Abuse of private financing

15 May 2018

Martin Locke

Does the demise of the UK Private Finance Initiative (PFI) suggest where the Australian PPP market is headed? How applicable are the findings of the recently published UK National Audit Office report on PFI for Australian PPPs?

Not too long ago the UK was seen as the godfather of privately-financed infrastructure with some 55 PFI deals signed annually and over 700 operational deals with a capital value of around £60bn. But only one PFI transaction was executed in 2016-17 and the pipeline is non-existent. The UK National Audit Office (“NAO”) published a highly critical report on PFI in January 2018. Could Australia experience a similar decline?

The most startling revelation in the NAO report concerns the accounting treatment of UK PFI, indicating that the transactions are still categorized as off-balance sheet. Despite the tightening of financial reporting obligations with the latest accounting standards, specific tweaks to the PFI model were made to ensure off-balance sheet treatment persisted, in order to avoid a downgrading of the UK credit rating. Moreover, the future liability to pay availability payments under PFI is unfunded by central treasury, leaving departments to find the cash to repay the capital component in addition to the operating costs and stay within budget.

In Australia, PPPs have always been considered to be on-balance sheet, with State treasuries allocating capital to fund the capital recovery element of future availability payments. So in the absence of superficial accounting benefit labelled “fiscal illusion” in the UK NAO report, the prime motivator of Australian PPPs has been the pursuit of value for money as driven by optimising competitive tension between bidders and ultimately tested against the Public Sector Comparator. The UK approach highlights the asset-based emphasis of PFI with the use of an off-balance sheet financing tool. By contrast, recent published project summaries in Australia, for example, Melbourne Metro PPP, indeed quantify the future financial obligations.

The NAO notes that, in the face of affordability pressures, departments sought to squeeze PFI contracts by cutting back on maintenance and removing soft services from the scope of the outsourced PFI provider. This logic does not apply to Australia, where State treasuries have increasingly stressed that PPPs should be used as a deliverer of infrastructure services with the benefits of fully funded whole-of-life maintenance, innovative solutions, improved risk transfer and introduction of financial discipline from private financiers.

The NAO also highlights the cash impact of the need to pay future availability payments on PFI deals amounting to some £199bn until the 2040s, and comments upon the use of a high discount rate based on social time preference (6.09%) to assess the future cost rather than actual government borrowing costs (2-2.5%). It can be argued that the use of differential discount rates masks the higher private financing costs at the expense of cheaper government finance in projecting the narrow financial impact. So how do we treat this in Australia? Methodology prescribed by Infrastructure Australia requires discount rates to be based reflecting risk. An underlying risk-free interest rate (reflecting government bond rates) is the benchmark to which is added a margin for risk. So in the case of the recent Melbourne Metro PPP, the discount rate to determine the public sector comparator benchmark was 3.09%, whilst the discount rate for the private sector was 5.7%. This means that effectively the increased cost of private financing will result in higher nominal payments being paid over the duration of the contract, but that this increased cost reflects adjustment for pricing risk in financial markets.

HM Treasury responded to the failings of PFI to deliver value for money by introducing PF2 in December 2012. Only six deals have been completed under PF2 as at September 2017 indicating limited acceptance of the revised model. Some of the key changes were a requirement for public sector equity in PPP SPVs and changes in risk allocation including retention by government of risk around change-in-law, site contamination, utilities costs; but the lack of deal flow suggests that these structural reforms have failed to restore faith in the model.

The government equity stake, typically 10%, was intended to improve transparency but the NAO rightly questions why the public sector would be willing to take on equity risk rather than become a debt provider. The contrast with Australia is dramatic with States not favouring co-investment by way of government equity in preference for public sector capital to be contributed as a non-repayable funding source designed to reduce the availability payments by paying down expensive private sector capital. For example, under the $6bn Melbourne Metro PPP, the Victorian Government is set to make a $2.5bn construction contribution, followed by a $1.5bn payment upon provisional acceptance, reducing the private financing to be repaid through the availability payments to $2bn. The use of the capital contribution has clearly helped to deliver value for money by mitigating the higher cost of private finance, whilst still ensuring the risk allocation and payment mechanism retains strong financial incentives to perform.

Interestingly, in the UK some thinking was given to the introduction of an equity gain share provision (or cap on returns) to mitigate the risk of windfall capital gains being made by investors. Such profits could be realised upon the sale of equity at lower yields, reflecting projects progressing beyond high-risk construction phases and becoming operational; movements in financial markets and the shift to a lower interest rate environment were also factors. (The NAO refers to investors in the M25 PFI contract realizing equity returns of 31% a year and the risk of inefficiencies in the initial pricing of contracts.) The UK rejected the introduction of an equity gain share on the basis that this might result in reduced investor demand and potential on-balance sheet treatment of PFI investments. Equity gain share has not been included as a standard provision of Australian PPP contracts. Initial equity investors in recent Australian PPPs, who have opted to sell down post-construction, have been able to realize substantial capital gains as a reward to overcoming greenfield project risks. Sharing of gains in standard Australian PPP contracts relate to debt refinancing on more favourable terms and upside revenue sharing on user-pays infrastructure such as toll roads.

In conclusion, obsession with off-balance sheet financing has not been a prime motivator of PPPs, so a similar decline in the use of private finance as seen in the UK is unlikely. There remains a healthy pipeline of PPPs with major transactions in procurement such as $5.4bn Cross River Rail, with the primary justification for the PPP model being based on whole-of-life efficiencies, potential for improved risk transfer/cost outcomes and scope for innovation.


HM Treasury, National Audit Office, PFI and PF2, January 2018

Melbourne Metro Rail Authority/Victoria State Government, Metro Tunnel Project Summary, February 2018

Queensland Government, Building Queensland, Cross River Rail Business Case, August 2017