Pfi Credit Crisis

8/4/2019 Pfi Credit Crisis

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HM Trsr

Financing PFI projects in the creditcrisis and the Treasurys response

RepoRT by THeCoMpTRolleR andaudiToR GeneRal

HC 287

SeSSion 20102011

27 july 2010


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The National Audit Ofce scrutinises public spending on behal o

Parliament. The Comptroller and Auditor General, Amyas Morse, is an

Ofcer o the House o Commons. He is the head o the National Audit

Ofce which employs some 900 sta. He and the National Audit Ofce

are totally independent o Government. He certifes the accounts o all

Government departments and a wide range o other public sector bodies;

and he has statutory authority to report to Parliament on the economy,

efciency and eectiveness with which departments and other bodies

have used their resources. Our work leads to savings and other efciency

gains worth many millions o pounds: 890 million in 2009-10.

Our vision is to help the nation spend wisely.

We apply the unique perspective o public audit

to help Parliament and government drive lasting

improvement in public services.


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Ordered by the House o Commons

to be printed on 26 July 2010

Rrt th Cmtrr atr Gr

HC 287 Session 20102011

27 July 2010

London: The Stationery Oce

14.75

This report has been

prepared under Section 6

o the National Audit Act

1983 or presentation to

the House o Commons

in accordance with

Section 9 o the Act.

Amyas Morse

Comptroller and

Auditor General

National Audit Oce

22 July 2010

HM Trsr

Financing PFI projects in the creditcrisis and the Treasurys response


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This report examines the eects o the

credit crisis on privately nanced government

inrastructure projects, the Treasurys response

and the challenges ahead.

National Audit Ofce 2010

The text o this document may be reproduced ree o charge in

any ormat or medium providing that it is reproduced accurately

and not in a misleading context.

The material must be acknowledged as National Audit Ofce

copyright and the document title specifed. Where third party

material has been identifed, permission rom the respective

copyright holder must be sought.

Printed in the UK or the Stationery Ofce Limited

on behal o the Controller o Her Majestys Stationery Ofce

2378668 07/10 STG


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Contents

Summary 4

Part One

The Treasurys response

to the eect o the credit

crisis on privately nanced

inrastructure projects 14

Part Two

The eect o the new

nancing terms on contracts

let since the credit crisis 20

Part Three

The inrastructure challenges

in the current economic

environment 26

Appendix One

Methodology 29

Appendix Two

PFI Benchmarking 31

Appendix Three

Case Studies 32

Glossary 34

The National Audit Oce study team

consisted o:

Mark Halliday, David Molony,

Colin Ratclie, Jonathan Tang and

Richard Wade, under the direction

o David Finlay

This report can be ound on the

National Audit Oce website at

www.nao.org.uk/inrastructure-

nancing-2010

Photographs courtesy o

xxxxxxxxxxxxxxxxxxxxxxxx

For urther inormation about the

National Audit Oce please contact:

National Audit Oce

Press Oce

157-197 Buckingham Palace Road

Victoria

London

SW1W 9SP

Tel: 020 7798 7400

Email: [email protected]

Website: www.nao.org.uk

Twitter: @NAOorguk


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4 Smmr Financing PFI projects in the credit crisis and the Treasurys response

Summary

Introduction

Economic and social inrastructure orms the backbone o economic activity1

in the United Kingdom, and enables the delivery o public services across thecountry. The term inrastructure encompasses social and economic sectors such as

communications, education, energy, health, transport, waste and water.

In the ve years to April 2010 approximately 30 billion per year was invested in2

UK inrastructure. Future investment is orecast in the range o 40-50 billion per annum

until 2030. Investment is nanced in a range o ways:

Finance can be provided by private companies, but with some orm o explicit

public regulation or implicit public support. Examples include the water and energy

sectors, which are largely privately owned and nanced.

Finance can be provided by public resources only, or or large one-o projects

such as the Olympics, with a mixture o public and private resources.

Finance can also be provided under the Private Finance Initiative (PFI) or other

orms o Public Private Partnership (PPP). Sectors o economic and social

inrastructure provided in this way include, or example, new hospitals and

some roads.

PFI projects are long-term contractual arrangements between public authorities3

and private sector companies with project nancing raised by private companies.

Project nance means that the nancing is provided or a sole project, through a special

company set up or the purpose. Departments generally conclude that the contract

oers value or money when the benets associated with the transer o project risk

outweigh any additional PFI nancing cost.

PFI projects typically use around 90 per cent debt nance and 10 per cent equity4

nance. The debt portion o this nancing can be provided by bank loans and/or bonds.

The banks and bond holders receive interest on their loans related to risks. Interest

charged on a bank loan is usually a combination o two parts, the reerence rate (usually

the interbank rate) and the loan margin (Fgr 1). The interbank rate refects general

market risks, while the loan margin refects project specic risks. Variable rate bank loans

are swapped to xed rates to provide stable monthly payments over the project lie.


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Financing PFI projects in the credit crisis and the Treasurys response Smmr 5

Bond nance is where a loan is split up into many identical bonds which saving5

institutions can trade in public markets known as capital markets. Credit Rating

Agencies analyse individual project and nance structure risks and publish a rating as

a guide to investors. Beore the credit crisis, the purchase o credit insurance could

improve the rating o the bond, thus making the risks acceptable to non-specialised

lenders such as pension unds.

In late 2007, market condence in the providers o this credit insurance collapsed,6

leaving PFI projects in the United Kingdom without access to capital markets.

The bank loan market, however, continued to unction. Banks can make loans7

while they have sucient reserve capital (see Glossary) to allocate against them. To keep

making new loans banks must ree up reserve capital by selling existing loans, in whole

or in part, to other banks or raise new capital. This process is known as syndication.

The collapse o Lehman Brothers in September 2008 led to a halt in loan syndication,continuing throughout 2009. This limited the ability o banks to make new PFI loans.

The equity nance is provided by a projects contractors and nancial institutions.8

It typically comprises a mixture o shares and shareholder loans. Equity nance is known

as risk capital because, generally, the equity will be lost rst i the project company

ails. The shareholder loans are higher risk as their repayment in a ailure is junior to the

external debt, known as senior debt, which is repaid rst.

Figure 1

This shows how a variable rate loan is converted to a fixed rate and the

composition of loan interest costs

NOTES

1 LIBOR means the London Inter Bank Offered Rate (see Glossary) which is similar to base rate, but usually higher to

reflect risk of bank failure.

2 A swap fee is payable to convert a variable rate loan to a fixed rate loan. Short-term rates can often exceed long-term

rates during the life of a project.

Source: National Audit Office

Reflects

Project Risks

Reflects

Market Risks

Cushion for changes

in Market Risks

Swap Fee

Margin

Index Rate

(LIBOR) Variable

Swapped Rate

(LIBOR)

Fixed Long Term

Margin


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Sc

This report examines the eects o the credit crisis on privately nanced9

government inrastructure projects and the Treasurys response. Although unable

to control conditions in the nancial markets, the Treasury sets guidance on how

departments assess value or money and approves signicant projects. It thereore

was responsible or coordinating the Governments response to the nancial crisis and

mitigating its impact on inrastructure procurement. In particular, the report sets out:

how the Treasury responded to the impact o the credit crisis on the availability

and terms o nance or PFI contracts;

the impact o the credit crisis on the cost o nance or PFI contracts; and

the challenges ahead.

The report does not consider the value or money o individual projects, nor does it

address the remit o Inrastructure UK, the new body established to coordinate the

Governments approach to the inrastructure challenge. The report does, however, make

recommendations on issues that Inrastructure UK should address.

Figure 2

Average international project finance loan margins compared to PFI

Margin (%)Credit Crisis

Year

No of PFI deals

NOTES

1 The margins are averages based on monthly data.

2 Numbers in bold are the number of PFI projects financed in that year.

Source: National Audit Office and project finance chart based on data from the Infrastructure Project Finance Benchmarking Report 1995-2009 further

description at http://infrastructureeconomics.org/2010/02/09/project-finance-benchmarking-report/

0.0

0.5

1.0

1.5

2.0

2.5

3.0

3.5

1998 1999 2000 2001 2002 20031995

1 15 24 46 54 68 52 54 51 61 50 57 57 31 35

1996 1997 2004 2005 2006 2007 2008 2009

All PFI


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K fgs

The Treasurys response to lower availability o nance

The Treasurys role in establishing the PFI market contributed to reductions10

in the risk margin o private debt nance between 1999 and 2007. Over this period,

the establishment o the PFI market and the availability o bank nance lowered nancing

costs as bank competition increased. Departments took advantage by letting around

300 contracts with relatively low nancing charges. The part o the interest cost relating

to project risk, the PFI loan margin, averaged around one per cent, or less. These rates

were lower than intern ational project loan margins which averaged 1.7 per cent rom

1994 to 2008 (Fgr 2).

As the credit crisis took hold in autumn 2008, debt nance became11

increasingly unavailable. As a result o market conditions, largely outside the

Treasurys control, rst bond nance, and then bank nance, became severely restricted.

But as the UK economy entered recession, the Government had a signicant pipeline o

inrastructure projects, with an investment value exceeding 13 billion (Fgr 3).

Figure 3

The investment value of UK infrastructure projects notified in the Official Journal of the European

Union as at March 2009

billion

NOTES

1 Building Schools for the Future (BSF) is a secondary schools investment programme.

2 Local Improvement Finance Trusts (LIFT) finance primary medical care projects.

Source: HM Treasury

Capital value of pipeline by sector

0.0

0.5

1.0

1.5

2.0

2.5

3.0

3.5

4.0

4.5

Housing Health Street

lighting

Emergency

Services

Libraries Education

(other)

Waste Educat ion

(BSF)

Transport Leisure Prisons NHS

LIFT

Joint-service

centres

Courts


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The Treasury was concerned about the macroeconomic impact o the12withdrawal o debt nance. With debt nance increasingly unavailable, individual

contracts became harder to nalise. The Treasury eared that, as a result o this potential

slowdown in new PFI contracts, the opportunity to stimulate the economy through

new inrastructure would be lost. In addition, important benets, or example, improved

school acilities and dealing with road congestion, depended on the completion o

planned PFI projects.

The Treasury thereore sought to maintain a fow o signed PFI contracts.13

The overarching Government policy in late 2008 was that the pipeline o PFI deals

should reach nancial close promptly, to stimulate national and local economies, and

create jobs. The Treasury ollowed this policy whilst continuing to apply standard PFIvalue or money tests.

Bank lending was so restricted in late 2008 that, despite Treasury14

encouragement, no sizeable contracts could be let. In September 2008, the

Treasury asked the European Investment Bank to step up its lending to inrastructure

projects which the Bank did. The Treasury, however, did not set PFI lending targets or

UK banks when they received government support during that winter. The Treasury

initiated internal discussions about such targets but did not pursue them because the

banks concerned were a sub-set o the PFI lending market and because PFI lending

was only a small part o the issues acing the Treasury in relation to its banking support.

In early 2009, there continued to be insucient bank debt or larger projects becausebanks did not resume lending as expected.

The Treasury helped to reactivate the lending market or inrastructure15

projects by setting up its own nance unit. In March 2009, the Government rapidly

set up The Inrastructure Finance Unit to address the scarcity o debt nance. The

units role was to be available to provide government loans to inrastructure projects, on

commercial terms, so shortalls in the amount o available bank nance could be met.

In April 2009, The Inrastructure Finance Unit helped to nalise a large waste16

treatment and power generation project. The unit provided a 120 million loan to

complete a 582 million nancing package or a waste treatment and power generation

project in Greater Manchester. The Treasurys participation in this loan, on the same

terms as commercial banks, is intended to be temporary and reversible.

The Treasurys willingness to lend improved market condence and17

subsequently around 35 government inrastructure projects have been agreed

without any urther public lending. The Inrastructure Finance Unit has not made any

urther loans. But since its establishment, around 35 projects have been agreed. There

is thereore some evidence that the unit improved market condence. In addition, the

availability o government loans provided some competitive tension to the banks in a

market which, since 2008, had lacked competition on loan nancing terms.


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Th cst fc

We ound that as a result o the credit crisis, the total interest cost o bank18

nance increased by one-th to one-third. In the 35 projects agreed ater the

establishment o The Inrastructure Finance Unit, we ound that the part o the cost

relating to loan margins on PFI deals, which had been 1 per cent or less, widened

signicantly to around 2.5 per cent on average (Fgr 4). Some, or example, the

complex Greater Manchester Waste project, will rise to more than 3 per cent in stages

over the project lie. The increased loan margins resulted in substantial increases to the

cost o nance (Figure 4).

These increases occurred despite the all in short-term borrowing rates and19

little change in the intrinsic risk prole o projects. The all in the underlying short-

term bank lending rate (the base rate) to 0.5 per cent only had a slight impact on PFI

deals. This is because the private sector xes the interest cost on their long-term PFI

borrowings. This xed interest rate, currently around 4 per cent, refects the risk o uture

changes in interest rates and is a market actor that is not specic to PFI.

In line with policy on acting to stimulate the economy, the Treasury gave20

priority to closing deals at the prevailing market rates, even i this meant paying

more and banks carrying less risk. In addition to charging higher margins, the

banks have sought to de-risk their lending to projects ollowing the credit crisis. They

renegotiated their lending terms with preerred bidders, through: lowering the proportion

o debt in projects; increasing cover ratios (see Glossary); requiring the private sector

to inject risk capital earlier; and placing more onerous conditions on when the private

investors can withdraw cash rom the project.

Figure 4

Comparison o interest costs on PFI projects

Str ds lrg ds

pr crss pst crss pr crss pst crss

K csts Sm rcts(2007)

Sch sm(2009)

FSTa(Mrch 2008)

GMW(ar 2009)

M25(M 2009)

Level o project risk Various Low High/medium High Medium

Interest rate margin (%) 0.79 2.51 1-1.15 3.25-4.50 2.5-3.5

Total interest cost (%) 5.9 6.9 5.9-6.1 7.7-8.91 6.9-7.9

Increase post crisis

(minimum) (%)

+18 +31 +17

noTeS

1 The indicative level o project risk shown above illustrates the act that the projects are not directly comparable. The change in interest margin

percentages partly reflects this.

2 The Future Strategic Tanker Aircrat (FSTA) project raised unding o 2.5 billion. Greater Manchester Waste (GMW) borrowed 582 million.

3 The increase post crisis will rise with stepped increases in the interest rate margin i refnancing (see Glossary) does not take place.

Source: KPMG and National Audit Office


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Our analysis shows that the higher nancing costs increased the annual21charge o typical PFI projects by 6 to 7 per cent (Appendix Two). Riskier PFI

projects experienced a larger increase. For example, we estimate that the increase in

the nancing charges o the Greater Manchester Waste project added 12 per cent to

its annual contract price (Figure 11 on page 25). To address this, in October 2008 the

Treasury increased the public sector share o any uture reductions in debt costs rom

50 per cent to 70 per cent.

We estimate that between 500 million and 1 billion o higher cost has been22

locked in, partly oset by the increased public sector share o renancing gains.

The higher end o this range refects the dierence between current PFI bank rates and

low rates prior to the credit crisis. Although departments can now press investors torenance, any renancing requires careul judgement and will depend on uture market

conditions. We doubt whether more than hal o the current higher nancing costs might

be recovered.

Higher nancing costs eroded the value or money advantage that23

departments attribute to PFI. Departments initially seek assurance on the value

or money o PFI procurement by comparing alternative ways o providing the same

results. Although we have oten expressed concern about these calculations, the

typical estimate o the PFI cost advantage lay in the range o 5 to 10 per cent (and

some cases we have audited showed smaller savings). We estimate that nancing rate

changes increased the annual contract charge by around 6 to 7 per cent. This ndingsuggests an increased risk to value or money resulting rom the credit crisis. Given the

Governments policy objectives or stimulating the economy, we accept, however, that

delays rom resubmission o individual business cases might have put the policy at risk.

Although the Treasury and departments took steps to assess the impact24

on the value or money o projects, there were limitations to their assessment.

Despite the higher nancing costs the Treasury and departments considered that all

35 contracts let in 2009 continued to represent value or money. The Treasury relied

on the normal review processes or PFI projects and a review by Partnerships UK o

the expected eect o higher bank risk margins on a sample o projects. There were,

however, limitations to this approach, as:

although the Partnerships UK review, commissioned by the Treasury, was useul

analysis, it did not cover all projects let or all aspects o nancing costs. In addition,

the Treasury monitored actual nancing terms, but did not have a ull analysis o the

impact o the higher rates on the cost o projects that closed in 2009;

some schools projects did not ully reassess their business cases, using out o date

guidance which had said an updated quantitative analysis was only necessary i

costs increased by 25 per cent; and

the value or money assessments or the M25 and Greater Manchester Waste

projects continued to rely on assumptions, rom earlier business cases,that high savings in uture whole lie costs would not be available under

conventional procurement.


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Challenges

The Treasury, through Inrastructure UK, aces a number o challenges to25

identiy the best unding models or projects now being developed. The Treasury

has ormed Inrastructure UK to oversee inrastructure investment in the UK, including

aspects o Government capital spending. It will ace important challenges regarding the

prioritisation o projects and procurement methods given the large decit in the public

nances and the increased cost o using private nance.

There are alternative nancing options to PFI.26 Projects such as the Olympics

and Crossrail have relied on, or will be using, a greater input o public money. There were

other nancing options, and although these would not have been likely to achieve the

Governments policy objectives in 2009, they could be relevant in uture:

The French government guarantees 80 per cent o the debt, once a project

is operating successully, to reduce the use o bank risk capital and thereore

nancing costs. The disadvantage is that this approach is not a temporary or

reversible intervention and retains some operating project risk or the public sector.

The not-or-prot European Investment Bank (EIB) is generally able to make unding

available on more avourable terms (such as margins and ees) than commercial

banks. Some European countries have used public loans in a similar manner.

Ccs v r m

We have assessed how the Treasury managed the risks to value or money,27

rather than examining individual projects. Departments ability to nance the existing

programme was in doubt until the Treasury set up The Inrastructure Finance Unit and

reactivated the lending market. Our value or money conclusion relates to projects

actually nanced in 2009. However, we accompany that conclusion with a warning on

value or money or subsequent projects.

On projects nanced in 2009:28 It is our opinion that in the circumstances the extra

nance costs o projects nanced during 2009 were value or money. We take this view

because the overarching policy priority to provide economic stimulus severely limited thescope or the Treasury to do more than they did to protect public value while ensuring

that the programme o PFI projects was moved orward. In reaching this view we

considered the act that the nancing margin being paid had widened signicantly, and

that banks renegotiated lending terms which resulted in an increased cost o risk or the

public sector. We regard this as having been oset to some extent, and as ar as was

reasonably achievable in all the circumstances, by the increased renancing gain share

terms obtained by the Treasury.


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We also considered whether the PFI deals could have been required to29submit individual revised business cases, which might have led to some o the least

advantageous projects being postponed or discontinued with the eect o improving

overall value or money. We concluded that this requirement would have imposed urther

delay that might have put the policy objectives at risk, and would not thereore be a

reasonable yardstick to assess the protection o value or money in the programme.

However, having concluded thus positively on projects nanced at the height o the

crisis, we would expect more exacting criteria to be applied subsequently.

On projects which have yet to be ully developed:30 There should be no

presumption, based on earlier business case analysis, that continuing the use o private

nance at current rates will be value or money. We now expect a thorough projectby project review o the orward programme to apply more exacting and narrower

criteria than applied to projects nanced at the height o the crisis. PFI is less likely to

be value or money unless there are substantial and credible savings to oset higher

nancing costs. The Treasurys ormation o Inrastructure UK gives a platorm or wider

consideration o risks, other unding options and alternative procurement models.

Rcmmts

To the Treasury

Market disruption, causing a lower availability o nance, has interrupted

the Governments inrastructure programme.The Treasury should analyse

the lessons rom the past two years. It should use these lessons to prepare a

contingency plan or how departments should handle uture market disruption

aecting procurement plans.

There is limited evidence that projects undamentally re-evaluated their

business cases in light o the credit crisis. Where there are material changes,

such as project costs increasing by 15 per cent, the Treasury should require that

the department re-evaluate the project. This re-evaluation should assess all the

benets, and potential loss o benets, o continuing the project in its current orm,

compared to other available options, including other orms o procurement.

Increased reliance on a single type o nance, with reduced competition,c

promotes ineciency. The Treasury should continue to consider how a greater

mix o nance sources, with less emphasis on the use o commercial bank loans,

can be used to nance inrastructure projects.


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To the Treasury and departments

Allowing individual projects to negotiate renancing will lead to variable and

overall sub-optimal outcomes. The Treasury should adopt a portolio approach

to renancing, with input rom the relevant departmental team, so that individual

authorities do not exercise any right to a renancing on a piecemeal basis. During

the operating phase o a number o projects, taking a portolio approach will

enhance the public sector bargaining position, reduce transaction costs and

increase potential gains. The Treasury should also consider whether the returns to

equity investors are aligned with the changed risk allocation in deals that has arisen

ollowing the credit crisis.

The increase in nance costs, including some reduction in risk borne by

banks, makes PFI less likely to be a value or money solution. In line with

Treasury guidance, departments should not presume that a wholly privately

nanced project oers a solution likely to secure good value or money. During

procurement, and in drating notices or the Ocial Journal o the European Union,

departments should assess a range o nancing options, including all public

nance or part public and part private nance.

The public sector gave greater priority to securing agreed contracts than

to negotiating better outcomes. In such situations, departments should

nevertheless make greater use o sensitivity analysis to inorm decision-making

over negotiation on possible small changes in nancing rates and on each request

to take on additional project risk.


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14 prt o Financing PFI projects in the credit crisis and the Treasurys response

Part One

The Treasurys response to the eect o the creditcrisis on privately nanced inrastructure projects

During 2008, the market capacity or providing bank nance decreased, pricing1.1

increased and other terms tightened. Fgr 5 shows the main changes aecting the

nancing market and the eect on inrastructure projects.

Th Trsrs t rss t th mct pFi ctrcts

The Treasurys initial response was to evaluate the extent o the impact o nancial1.2

market disruption on PFI projects. From June 2008, it analysed increasing evidence that

the disruption to the credit markets was aecting unding or the PFI market, in terms

o both the pricing and availability o project debt. In particular, it concluded that market

changes had increased project costs, leading to delays, and putting the overarching

policy o stimulating the economy at risk. In addition, i cheaper nance were to become

available in the uture, the private sector would then gain more benet rom renancing

(see Glossary). Departments were, thereore, already being advised to seek a right to

bring about a renancing and obtain an increased share o any gains. In October 2008,

this was made a ormal amendment to standard contract terms.

Banks put up their ees and interest charges to borrowers generally, including1.3

PFI borrowers, but most were unwilling to provide long-term loans in greater amounts

than about 25 million per project. As a result many PFI borrowers had to take time to

assemble a club o ve or six banks to do a large deal. Such a deal would previously

have involved only one negotiating bank and later syndication on pre-agreed terms at

the risk o that lead bank.

All-in interest charges and other lending terms worsened or PFI deals during 2008,1.4

and most notably during 2009. Complex deals, like the M25 project and the Greater

Manchester Waste project struggled to orm bank clubs or the substantial amounts

they needed.


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Financing PFI projects in the credit crisis and the Treasurys response prt o 15

Figure 5

Key events and Treasury response

pr/dt K vts Trsr

rss

ect rstrctr rcts

December 2007 Last bond issue: Northern

Ireland Road II project raises

146 million

Projects, such as the Ministry o Deences Future

Strategic Tanker Aircrat project, change rom bond

to bank inance

March 2008 Future Strategic Tanker

Aircrat inancing raises

2,200 million

Bank group ormed with eight arranging banks and

15 participants. Interest cost about 6 per cent, up to

1.15 per cent above the then bank cost o unds

September 2008 Lehman collapse Some banks withdraw, others charge more than

1.5 per cent above cost o unds (some as high as

2.2 per cent) compared with 1 per cent previously.

This makes it diicult to procure debt inance to

complete contracts. Major projects such as the

Greater Manchester Waste project and the M25

are delayed

October 2008 Government provides banks

with inancial support

Treasury notes unding

gaps or large or more

complex projects

Projects compete with corporate borrowers or

scarce bank capacity. Finance cost increases are

partially oset by alling underlying interest rates.

Government support to the banking sector does not

trigger a rapid resumption in lending

November 2008 Treasury proposes a range o

possible solutions, including

greater EIB involvement

Increased Authority capital contributions

Authority loans on commercial bank terms

Working Group on medium-term solutions

January 2009 Treasury proposes direct

lending accepted

30 January 2009

Advice leaves open any decision on the lending

body, although Department or Transport may act

as lender on the M25

March 2009 Ministerial Statement on The

Inrastructure Finance Unit

Treasury lends 120 million to the Greater

Manchester Waste project which, in April 2009, is

the irst contract to be let ollowing the credit crisis.

Treasury places letter with lending criteria on websitein May. The market realises that it is now possible to

complete PFI deals in the current market conditions.

The M25 contract is let in May 2009 without the

need or a departmental loan

August 2009 Treasury Application Note

provides new guidance

or taking orward private

inance projects

No signiicant change is made in the way that projects

are assessed ater the Outline Business Case. The

intent is to avoid excessive reliance on uncertain

inancing proposals early in procurements, the low o

new deals is now becoming more established



18/37


The Treasury approached the European Investment Bank in September 2008, to1.5step up its lending activity to help ease the situation. The Treasury, however, did not

set PFI lending targets or UK banks when they received government support during

that winter. The Treasury initiated internal discussions about such targets but did not

pursue them because the banks concerned were a sub-set o the PFI lending market

and because PFI lending was only a small part o the issues acing the Treasury in

relation to its banking support. Banks did not resume lending as expected and, between

October 2008 and March 2009, only our smaller PFI projects were nanced, including

two school projects.

Th mct v r m ssssmts

The Treasury-chaired Project Review Group was responsible or the scrutiny o1.6

business cases or major PFI contracts. Partnerships or Schools undertakes the same

role or schools contracts. Both require projects to rework the economic assumptions

behind the choice o procurement route, made at the Outline Business Case stage, i

there has been market ailure or a major change. Current guidance does not contain

an actual number to dene what constitutes a major change, relying instead on overall

judgement. Some projects such as schools, however, took guidance rom August 2004

exempliying major change as an increased cost, in real terms, o 25 per cent.

In our audits, previous business cases oten indicated that PFI projects were1.7

expected to deliver savings in the range o 5 to 10 per cent. We have also reported in thepast that there were faws in these comparisons between the PFI price and conventional

procurement.1 An increase in the cost o nance thereore represented an increased

risk to value or money, and could have led to reappraisals o the value or money o

individual projects. A review o a sample o Outline Business Cases by Partnerships UK

estimated, however, that all cases remained value or money at higher bank risk margins

o 3 per cent.

Given the Governments policy objectives or stimulating the economy, we accept1.8

that delays rom resubmission o individual business cases might have put the policy at

risk. We also generally accept the case or absorbing higher nancing costs or projects

at an advanced stage in 2009, but would still have expected some supplementaryanalysis o the impact at the project level. In particular, where projects had yet to be ully

developed, we would have expected departments to have presented wider value or

money assessments to the Treasury on the benets and disadvantages o proceeding

with their PFI projects.2 Where applicable, this should have included the eect o the

public sector taking on greater project risks, where the banks made this a condition o

their nancing, balanced against lost service benets rom delaying the projects. Such

analysis would have improved the Treasurys understanding o the trade-os involved in

accepting higher nancing costs, as well as inorming uture decisions on the use o PFI.

1 See, or example, Private Finance Projects, A Paper or the Lords Economic Aairs Committee, October 2009,

paragraph 4.9, pages 46-47.

2 An example o this orm o analysis is in Appendix Five o this report and can be ound at www.nao.org.uk/

inrastructure-fnancing-2010.


19/37


Delayed projects were vulnerable to the credit crisis. The M25 case study, or1.9example, shows a cost increase o over 600 million on a contract which had originally

been due to close in February 2008 (Appendix Three).

One school case, however, illustrates how innovation mitigated the disruptive eect1.10

that the credit crisis had on certain projects reaching contract closure. In this project, to

build a new school in the London Borough o Newham, the bank supporting the winning

bidder withdrew a month beore the planned nancial close. Partnerships or Schools

proposed a solution based on the Local Education Partnership contracting a Design &

Build contract, without committed private nance.3 On an exception basis, the Treasury

allowed the London Borough o Newham to conclude this school project on condition

that interim grant unding would be replaced by private nance within six months, whichwas achieved.

The establishment o The Inrastructure Finance Unit

Following the worsening o the credit crisis in autumn 2008, it became clear that1.11

sucient debt nance, whether bank loans or bonds, was no longer available to privately

nance larger government inrastructure projects. The Treasury wished to close the

contracts in the pipeline to re-establish the market or government inrastructure projects

as part o the broader scal stimulus package. The Treasury thereore considered

options and developed a contingency plan to establish a lending unit. This unit obtained

Government approval at the end o January 2009.

In March 2009, the Government implemented its plan or the lending unit to ensure1.12

that some 110 privately nanced inrastructure projects (exceeding 13 billion) would go

orward, despite diculties in raising debt nance. The unit, known as The Inrastructure

Finance Unit, was created with the purpose o unding any shortalls in bank nance

on privately nanced inrastructure projects. The lending terms would be on the same

commercial terms as the banks.

Ater ten months o negotiation, with almost all o the available banks, the Greater1.13

Manchester Waste project had remained unable to raise the last 120 million to

complete its nancing. In March 2009, the Treasury agreed to make up this shortallthrough a 120 million loan. The Inrastructure Finance Unit subsequently monitored and

provided support to a number o other projects but no urther loans have been required.

The Treasury intervention on the Greater Manchester Waste project was timely1.14

and helped to reactivate the market. The Treasury chose this project because it clearly

met its lending criteria. Raising enough bank nance had proved dicult because the

project carried more risk than the average PFI project (see Part Two). The possibility o

Treasury loans was not needed on the other large complex deal, the M25 project, as

the Department or Transport had already developed a contingency plan to be ready

to act as a co-lender to the project. Other projects were smaller and did not appear to

have nancing gaps or could be grant-unded on a temporary basis, as permitted in theexceptional case o the Newham school.

3 See National Audit Ofce The Building Schools for the Future Programme Renewing the secondary school estate,

February 2009 or an explanation o the Local Education Partnership role.


20/37


Although helpul in moving projects in the pipeline towards contract closure,1.15Treasury lending created increased risks or the public sector parties. Public sector

lending also caused some concerns or the private sector about inormation sharing

(Fgr 6).

During the onset o the credit crisis rom autumn 2008 through to summer 2009,1.16

the Treasury amended renancing provisions and continued to apply existing guidance

to departments on how they were to consider value or money issues on PFI contracts.

Rather than issue additional guidance, the Treasury ocused on getting procurements

moving again and later on the ormation o its lending unit. A guidance note on eligibility

or Treasury loans was issued in May 2009, and an Application Note on PPP projects in

current market conditions was issued in August 2009. The latter did not make materialchanges to the tests that should determine value or money in the nancing conditions

that had arisen ollowing the credit crisis because the Treasury believed its value or

money guidance remained sound.

Figure 6

The main risks and concerns related to Treasury lending

I the project ailed then the Treasury might lose part or all o the money it had lent. As the economy

was in recession there was a higher risk o project ailure due to service deliverers running into

inancial diiculties than beore the credit crisis. This risk was mitigated by hiring sta with appropriate

proessional experience.

There was the potential or conlicts o interest within government over decision-making i a project ran

into diiculties. The procuring department would be seek ing to protect service delivery, and i the project

had to be terminated it would expect the banks to share in any losses that would arise. The Treasury, as

lender, would be motivated in the opposite direction to ensure that it recovered as much as possible o

the money it had lent. This risk was mitigated by a governance structure including a credit committee and

a steering group with some independent members.

The commercial banks lending to the project would be concerned that the Treasury, as lender, might

receive inormation about the departments intentions or the project which had not been communicated

to the banks. The Inrastructure Finance Unit is, however, treated in the same way as any commercial

lender in terms o access to inormation.



21/37


othr ts r mtg rct csts

There were other nancing options, and although these would not have been likely1.17

to achieve the Governments policy objectives in 2009, they could be relevant in uture.

The French government guarantees 80 per cent o the debt, once a project is

operating successully. Although this can reduce nancing costs by several million

pounds, it increases public sector exposure to operating risks. Large projects in

France have struggled to reach conclusion on this basis since 2008, and none

closed in 2009.

The not-or-prot European Investment Bank (EIB) is generally able to make unding

available on more avourable terms (such as margins and ees) than commercial

banks. Some European countries have publicly owned banks playing a similar

role. Lending at similar rates was not pursued because the Treasury considered

government lending should be temporary and reversible. In a uture renancing, it

would be dicult to sell such loans to other parties to recover the original unding.


22/37

20 Part Two Financing PFI projects in the credit crisis and the Treasurys response Financing PFI projects in the credit crisis and the Treasurys response Part Two 21

During 2008, the market capacity or providing bank nance decreased, pricing2.1

increased and other terms tightened. Figure 7 shows the main changes in the nancing

market and their eect o n the timing o the inrastructure projects we reviewed.

Helped by the Treasurys establishment o its lending unit, condence improved,2.2

market activity resumed and 35 delayed projects closed between March and

December 2009 (Figure 8 overlea).

Where private nance has been used since the credit crisis, however, the cost was2.3

always more expensive than beore, generally by around one per cent. The act that the

base rate is currently at an all time low has not ully oset the higher loan margins that

banks are charging. This is because the cost o a xed interest loan, as with government

borrowing over 20-30 years, refects uture interest rate expectations. These rates are lower

than two years ago but the reduction has not been sucient to oset the signicantly wider

loan margins now charged by the banks (Figure 9 overlea).

Part Two

The eect o the new nancing terms on

contracts let since the credit crisis

1 Jun

2009

1 May

2009

1 Apr

2009

1 Mar

2009

1 Feb

2009

1 Dec

2008

1 Nov

2008

1 Oct

2008

1 Sept

2008

1 Aug

2008

1 Jul

2008

1 Jun

2008

1 May

2008

1 Jan

2009

8 Apr 2009

Financial close

December 2008

Department for Transports

willing-to-lend letter

20 May 2009

Financial close

16 Sept 2008

Lehman Brothers

filed for bankruptcy

27 Mar 2008

FSTA project reached

financial close

8 Oct 2008

Banking support

measures announced

by the Treasury

19 Jan 2009

Further support

measures announced

5 Mar 2009

Bank of England started

Quantitative Easing

3 Mar 2009

Treasury

announced

lending unit

3 Apr 2009

EIB increased capital by

67bn (or 40%) to expand

lending during crisis

16 Jan 2009

Contract signed for design and build

aspects with a Laing ORourke consortium

23 Jun 2009

Financial close

13 Nov 2008

BP4L consortium

selected as

preferred partner

7 Jul 2009

Financial close

8 May 2008

Connect Plus selected

as preferred bidder

Figure 7

Timeline of key events affecting case examples after notice in Official Journal of the European Union (OJEU)

PFI project/capital value


Barnsley

schools 111m

Newham

schools 69m

M25 1,073m

Greater Manchester

Waste 795m

1 Apr

2008

1 Mar

2008

1 Feb

2008

1 Jan

2007

1 Jan

2006

1 Jan

2005

1 Jan

2008

22 Feb 2005

OJEU issue

1 Oct 2005

Pre-qualification/bidder invitation

to submit outline solution

29 Jan 2007

Viridon/Laing selected

as preferred bidder

Change in

timeline scale

Major events

during credit crisis

Continuous delays in achieving financial close

23 Mar 2005

OJEU issue

13 Oct 2006

Flow, Connect Plus, Amey/Laing,

ORourke/Ferrovial shortlisted

19 Dec 2007

Downgraded credit ratings of a

number of credit insurers

13 Sept 2007

Run on deposits

in Northern Rock

Further downgrades by credit

rating agencies on credit

insurers during first half of 2008

26 May 2006

OJEU issue

7 Aug 2006

Invitation to tender

11 Apr 2008

Preferred

bidder selected

16 Mar 2007

OJEU issue

17 May 2007

Bidder

longlist

selected

23 Jan 2008

Number of

bidders

reduced to two

21 Jun 2007

Bidder

shortlist

selected


23/37

22 prt Tw Financing PFI projects in the credit crisis and the Treasurys response

The increased nancing costs since the credit crisis have come ater a period in2.4

which around 300 PFI contracts were let at relatively low nancing rates when compared

to other types o project nancing, as shown earlier (Figure 2 on page 6). The low rates

refected the successul establishment o the PFI market and availability o bank lendingwhich encouraged competition in the nancing terms.

Th mct hghr t fc csts c sctr

srvc mts

The increased cost o nance has generally been passed through by the private2.5

sector service provider to the public authority in the orm o an increased monthly

payment, known as the unitary charge. In Appendix Two, Figure 15 sets out the impact

in real terms, compared to projects that were nanced in 2007, and suggests that, on

an all-in basis, the extra cost increased by around 5.6 per cent to 7.4 per cent. The

nancing costs o schools projects, which are airly typical, moved up sharply at the starto 2009 (Fgr 10).

Figure 9

Increase in loan margins applied by the banks

2007 2009 j 2010

Borrowing rate (%) 5.1 4.46 4.18

Schools margin (%) 0.6 2.55 2.23

annual interest cost or a typical 20 million 1.1m 1.4m 1.3m

school project

Waste project margin (%) 1.2 Above 3

annual interest cost or a typical 190 million 10.8m 14m

waste project

noTe

1 Project values shown above relate to the amount o senior debt and the annual interest cost reduces as loan

repayments are made.

Source: National Audit Office analysis

Figure 8

PFI deals concluded April to December 2009

ds Ct V (m)

Greater Manchester Waste PFI 631

M25 project (whole lie present cost 3,360 million) 1,073

20 PFI school projects 1,396

12 other PFI/PPP deals 1,795

Total 4,895



24/37

Financing PFI projects in the credit crisis and the Treasurys response prt Tw 23

Figure 10

Typical changes, after December 2008, in loan margins and total interest

rates, exemplified by Building Schools for the Future (BSF) projects

Percentage

BSF PFI deals bank average margins

0.00

0.50

1.00

1.50

2.00

2.50

3.00

Percentage

14 Dec

2005

2 Jul

2006

18 Jan

2007

6 Aug

2007

22 Feb

2008

9 Sept

2008

28 Mar

2009

14 Oct

2009

2 May

2010

14 Dec

2005

2 Jul

2006

18 Jan

2007

6 Aug

2007

22 Feb

2008

9 Sept

2008

28 Mar

2009

14 Oct

2009

2 May

2010

NOTES

1 The first chart shows the effect on bank margins. The second chart shows the effect on total interest costs. The charts

show two main points:

a There was a dramatic increase in bank margins between July 2008 and June 2009. There has been a very slight

easing in the margins, moving into 2010.

b The total increase in interest costs (i.e. bank margins + swap rates) is not as great as the increase in bank margins.

This is due to the fall in swap rates, by about one per cent, over the same period.

Source: Partnerships for Schools

BSF PFI deals total interest rates

0.00

1.00

2.00

3.00

4.00

5.00

6.00

7.00

8.00

PFI school deal interest rates Bank base rate 25-year gilt rate


25/37

24 prt Tw Financing PFI projects in the credit crisis and the Treasurys response

The Treasurys approval o the nal nancing terms or contracts, such as the2.6Greater Manchester Waste project and the M25, demonstrates that it gave priority

to agreeing contracts, and that it believed that it aced a lenders market. In such a

lenders market, it was not possible to resist price increases, particularly ater the Future

Strategic Tanker Aircrat (FSTA) nancing in March 2008, as shown in Fgr 11.4

A similar trend was starting to be visible in other countries. The nearest comparator or

the M25, a toll road in Germany obtained project nancing in March 2009. That projects

total interest cost was about 6.5 per cent, including debt margins o over 2 per cent

during construction (M25 2.5 per cent) and early operating years (over 3 per cent

ater 10 years M25: 3.0-3.5 per cent).

On large deals it was dicult, costly and time consuming to arrange bank nance.2.7A very large deal, such as the M25 described in Appendix Three, also resulted in a club

o 16 banks eventually taking shares o around 25 million to 65 million each.

Margin increases have not been the sole impact o any reduced competition2.8

resulting rom club deals. Based on analysis o projects concluded in 2007 and 2009

(see Appendix Two), banks have also sought to reduce their project risk by lowering the

proportion o debt in projects and increasing cover ratios (see Glossary). This increases

the risk to investors, who have passed the corresponding cost to the public sector

by increasing the unitary charge. The M25 cover ratio originally required cash, at a

minimum, exceeding 1.23 times the amount needed in each period to service the debt.

The banks increased this coverage requirement to 1.4 times the amount needed tocover the debt. The nal M25 contract also resulted in some additional risks being borne

by the Highways Agency. The Agency negotiated concessions in return.

In all types o lending, banks are seeking shorter periods or the repayment o2.9

their loans. In the case o PFI, or example, at the time o selecting the Preerred Bidder

(July 2008), the planned nal repayment o the M25 loans was six months beore the end

o the concession and it was subsequently increased by three years.

In the Greater Manchester Waste project, there are progressive step-ups in loan2.10

margins ater the ninth year (see Appendix Three). The banks chose this structure to

increase the likelihood o the private borrower and/or the public authority seeking a

renancing at lower margins. This is preerable to imposing an obligation to renance the

loans at a specied uture date.

Ftr rfcg

Based on a survey we commissioned with market participants, the consensus view2.11

was that they expected margins in three to ve years time to be in the range o 1.25 per cent

to 1.75 per cent. As such, we have assumed the new debt margin on the renanced debt to

be 1.5 per cent. The potential eect on a typical project is set out in Fgr 12.

4 National Audit Ofce Delivering multi-role tanker aircraft capability, March 2010, reported in paragraph 18 that the

selection o a PFI solution was made without a sound evaluation o alternative procurement routes to justiy why

the PFI route oered the best value or money.


26/37

Financing PFI projects in the credit crisis and the Treasurys response prt Tw 25

Renancings will only occur i market conditions improve and i the private sector2.12can be motivated to renance the projects with revised arrangements that now give

most o the renancing benet (70 per cent o typical renancings) to the public sector.

Since October 2008, the public authority has a contract right to request a renancing,

which is exercisable once in any two year period.5 Until that time is judged to be right,

the Government is locked into substantially higher nancing costs that we estimate to be

between 500 million and around 1 billion.

Taking the illustrated level o renancing gain, at the our year stage, an aggregate2.13

recovery o 400 million might be obtained across the basket o deals concluded in 2009.

Although there are some technical actors that could increase the renancing gain, these

are likely to be oset by the private sectors share o the gain and by transaction costs.

5 Refnancing gains are shared on a sliding scale basis: Up to 1 million 50 per cent; between 1-3 million 60 per cent

and greater than 3 million 70 per cent. Both Greater Manchester Waste and the M25 achieved higher shares.

Figure 11

Change in notional unitary charge on large, complex projects

Trm FSTa

Mrch

2008

GMW

ar

2009

M25

M

2009

Level o project risk High/

medium

High Medium

Total interest cost (%) 5.9 - 6.1 7.7 - 8.9 6.9 - 7.9

Final repayment (months beore end o concession) 24 months 18 months 42 months

Debt inance proportion (%) 86.2 85.2 84.7

Unitary charge increase compared to FSTA (%) 12 6

noTe

1 Although the projects dier, and each has dierent proportions o operating costs, the unitary charge has been

re-scaled, or comparison with the typical 190 million base case in Appendix Two.

Source: KPMG and National Audit Office

Figure 12

Potential renancing gains on a project with 190 million senior debt andan estimated locked-in cost o 8.6 million

Rcg dt ptt G

(rs tr strt orts) (nt rst v m)

Three years 3.52

Four years 3.45

Five years 3.37

noTe

1 The gain is calculated gross (beore sharing) on an original capital investment o 170 million.



27/37

26 prt Thr Financing PFI projects in the credit crisis and the Treasurys response

Part Three

The inrastructure challenges in the currenteconomic environment

Th chgs t th Gvrmt

The Government aces challenges in planning inrastructure investment in3.1

the current economic environment. Inrastructure UK, the new coordinating body

established within the Treasury, estimates that the Government needs to continue

to encourage substantial investment in new inrastructure, possibly 40-50 billion

per annum until 2030.6 But government departments need to reduce annual spending

to assist the public nances; and the cost o using private nance has increased

signicantly compared with beore the credit crisis.

Th cst sg rvt fc

Our analysis in Part Two has shown the increase in the cost o using private nance3.2

compared with beore the credit crisis. This increased cost may not be a temporary

phenomenon, because one o the primary eects o the credit crisis may have been to

change the attitudes to corporate and project risk within banks. As a result, there may

have been a long-term increase in the cost o using private nance.

In addition, a signicant problem or banks at the peak o the credit crisis was the3.3

mismatch between long-term loans (their assets) unded by short-term borrowing (their

liabilities). So although PFI projects are underpinned by revenue rom public unds, the

combination o long-term loans and remaining risk transer may have permanently increasednance costs and reduced the number o participants willing to lend in this market.

Th stshmt irstrctr uK

Inrastructure UK was established ater the 2009 Pre-Budget Report to coordinate3.4

the long-term inrastructure needs o the UK. Inrastructure UK is a unit inside the Treasury

incorporating a number o policy, nancing, and delivery bodies to lead work within the

Treasury to enable greater private sector investment in inrastructure, and improve the

Governments long-term planning and delivery. In the autumn, the Government will publish

a national inrastructure plan that will set out priorities or UK inrastructure on a cross-

sector basis. Inrastructure UK will also carry out an investigation into how to reduce thecost o delivery o civil engineering works or major inrastructure projects.

6 HM Treasury Strategy or national inrastructure March 2010.


28/37

Financing PFI projects in the credit crisis and the Treasurys response prt Thr 27

By consulting stakeholders, Inrastructure UK has identied that there is a3.5signicant risk o a gap emerging in the provision o equity capital to large complex

inrastructure projects, particularly in the energy sector, within the next ew years.

This issue compounds the challenges posed by the reduction in availability and increase

in cost o debt nance highlighted in this report. Inrastructure UK has also set out to

identiy the critical interdependencies that impact on economic inrastructure investment

needs (Fgr 13) and will publish an action plan, setting out how the risks and

interdependencies will be managed, by spring 2011.

As a result o the interaction o these issues, there is a need to re-evaluate3.6

unding mechanisms across the whole range o public and private inrastructure

investment. Some unders may be repaid rom public sector payments or services,mostly originating in taxation, and others out o payments by users or consumers

(see Fgr 14 overlea).

Inrastructure UK recognises that it needs to nd ways to maximise unding sources,3.7

and in particular to nd new ways or inrastructure projects to obtain unding rom the

capital markets. The main obstacle is that institutions, such as pension unds, do not have

the internal credit approval processes and skills to assess the risk and return or investing

in project bonds, typically issued with a lower credit rating than BBB.7 Such investors

will only develop this new line o business i they believe that there is a substantial uture

pipeline o inrastructure projects that carry relatively low repayment risk.

7 Investments are graded according to methodologies produced by credit rating agencies such as Standard and

Poors (Range: AA A to D). Triple B (BBB) is the lowest investment grade rating and indicates a 0.32 per cent

probability o deault.

Figure 13

Economic inrastructure

Sctr Sgct ssts

Water Water resources (rivers, reservoirs and dams), drink ing water distr ibution (pipes

and pumping stations), waste water treatment, sewerage systems, lood and

coastal deences.

Waste Landill, recycling acilities, waste collection and processing, hazardous waste

treatment, energy recovery.

Transport Roads (strategic and local), heavy rai l, l ight rai l, a irports, ports, metro systems.

Energy Gas storage, transmission and distribution, electr icit y generation (renewable and

non-renewable), transmission and distribution.

Communications Fixed voice and data networks, mobile voice and data networks, satellite

networks, television and radio broadcast networks and radio spectrum.

Source: Strategy for National Infrastructure


29/37

28 prt Thr Financing PFI projects in the credit crisis and the Treasurys response

Renancing and secondary market equity sales

The risk proles o PFI projects vary considerably during the construction phase3.8

making it dicult to renance a number o projects on a pooled basis. Once in

operation, many dierences all away making possible an approach that coordinates

the right to renance by a number o public authorities. This aligns with the interest o

lenders in selling loans to ree up reserve capital and then support new projects.

In March 2010, the House o Lords Select Committee on Economic Aairs,3.9

in its report Private Finance Projects and off-balance sheet debt8 called or urther

investigation o any impact on service delivery that may result rom the sale o shares by

the original private sector investors, known as secondary market sales (See Glossary).

Treasury guidance currently permits such equity sales without the sharing o resulting

gains with the public sector. The Treasury has yet to publish research on the contribution

made by equity investment at various stages in the lie o a public private partnership.

8 Published 17 March 2010 (HL Paper 63-I and 63-II).

Figure 14

Methods o inrastructure unding by sector, with examples

WtrWstTrsrtTcmserg

Source: Strategy for National Infrastructure

pc ct

User

unding

Public

industry

commercial

waste

operations

by Local

Authorities

Scottish

water

Taxpayer

unding

Conventional

capital

procurement

most

roads

municipal

waste

acilities

lood and

coastal

deences

prvt c

Taxpayer

unding

PPP/PFI M25

widening

municipal

waste

treatment

Northern

Ireland

water PFIs

User

unding

Economically

regulated

private industry

National

Grid

BT

Openreach

some

airports

England and

Wales water

supply and

sewerage

Other private

industry

electricity

generation

cable

networks

ports commercial

waste

disposal


30/37

Financing PFI projects in the credit crisis and the Treasurys response ax o 29

Appendix One

Methodology

This report examined whether the Government has put in place an economic, ecient

and eective strategy or nancing public services projects ollowing the banking crisis.The main elements o our eldwork, which took place between November 2009 and

April 2010, were:

Mth prs

Banks survey

We commissioned KPMG to survey 40 banks and

inancial institutions, incorporating all the main PFI

lenders, on an anonymous basis.

To understand:

Views o market participants on current PFI

issues, in particular:

The appetite or PFI lending.

Credit terms and conditions.

Role o The Inrastructure Finance Unit.

Approaches and lessons learned on major

recent transactions.

Future expectations.

Interviews

We also held semi-structured interviews with

other key stakeholders, including HM Treasury,

Partnerships UK, Department or Environment,

Food and Rural Aairs (DEFRA), and Partnerships

or Schools (PFS), and inancial institutions including

the Bank o Ireland and the European InvestmentBank (EIB).

To identiy:

Views o stakeholders.

Benchmarking and modelling o results

Using market data provided by KPMG, DEFRA

and PFS, we analysed the changes in loan terms

between 2007 and 2009.

We also commissioned KPMG to analyse the

aordability impact o change in inancing terms.

Using a generic PFI inancial model, KPMGs

sensitivity analysis illustrates how the change in

each variable has led to changes in unitary charge

and returns to sponsors.

To identiy:

The trends in banks PFI margins and other

terms beore and during the banking crisis.

Using sensitivity analysis and the inancial

model, the relative weight o each driver and

the extent o any recoverable costs.


31/37

30ax o Financing PFI projects in the credit crisis and the Treasurys response

Mth prs

Case studies o changes in scope and bank

pricing and impact on VFM

We identiied our case studies which represent

signiicant developments in the PFI market during

the credit crisis:

Greater Manchester Waste the only project in

which the Treasury made a loan.

M25 Design Build Finance Operate project.

Newham School.

Barnsley School.

To identiy:

Comparison o terms at Outline Business Case

stage and Final Business Case.

Whether costs and beneits had been checked

or adjusted.

The involvement o The Inrastructure Finance

Unit as a lender.

The role o the European Investment Bank as

a lender.

Documents Review

We reviewed relevant documents including:

Documents, emails and minutes relating to

inancing inrastructure projects held by the

Treasury in the period leading up to setting up

The Inrastructure Finance Unit.

To understand:

The rationale or setting up The Inrastructure

Finance Unit.

Changes in guidance.

Overseas comparison

We also reviewed documents rom the

European PPP Expertise Centre (EPEC)

on how other countries are undinginrastructure projects.

EPEC/EIB documents.

To understand:

How other countries have responded to

the crisis.

Potential savings i the UK were to adopt the

French guarantee scheme.

Expert Panel

We established an expert panel who, together,

had expert knowledge o the banking and

inrastructure/project inance sector, to provide

challenge and assurance or the study.

The members o the panel were:

Dr Harry Bush, CB, Board Member and Group

Director, Civil Aviation Authority

Jeremy Barker, Director, KPMG

Corporate Finance

John Layton, CPA

Proessor Roger Strange, Proessor o

International Business at the University

o Sussex

To identiy:

Challenges to study indings.


32/37

Financing PFI projects in the credit crisis and the Treasurys response ax Tw 31

Appendix Two

PFI Benchmarking

As part o the eldwork, and under our direction, KPMG have benchmarked1

changes in the cost o PFI nance. The table at Fgr 15 below sets out the eects ona base case model o a variety o changes, drawing on data taken rom a broad sample

o actual projects.

Figure 15

Impact on aordability o changes in nancing terms rom 2007 to 2009

Ctgr assmt

2007

assmt

2009

a

utr

Chrg

()

Chg

2009

(%)

Base Case model (2007) 33,392

Debt amount as a percentage 89.7% 87.7% 33,790 1.19

Swap Rate (variable to ixed) 5.1% 4.3% 32,315 -3.23

Loan margin 0.79% 2.39%-2.59% 36,145 8.24

Arrangement Fee 1.1% 1.57% 33,530 0.41

Commitment Fee 0.38% 1% 33,575 0.55

Interval ater inal repayment 11 months 15 months 33,487 0.28

Minimum ADSCR/LLCR 1.17x/1.22x 1.19x/1.23x 33,500 0.32

Swap Credit Spread 0.11% 0.25% 33,662 0.81

2009 model (rom range o results) 25th Percentile 35,295 5.7

75th Percentile 35,870 7.4

noTeS

(see Glossary or ADSCR and LLCR under Cover ratios)

1 The unitary charge shown above is based on separately applying the terms & conditions to a typical size deal with

a capital cost o 170 million and debt o about 190 million and a rate o return to equity o 12.5 per cent.

2 The sum o the price impacts o each change individually, totalling 8.57 per cent, would be incorrect and greater

than the price impact rom the base case to the current climate. The reason or a lower result is that increasing the

unitary charge, to fx a par ticular variable, mitigates the impact o other changes.

3 I the unitary charge is held constant, the rate o return to equity alls to 6.55 per cent.

Source: KPMG


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32ax Thr Financing PFI projects in the credit crisis and the Treasurys response

Appendix Three

Case Studies

bchmrkg th M25 dsg b Fc ort prct

The single Design Build Finance Operate project or the M25 will widen1

two sections (38 miles). The 30-year cost includes maintaining the Dartord crossings

and operating 250 miles o existing motorway. This cost increased by 23 per cent rom a

net present value o 2,756 million beore the banking crisis, to 3,400 million by the time

the nancing was complete in May 2009.

We estimate that the largest component o the increase aced by the Highways2

Agency was an increase, arising rom debt nance costs, o around 15 per cent compared

to market terms available in 2007. This nding is extrapolated rom our benchmarking

model or typical cost changes on smaller transactions (see Appendix Two).

Larger and more complex projects were already acing higher bank costs in3

March 2008 when the Future Strategic Tanker Aircrat (FSTA) project closed early in

the credit crisis (see timeline in Figure 7). The M25 nancing terms, when applied to

the KPMG model, show a cost 6 per cent greater than that derived when applying the

FSTA nancing terms. This is similar to the lower end o increases experienced since

October 2008 on other PFI projects.

We will be reporting separately on the value or money o the M25 project.4

l mrgs r th Grtr Mchstr Wst rct

The Greater Manchester Waste Authority is the largest waste authority in England,5

covering 5 per cent o national waste. The 25 year recycling and waste management

project includes 36 recycling acilities, across 23 sites, and a waste-red thermal power

station. The project will reduce local waste diverted to landll by 75 per cent.

In addition to 184 million rom the European Investment Bank, the banks6

supporting the project set market pricing or 280 million o lending, leaving a gap o

120 million. The Inrastructure Finance Unit provided this balance on the same terms as

the banks.


34/37

Financing PFI projects in the credit crisis and the Treasurys response ax Thr 33

It is dicult to benchmark this pricing, in order to be satised that lenders did not7behave in an opportunistic manner. Unlike a schools project, primarily providing lower

risk accommodation, waste projects involve complex industrial processes which rely

on the nancial and technical ability o companies to perorm inter-related contracts.

These higher risks result in higher margins and the most similar deal, which had closed

in 2008, had a provisional margin o 2 per cent that was increased to 2.75 per cent in

January 2009 at the launch o syndication. Subsequently, at least one bank told Bank o

Ireland that it could not expect an approval rom its credit committee unless the margin

was set at more than 3 per cent.

Greater Manchester Waste closed with margins on the ollowing sliding scale:8

Construction 3.25%

Completion to Year 9 3.35%

Years 9 to 15 3.70%

Years 15 to 21 3.95%

Years 21+ 4.50%

The amount o department credit support accorded to this project, as a result o9

the banking crisis, was increased rom 109.5 million to 124.5 million. In January 2007,

the second stage review by Partnerships UK commented It is also apparent romthe bids received, that the Authoritys original cost assumptions were excessively

conservative, hence the considerable aordability headroom.

Additional Appendices Four and Five are at www.nao.org.uk/inrastructure-

nancing-2010.


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34 Gssr Financing PFI projects in the credit crisis and the Treasurys response

Glossary

Trm dft

Cover Ratios Ratios that measure the extent to which current and uture

liabilities to lenders are covered by available cash fows.

There is a minimum Annual Debt Service Cover Ratio

(ADSCR) and a Loan Lie Cover Ratio (LLCR).

Debt service costs The periodic instalments o loan principal and interest, and

associated ees, due rom a consortium to its lending banks.

Floating/variable

interest rate

A rate o interest which varies periodically, in accordance

with a stated market reerence, usually the London

Interbank Oered Rate (LIBOR).

Interest/lending margin An additional amount that a bank charges on a commercial

loan over and above its own cost o providing the loan. The

margin compensates the risk o not having the loan repaid,

potentially providing a prot.

LIBOR London Interbank Oered Rate. The interest rate at which

banks will lend to each other, which became dicult to

determine at times during the banking crisis.

Renancing The process by which the unding terms, put in place at

the outset o a PFI contract, are later changed, usually

with the aim o creating benets or renancing gains.

Renancing may be benecial where project risk has

reduced, or example, ater the completion o construction.

Reserve Capital The amount o capital regulators require a bank to hold

in relation to its lending based on international guidance

produced by the Basel Committee on Banking Supervision.

Secondary market The market or buying and selling shares in project

companies that, usually, have commenced trading.

Swap An arrangement whereby a loan which has a variable rate

o interest (which continually changes in relation to market

rates o interest) is exchanged or a loan which has a xed

rate o interest.

Unitary Charge The amount that the public body contracts to pay

each month or the service being delivered. It will cover

operations and maintenance, on a whole-lie basis as well

as the ully nanced construction cost.


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