Infrastructure Projects Financing

8/9/2019 Infrastructure Projects Financing.

1/11

HM Trsr

Financing PFI projects in the creditcrisis and the Treasurys response

RepoRT by THeCoMpTRolleR andaudiToR GeneRal

HC 287

SeSSion 20102011

27 july 2010


2/11

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.


3/11

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


4/11


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


5/11


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


6/11


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.


7/11


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


8/11


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.


9/11


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.


10/11


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.


11/11


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.

Documents

Infrastructure Projects Financing