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Energy Law Exchange

September 1, 2013

PF2 and its relevance to PPPs in the GCC


The Private Finance Initiative (PFI) was a public-private partnership (PPP) model introduced by the United Kingdom government back in 1992 as a tool to engage the private sector to design, construct, finance and operate public infrastructure, whilst at the same time promoting the delivery of a superior quality of service and value for money for the government. Under the PFI model, the private sector finances each project and starts receiving payments only once services are commenced. If costs overrun, or if the service is not provided, the private sector bears the financial consequences. Compared with more conventional forms of asset procurement, PFI is structured to provide an incentive for the private sector to deliver the services and the underlying assets on time and to budget.

PFI brings with it a considerable number of advantages, including an ability to benefit from the private sector's project management skills, risk management expertise and innovation. Since its inception, the model has been used in various fashions by governments around the world. The UK alone has seen the delivery of more than 700 projects involving private sector investment with a combined value in the vicinity of GBP 55 billion.

Notwithstanding this, PFI has not been without its share of critics who have claimed that past projects have demonstrated significant aspects that are less than satisfactory, including:[1]*there being a lack of financial transparency, particularly in respect to the returns made by investors and perceived 'windfall gains';

*the PFI procurement process being slow and expensive for both the public and private sector, leading to cost over-runs and reduced value for money for economic stakeholders;

*PFI contracts lacking flexibility during the operating period making it difficult to adapt to the concession grantor's changing service requirements; and

*risks having been inappropriately transferred to the private sector leading to a higher risk premium being charged by the private sector.

A new approach

In an attempt to address some of these criticisms and to enhance efficiency of projects, the UK Treasury has recently released a policy document entitled " A new approach to public private partnerships", or Private Finance 2 (PF2). The key changes that have been introduced under PF2 are to:

*provide the concession grantors with a minority equity share in the project;

*accelerate delivery of projects;

*apportion greater levels of public risk-taking in order to improve value for money ( i.e., in respect to changes in law, utilities cost, the site, contamination, ground condition, and insurance);

*provide greater project transparency; and

*ensure the future of affordable debt finance. This article explores some of the challenges for PF2 as applicable to PPPs in the Gulf Cooperation Council (GCC) and draws parallels with what is already being seen in the GCC's PPP market.

Concession grantor to take a minority share

The most significant change under PF2 is that the concession grantor will have the right to contribute equity as a minority shareholder in the special purpose vehicle that delivers the project. This is seen to strengthen partnerships and synergies between the parties, provide greater transparency in relation to the project, improve value for money (by enabling the concession grantor to share in perceived 'windfall gains'), whilst at the same time serving to reduce the high gearing on such projects (thereby reducing the risk of the project). Reducing the risk of the project serves to decrease the cost of capital, thereby increasing both the net present value and risk adjusted return of the project.

Interestingly, independent infrastructure projects (IIPs) and PPPs have for some time allowed the concession grantor in the GCC to take a minor equity stake in the project, either directly or via a fund established with a mandate to invest in infrastructure. An example of this is in independent power projects and independent water and power projects. A company is established by the successful bidder and a local holding company (established by the local electricity and water authority) with a minority share of the project owned by the successful bidder and the majority share owned by the local holding company. This model allows for many of the advantages that the Private Finance Initiative is seeking to deliver.

Faster and more efficient delivery

Competitive tendering of PF2 projects will now have to be completed within 18 months ( i.e., from issuance of the project tender through to appointment of the preferred bidder). Under the previous policy there was no set timeframe for completing the procurement process. Failure to meet the deadline will, in the absence of an exemption from the Chief Secretary, result in withdrawal of funding for the project. To further streamline the procurement process and assist in achieving the designated 18-month procurement cycle, a suite of new draft standardised contracts, "Standardisation of PF2 Contracts Draft" were launched in parallel with PF2.

There is no mandatory timeframe for infrastructure projects in the GCC. Competitively tendered projects can take up to 18 months, indeed longer given the scale and financing requirements. However, smaller IIPs ( i.e., water, district cooling, social infrastructure) have been closed within 12 18 months.

Reallocating risk sharing

Whilst effective risk management is essential for all forms of procurement, it is a significant change for PF2, since in the past the risk allocation under PFI has been perceived as failing to offer value for money. It is seen that by allocating more risk to the concession grantor, it will reduce costs by reducing the PF2 contractor's requirement to accumulate reserves against risk, thereby enhancing value for money.

Under PF2, there is greater retention and management of certain risks by the concession grantor. For example:

*the risk of additional capital outlay arising from an unforeseeable change in law will be taken by the concession grantor;

*utilities consumption risk will be taken by the concession grantor subject to a two-year 'handover test';

*the risk of off-site contamination will be taken by the concession grantor where it has provided the site;

*the onus will be on the concession grantor's to carry out adequate due diligence into legal title for sites made available to bidding contractors and provide a warranty to the contractor ( i.e., assume site risk); and

*where the concession grantor provides the site for the project, they will also be required to procure ground condition surveys and make them available to all bidders with a warranty in favour of the contractor ( i.e., assume ground condition risk). Many of these changes are already applicable to various infrastructure projects in the GCC. For example, it is already market practice to share change in law risks through either splitting the categories of change in law (specific versus general) and/or through monetary thresholds. In utilities IPPs, the risk of increased consumption input costs is passed through to the concession grantor (under single off-take concessions) and end-users (under end user off-take concessions). It is also common in the GCC for the risk associated with compensation events (or increased cost events) to be apportioned or have a monetary threshold under which the parties share costs.

Conclusion

The IIP/PPP model has become fashionable as a method for successfully delivering infrastructure projects for government and semi-government entities across the GCC. Interestingly, in some respects the IIP model in the GCC, particularly for utilities IPPs, already adopts many of the changes suggested under PF2. There is still scope, however, for the UK and the GCC markets to continue to learn from each other in streamlining their models successfully to deliver projects.

[1] HM Treasury, A new approach to public private partnerships (December 2012) at p.6.