Waste: Better off without PFI?

The deadline to fulfil landfill diversion targets draws nearer. In response, the favoured technique in the past has been to use PFI to develop new waste projects, but better alternatives are increasingly available writes Didar Dhillon.

Whilst Defra has concluded that there is sufficient treatment capacity available to satisfy the 2020 landfill diversion targets, many local authorities have been left facing the potentially crippling effect of spiralling landfill tax and disposal costs. The unprecedented strain on the public purse, the repercussions of the Comprehensive Spending Review and the lingering liquidity issues in the financial market have rightly drawn into question the viability of PFI.

Indeed, the recent withdrawal of PFI credits for 7 waste projects was widely seen as the final nail in its coffin. Looking back 18 months, many commentators were asking whether PFI was capable of delivering value for money when private sector borrowing terms were bordering on unaffordable and lenders (rather than procuring authorities) were dictating the terms of the project.

Today, the financial market has softened and we have seen some new entrants – but the fact remains, PFI subsidy (or revenue support in Wales) does not stretch far enough to compensate the escalating costs of PFI projects and the too easily tolerated delays that typify bank financed deals. Here we consider the benefits of prudential borrowing as a "banked" alternative that has the potential to provide much needed support for struggling local authorities.

Who needs PFI?

Lincolnshire County Council (LCC) withdrew from the WIDP programme and concluded that it could procure better value for money without PFI subsidy. A bold statement, but the proof is certainly in the pudding. Two years on, LCC reached contract close on its 150,000 tonne residual waste project, which is the first project to be funded 100% through public funds (reserves generated through savings and prudential borrowing from the Public Works Loans Board).

Having secured detailed planning permission, the new facility should be operational in late 2013. By way of comparison, Gloucestershire County Council (which was in the same bidding round as LCC and is broadly the same size) secured WIDP approval in October 2008 and only very recently announced their CFT shortlist – arguably, some 8 to 12 months away from contract award without planning permission.

Tangible Benefits?

In summary:-

· Accelerated procurement timetable: LCC achieved contract award 24 months after issuing the OJEU notice. An impressive feat when you factor in the resource hungry competitive dialogue procedure and the untested nature of this procurement strategy. As we all know, time is money!

· Cheaper cost of borrowing: Notwithstanding the recent Public Works Loan Board rate rise, a large gap remains between the cost of private sector borrowing and the cost of public sector borrowing. In addition, prudential borrowing does not attract the arrangement fees, agency fees, commitment fees and due diligence costs that significantly inflate the cost of private sector borrowing. In short, prudential borrowing maximises the benefits of corporate finance without having to deliver double digit project returns.

· Alternative risk allocation model: Wherever possible, LCC sought to eliminate PFI type risk pricing by adopting an open-book pass through model. For example, by removing the sharing concept for Qualifying Change in Law, the contractor provided the pricing benefits of not having to assume a cash reserve and a change in law facility. LCC recognised that once the exposure had crystallised (subject to mitigation and the like), they could fund the increased cost more economically than the private sector. Operating outside of the WIDP programme enabled LCC to drive out savings through an alternative risk profile.

· Robust security package: In its role as funder, LCC was able to secure an enhanced security package (well beyond market precedent) to underwrite the increased risk to the public purse. Significantly, such security was backed by entities of substance and was not tempered by the recovery risk issues associated with limited recourse project finance vehicles.

A new form of contract...

The prudential borrowing model necessitates a new form of contract. For LCC, we developed a bespoke form of contract that effectively weaved together an EPC type construction contract with a familiar WIDP long term service contract. This was not straightforward and the key challenges were:

· reconciling the very different payment profiles during the works period and the
services period;

· securing extensive yet practicable monitoring and testing regimes for both pre
and post acceptance of the new facility;

· harmonising the works and the services compensation on termination provisions;

· recognising the relatively "thin" nature of the service charge and rethinking the
sole remedy and associated provisions; and

· achieving long term incentivisation.

Now road tested and "banked", we are confident that this new form of contract not only provides a credible alternative to PFI – it delivers better value for money.

Not right for all?

Let's be clear – prudential borrowing may not be appropriate for all types of waste procurement. The "no service, no fee" protection under the project finance model should not be underestimated, particularly where relatively new or untested technology is to be procured. By prescribing EfW moving crate technology, LCC considered itself to be on relatively safe ground.

There is no reason why this approach cannot be applied to the procurement of MRF, AD or MBT facilities. Where concerns do exist (for example, autoclave technology), the risks may be mitigated by requiring contractors to corporately finance the construction and then refinancing the debt via prudential borrowing following issuance of the acceptance certificate.

We recognise that some local authorities may simply not have the borrowing headroom to access the advantages outlined here given the need to balance all the competing service delivery requirements that may call on a self-financing approach. However, the benefits of prudential borrowing can equally be applied to alternative funding models such as local authority bond financing or other long term institutional funding models.

LCC has clearly demonstrated that procuring authorities no longer need to accommodate overly cautious funder requirements, or concern themselves with WIDP's deliverability agenda - the focus now is simple, value for money.

Didar Dhillon is a senior Associate at Pinsent Masons LLP

T: +44 (0) 121 335 2932

E:This email address is being protected from spambots. You need JavaScript enabled to view it.

This article first appeared in 'A Passion for Leadership & Going Beyond Austerity, published in November 2011 by the Association of Council Secretaries and Solicitors (ACSeS).

To order or download a copy from the ACSeS website, please click here.