement Directive in February 2014, the Government has published draft new procurement regulations, due to come into effect at some time in 2015 (the “2015 Regulations”). Under the new Directive and 2015 Regulations, a new procurement procedure has been introduced to replace the old negotiated procedure – the “competitive procedure with negotiation”. While the procedure has similarities with both the old negotiated procedure and the competitive dialogue procedure, there is one key difference. Under the new procedure, while negotiations can take place on initial and subsequent interim tenders, no negotiations will be permitted on the final tenders submitted by bidders. Under the old negotiated procedure, negotiations continued with the preferred bidder up to financial close. Under the competitive dialogue procedure, as set out in the 2015 Regulations, final tenders can be “clarified, specified and optimised” with bidders, and negotiations can continue with the selected bidder to “confirm financial commitments or other terms” in the tender, provided that in either case this does not have the effect of materially modifying essential aspects of the tender or procurement, or risk distorting competition. The current negotiated procedure has always been considered more flexible than competitive dialogue, particularly in terms of post tender negotiations. However, under the new draft 2015 Regulations, the opposite will be the case. It therefore seems likely that the competitive dialogue procedure is here to stay for many complex procurements, such as PF2.