HM Treasury’s 2013 Code of Conduct for PFI contracts placed commitments on the signatories that are pertinent to the ability of the public sector to make meaningful savings on their existing contracts. These include:
“Making savings in operational PFI contracts” included a number of recommendations that would necessitate the amendment of the original scope of the project through the variation mechanism contained within the PFI Project Agreement. These include for example, removal of Hard FM and lifecycle risk (para 3.48), removal of Soft FM Services from the scope (para 3.49) and removal of change in law risk (para 3.68).
Every signatory to the Code of Conduct, therefore, must accept that the public sector should be entitled to vary or omit work from a PFI/ PPP contract in order to make savings.
However, even since the introduction of the Code of Conduct, we are seeing a tendency on the part of the private sector (including signatories to the Code of Conduct) to defend the original scope of the Project Agreement in contradiction to this principle.
Variations are an important facet of PFI contracts. The terms of these agreements are typically from 25 to 50 years in length and, given the rate of change in how public services are delivered, flexibility in respect of how and what services are required has always been a key component. To that end, PFI Agreements have detailed drafting contained within them to allow variations to occur.
The first defence that we see the private sector deploying is the principle that variation clauses do not cover a situation where the employer wishes to omit work and give it to others. Put another way, absent clear words in a contract, the right to omit works from the contract does not include the ability to omit work and have it done by someone else. This is not a contract provision of PFI Agreements but a principle of law.
This is the swings-and-roundabouts principle. The legal premise is that a contractor, when pricing the contract, has struck an overall bargain and in doing so recognises that it will gain on some elements and lose on others. Allowing an employer to cherry-pick individual elements to vary and in particular omit from the contract would therefore, in the absence of clear agreement, be unjust as it would deprive the contractor of his bargain.
Where the courts have previously adjudged work to be wrongfully omitted, most often in relation to construction contracts, then they have had to assess the contractor’s loss. Generally, this is the loss of profit on the omitted work.
However, unlike traditional construction contracts in which this principle has been applied, PFI variation provisions keep the contracting counterparty to the public sector, the Special Purpose Company (SPC), whole, i.e. in a no better / no worse position. In such a case there will be no loss on the part of the SPC as a result of the variation.
The contract terms in a PFI arrangement look back to the position that the parties agreed on at the point the contract was signed. Within the Financial Model, there is expressed an Internal Rate of Return (IRR) for the SPC, on which the private sector will bid, and which is measured against the funds they invested. It is this that is protected by the ‘no better/no worse’ provision.
This is fair and reasonable for two reasons. Firstly, all bidding parties were required to openly declare the IRR they expected to receive on the project. Secondly, there was never an expectation, by the public or private sector, that SPCs would make a profit on the underlying provision of services. The profit element on service provision was contained either within the Construction Agreement or the Facilities Management Agreement. This position was also driven by project lenders who did not want SPCs (which, by their very nature, are thinly capitalised companies) taking risk on PFI projects, given that this could lead to loan default.
- Engage responsively when considering the type and price of variations, waivers, changes or approvals. Not unreasonably refuse to consent to these or make unreasonable charges for such consents.
- Engage constructively and in a timely manner when approached by public sector bodies to make savings on a specific PFI/PPP contract or across their portfolio of PFI/PPP contracts, including but not limited to exploring the potential cost savings measures set out in the July 2011 guidance entitled “Making savings in operational PFI contracts”. This approach should be flowed down from senior management to contract managers to support effective engagement.
“Making savings in operational PFI contracts” included a number of recommendations that would necessitate the amendment of the original scope of the project through the variation mechanism contained within the PFI Project Agreement. These include for example, removal of Hard FM and lifecycle risk (para 3.48), removal of Soft FM Services from the scope (para 3.49) and removal of change in law risk (para 3.68).
Every signatory to the Code of Conduct, therefore, must accept that the public sector should be entitled to vary or omit work from a PFI/ PPP contract in order to make savings.
However, even since the introduction of the Code of Conduct, we are seeing a tendency on the part of the private sector (including signatories to the Code of Conduct) to defend the original scope of the Project Agreement in contradiction to this principle.
Variations are an important facet of PFI contracts. The terms of these agreements are typically from 25 to 50 years in length and, given the rate of change in how public services are delivered, flexibility in respect of how and what services are required has always been a key component. To that end, PFI Agreements have detailed drafting contained within them to allow variations to occur.
The first defence that we see the private sector deploying is the principle that variation clauses do not cover a situation where the employer wishes to omit work and give it to others. Put another way, absent clear words in a contract, the right to omit works from the contract does not include the ability to omit work and have it done by someone else. This is not a contract provision of PFI Agreements but a principle of law.
This is the swings-and-roundabouts principle. The legal premise is that a contractor, when pricing the contract, has struck an overall bargain and in doing so recognises that it will gain on some elements and lose on others. Allowing an employer to cherry-pick individual elements to vary and in particular omit from the contract would therefore, in the absence of clear agreement, be unjust as it would deprive the contractor of his bargain.
Where the courts have previously adjudged work to be wrongfully omitted, most often in relation to construction contracts, then they have had to assess the contractor’s loss. Generally, this is the loss of profit on the omitted work.
However, unlike traditional construction contracts in which this principle has been applied, PFI variation provisions keep the contracting counterparty to the public sector, the Special Purpose Company (SPC), whole, i.e. in a no better / no worse position. In such a case there will be no loss on the part of the SPC as a result of the variation.
The contract terms in a PFI arrangement look back to the position that the parties agreed on at the point the contract was signed. Within the Financial Model, there is expressed an Internal Rate of Return (IRR) for the SPC, on which the private sector will bid, and which is measured against the funds they invested. It is this that is protected by the ‘no better/no worse’ provision.
This is fair and reasonable for two reasons. Firstly, all bidding parties were required to openly declare the IRR they expected to receive on the project. Secondly, there was never an expectation, by the public or private sector, that SPCs would make a profit on the underlying provision of services. The profit element on service provision was contained either within the Construction Agreement or the Facilities Management Agreement. This position was also driven by project lenders who did not want SPCs (which, by their very nature, are thinly capitalised companies) taking risk on PFI projects, given that this could lead to loan default.
The private sector agreed to the principle that, when valuing variations, as long as the SPC was left in a no better / no worse position when measured against the Project IRR, they were content and the variation had to be implemented.
Time has moved on. The original shareholders in SPCs have often sold out, at high levels of return, and the new shareholders from the secondary market are attempting to squeeze out as much profit as they can, often in order to justify large fund management fees. In doing so, they have sought to make a return on the underlying service delivery, rather than just on the capital they invested. They are therefore incentivised to fight against the removal of elements of the underlying service delivery, even when the mechanics of the contract leave them in a no better/ no worse position, and where the public sector can perform these services at a lower cost.
The second common defence is to argue that the contract limits variations to the statement of requirement for the services in question and do not extend to, for instance, changes to the price and the payment mechanism. Mechanically, this is because many PFI projects define Variations as a change to the Works or Services and Works and Services are defined in turn by reference to a specific Schedule to the PFI Agreement.
The argument runs that, unless the proposed variation is limited to matters contained within the Schedule that defines the Works or Services, then the changes the public sector are seeking fall outside the scope of the variation procedure.
Were this truly to be the case then no variation would have ever been allowed under PFI Agreements and as such it is, in our view, an extremely narrow interpretation of the contract. PFI Agreements are a complex suite of documents where, for instance, the price and payment mechanism are often contained within a different Schedule of the Agreement to the definition of Works or Services. By their nature, almost all variations will require changes to more than just the statement of requirement, not least because of the financial element of any change.
For instance it is logical that almost every variation to a PFI Agreement will affect the amount the SPC is paid and the basis of that payment. As such it is difficult to envisage any change that could comply with this wholly unrealistic construction. The private sector is basically arguing that, unless they agree, no changes can occur.
The intention of the Variation procedure for PFI contracts was never to restrict Trusts from adding or removing services or obligations from the scope of the Agreement, so long as the public sector did so in a manner that left the SPC in a no better / no worse position with regard to both profitability and risk. Indeed, where Trusts have added scope into PFI contracts, the private sector have never raised such arguments.
To spell it out clearly, the variation mechanism in a PFI contract allows for change and protects the equity return on which the contract was bid. In order to make savings the public sector now needs to enact changes, Rather than fight each change, the private sector, as outlined in the Code of Conduct, should assist knowing that the agreed equity returns are assured.
Time has moved on. The original shareholders in SPCs have often sold out, at high levels of return, and the new shareholders from the secondary market are attempting to squeeze out as much profit as they can, often in order to justify large fund management fees. In doing so, they have sought to make a return on the underlying service delivery, rather than just on the capital they invested. They are therefore incentivised to fight against the removal of elements of the underlying service delivery, even when the mechanics of the contract leave them in a no better/ no worse position, and where the public sector can perform these services at a lower cost.
The second common defence is to argue that the contract limits variations to the statement of requirement for the services in question and do not extend to, for instance, changes to the price and the payment mechanism. Mechanically, this is because many PFI projects define Variations as a change to the Works or Services and Works and Services are defined in turn by reference to a specific Schedule to the PFI Agreement.
The argument runs that, unless the proposed variation is limited to matters contained within the Schedule that defines the Works or Services, then the changes the public sector are seeking fall outside the scope of the variation procedure.
Were this truly to be the case then no variation would have ever been allowed under PFI Agreements and as such it is, in our view, an extremely narrow interpretation of the contract. PFI Agreements are a complex suite of documents where, for instance, the price and payment mechanism are often contained within a different Schedule of the Agreement to the definition of Works or Services. By their nature, almost all variations will require changes to more than just the statement of requirement, not least because of the financial element of any change.
For instance it is logical that almost every variation to a PFI Agreement will affect the amount the SPC is paid and the basis of that payment. As such it is difficult to envisage any change that could comply with this wholly unrealistic construction. The private sector is basically arguing that, unless they agree, no changes can occur.
The intention of the Variation procedure for PFI contracts was never to restrict Trusts from adding or removing services or obligations from the scope of the Agreement, so long as the public sector did so in a manner that left the SPC in a no better / no worse position with regard to both profitability and risk. Indeed, where Trusts have added scope into PFI contracts, the private sector have never raised such arguments.
To spell it out clearly, the variation mechanism in a PFI contract allows for change and protects the equity return on which the contract was bid. In order to make savings the public sector now needs to enact changes, Rather than fight each change, the private sector, as outlined in the Code of Conduct, should assist knowing that the agreed equity returns are assured.
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