Soft costs benchmarking for UK PFI projects

Market Testing and Benchmarking in UK PFI
06 June 2007

(IJ Online) The construction phase of UK PFIs have been shown to outperform coventional procurement in being delivered on-time and on-budget - but questions still remain concerning the performance of PFI over the contract life cycle.

As the UK National Audit Office releases its maiden report on Benchmarking and Market Testing in the services component of PFI projects, Lovells project finance partner Mike Matheou assesses the performance of deals to date.

Introduction
The National Audit Office issued its report on benchmarking and market testing (which they refer to together as 'value testing') the on-going services components of PFI projects on 6 June 2007. Working on very little data, the NAO are able only to draw limited conclusions about value for money where value testing processes have already been operated, but make a number of clear recommendations for the future, including in relation to:

The continued need to follow the Treasury's 'Operational Taskforce Note 1' of October 2006 ('the 2006 Guidance); and
Steps to be taken centrally to facilitate value testing, such as maintenance of databases for benchmarking, and enhancing competition, for example, by publicising market testing opportunities for bidders on the Partnerships UK website.

Background
Contractual provisions which separately identify elements of the 'unitary charge' attributable to components of the overall service under a PFI contract, and then provide for that component of the price to be varied separately appear to fly in the face some fundamental PFI concepts. However, this is an area where concepts and dogma give way to pragmatism and a need to manage risks on both sides.
It is now recognised that 'bundling' of soft services (such as cleaning, catering and message delivery within a building provided and maintained under PFI) is not automatically the correct approach to take (and this is reinforced by one of the NAO's recommendations).

However, once it is decided that including soft services represents value for money, then the value of these services should be periodically tested. The 2006 Guidance states that '…Value testing is designed to ensure that prices paid for soft services reflect a competitive market rate … It also provides an opportunity … to re-scope services to meet changing need [and] … to offer new approaches and technologies …'.


In fact, these provisions manage risks for both sides:
The public sector can ensure that prices paid reflect a competitive market rate and effectively keeps the private sector 'on its toes'
The private sector knows that it is only taking a 5 - 7 year risk that underlying costs may rise in excess of the RPI-linked indexation provisions governing the unitary charge, as opposed accepting that risk for the whole PFI contract period.

Two sorts of value testing provisions are in common use:
Benchmarking, whereby the private sector (at contractor or sub-contractor level) compares costs for providing the relevant services against corresponding market prices, which may lead to a price adjustment, but not to a change of the sub-contractor providing the services; and

Market testing, which is the re-tendering of the relevant service to ascertain the market price of that service, which may lead to the replacement of the sub-contractor operating that service by the winning bidder, along with an adjustment to the unitary charge.

PFI standard forms commonly provide for benchmarking as a first stage, and only if there is no agreed result from benchmarking do the parties move to market testing. SOPC4 now reflects the Treasury view that Market testing is preferred (reversing the previous view that benchmarking was to be preferred) but, the NAO concludes that there are advantages in having both benchmarking and market testing options since an authority can then choose the best process for its particular circumstances.

The evidence reviewed by the NAO
The NAO relates first consider the proportion of PFI contracts which include value testing. The Research on 102 projects identified that just over half the sample had some value testing machinery. Of the remainder the NAO agreed that no value testing was appropriate in many cases (for example, DBFO road projects where there are no soft services as such), but it also found some examples where the contract would have been suitable for these arrangements but they were not present.

Where the value testing arrangements were included there was a distinctly mixed view of the expected effectiveness. Lawyers appointed by NAO reviewed 34 contracts and concluded that the majority of the benchmarking provisions could be expected not to be effective, and there was an unqualified expectation of effectiveness in only half of the market testing provisions. Having said this, the sample is probably unrepresentative of the population of PFI deals as a whole as more than one third of the sample comprised early contracts, let before July 1999.

It is unsurprising that the NAO was only able to review a small sample of cases where value testing processes had been operated. Whilst there are now a large number of PFI projects, the period of rapid growth in the number of PFI deals signed was the beginning of this decade (and perhaps 6-12 months before that), so allowing 1 - 3 years for typical building periods, and then 5 - 7 years of operation before the value testing provisions are triggered, means that many deals are only just getting to their first value testing. Consequently, the NAO only considered nine projects, of which two were non-standard telecoms projects, and seven were more typical building projects. Of the building projects the NAO concluded that value for money had been achieved in three out of the seven cases, but that it was 'uncertain' in relation to the remaining four.

Recommendations for the future
The report includes eight recommendations. Of these, perhaps the most interesting in addition to those already mentioned above are that:

There need to be steps to ensure strong competition to reap the benefits of market testing: of the three exercises examined by the NAO two were won by incumbents, and one by an in-house team, and the NAO recognised that this could dissuade potential bidders from competing; and

In benchmarking costs authorities should be aware of potential savings of private sector participants who may derive economies of scale from involvement in a number of PFI projects (although this seems to distort the picture by changing the emphasis from the market price for the service to looking at a particular entity's underlying costs).