New guidance on making savings on operational PFI contracts

In the last month HM Treasury has issued guidance on making savings in operational PFI contracts.  The guidance follows the draft guidance issued in January this year and is intended to assist public sector PFI Contract Managers to identify and implement savings measures that would reduce costs whilst maintaining frontline services.

The guidance focuses upon four pilot cost saving reviews of operational PFI projects, one by HM Treasury with the Cabinet Office and three by the MoD.  The pilot reviews have confirmed the draft guidance recommendations for achieving operational savings identifying three main categories as follows: 

1. The effective application of existing contract provisions.

2. Optimising the use of asset capacity.

3. Reviewing the specification of soft services.

The guidance recommends that all authorities with operational PFI contracts instigate a contract savings review if a comprehensive review has not already been undertaken.  Whilst recognising that each PFI is individual, the pilots have confirmed annual savings of around 5% of the annual unitary charges are achievable.

The effective application of existing contract provisions

The guidance highlights the following issues that may generate savings via the effective application of existing contract provisions:

• Proactive application of contract provisions - reference is made in the guidance to research carried out by Ipsos-MORI and the NAO which has highlighted the importance of contract management in the operations phase of contracts.  There are concerns that contract managers do not fully utilise the provisions of their contracts including the use of the payment mechanism, benchmarking/market testing processes and service level standards.  The guidance recognises that there may not be sufficient resources committed to this essential aspect of contract management.
• Insurance provisions – contracts entered into after 2006 include insurance risk sharing provisions.  Where those provisions have been implemented, these have often yielded rebates in insurance costs for the public sector.
• Managing contract variations – variations are common and indeed essential in a long term contractual relationship such as PFI.  Negotiated variations may be required for both construction (e.g. to extend asset capacity) and to modify services.  The guidance emphasises that Authorities should have very clear objectives before going into negotiation for contract variations.
• Encouraging users to reduce energy consumption -  the guidance recognises that successful energy management is dependent on a good level of energy awareness throughout the organisation, and this is one of the first key actions which authorities should pursue.

Optimising the use of PFI assets 

The guidance recognises that PFI projects must be considered in the context of the public sector’s total asset base and recommends the increase in throughput or operational density as the most straightforward route to savings on a per unit basis, such as a “Total Place” approach to public services within a particular location.  Such an approach should lead to:

• Subletting – authorities should consider the income generation possibilities from assets such as function spaces and swimming pools and understand how any additional income would be treated under the contract.
• Increase occupational density – the guidance recognises that opportunities to increase occupational density of specialist assets (such as schools and hospitals) are likely to be more limited than for office accommodation, but that there may be opportunities to change the use of relatively generic space.
• Mothballing – if there are areas of accommodation that are not required and cannot be efficiently sublet, then it might be possible to mothball them so that full day to day service under the contract is not necessary and variable service costs can be avoided.  Authorities will need to consider the cost benefits of mothballing, and in particular the potential negative impact on the concentration of deduction risk into more operationally critical areas leading to a recalibration of the payment mechanism and associated costs.

Review service specification

Whilst the guidance recognises that PFI does not necessarily contract for the provision of “gold plated” services, it does recognise that if authorities believe that they are buying more than is required to deliver the service or are incurring additional cost as a result of inconsistent application of services standards across PFI and non PFI facilities, then a more appropriate services specification could be introduced as a variation.  Such measures are clearly project specific but could potentially include:

• Less frequent decorating.
• Changing to daytime cleaning to reduce lighting costs overnight.
• Improving energy efficiency by optimising minimum and maximum temperatures.
• Changing the frequency of fault inspections to reflect the history of occurrence and impact.
• Longer response times for helpdesk call resolution (appropriate to need and cost).
• More appropriate comparators or standards for services or replacement equipment (for example where standards are higher than other non PFI assets and higher than needed for the required service).

Notably any changes to the services specification should not harm the core function of the project or contravene safety standards, and any reduction in specification should not lead to PFI provider risks being passed back to the Authority without a careful vfm analysis.  The guidance recognises that, as a general rule, changes to the contracted lifecycle obligations can risk undermining the long term asset risk transferred to the Project Co and as such it is unlikely to represent vfm to remove hard facilities management services and lifecycle/major maintenance from the contract or introduce value testing of such services.

The guidance is careful to note that standards should not be relaxed if there is a concern that the PFI provider is not performing well against the existing requirements of the contract.  In this case, the payment mechanism should be used appropriately to ensure that the expected service level is being achieved and deductions made (or performance penalties awarded) if not.

In terms of timing, the guidance recommends timing any changes to the service specification to the soft services market testing/benchmarking date (typically every 5 years), so that changes can be re-priced under competitive conditions.  Market testing and benchmarking can be time consuming and expensive for an authority and therefore is may benefit an authority to “bundle” their PFIs, or for two Authorities to carry out the exercise together (particularly for projects that have common equity owners).  This may require the exercises to be brought forward or deferred to align their timetables, although this may require lender consent if lenders deem this to impact their risk profile.

In addition to changes to the services specification authorities may also wish to consider changes to the terms of the contractual arrangement itself.  The guidance suggests two possibilities:

• Taking back the providers' share of “change in law” risk – the benefits of this possibility will vary depending on the funding structure of the PFI but could result in a lower unitary charge or a capital payment to the authority.
• Energy purchasing – the guidance suggests that authorities should always consider the use of public sector buying organisations (such as Buying Solutions) for the purchase of their energy requirements.  According to the Cabinet Office, Buying Solutions is the single biggest buyer of energy in the UK.  One of the pilot schemes saw savings of between 11% and 27% by using Buying Solutions when compared to the benchmark price.

Approach to contract savings review

The guidance recognises that PFI projects are complex, long term arrangements with whole life costing, detailed risk allocation and clearly defined termination provisions.  As such, strategies applicable for saving costs in PFI contracts need careful consideration.

Department PFUs can provide invaluable advice and guidance for Authorities in achieving savings in operational PFIs.  Given the risk of undermining risk transfer within a PFI contract, the guidance also recommends that specialist support is sought before implementing any cost saving measures, unless the Authority is experienced in that area.  Failure to do so could potentially result in short term savings at the expense of long term vfm.  Bevan Brittan has advised on over 150 PFI projects and over 600 complex procurements including PPP schemes, giving us a wealth of experience on which to draw to assist authorities in implementing HM Treasury’s guidance and to realise savings on their long terms contracts.

If you want to discuss the more detailed recommendations from HM Treasury's guidance, or to discuss your specific PFI/PPP contracts, please contact Sharon Renouf, Duncan Weir or Louise Robling.