Local Authorities and PFI - have recent developments helped to make PFI projects more bankable?

A clearer definition for Local Authorities' PFI?

Peter Long and Patrick Leece ask whether recent developments help make PFI projects more bankable

During its first year in office the Government has taken a number of measures to facilitate private finance initiative (PFI) transactions.

The Bates review of the PFI produced a long list of recommendations to improve the process, many of which the Government has now implemented. Some of these have been mainly "organisational" in nature: to help streamline the process and to assist participants to have a clearer understanding of what is required of them.

Other measures, however, have involved the introduction of legislation aimed at specific sectors. On local government projects, for example, the Government introduced the Local Government (Contracts) Act 1997 which addressed most of the concerns of the private sector as to the power of local authorities to enter into the long term commitments involved.

In February this year, the Government introduced a piece of secondary legislation which has been much less widely publicised but which nevertheless is of importance for local government private finance projects. The Local Authorities (Capital Finance) (Amendment) Regulations 1998 came into force on 20th March 1998. As its name suggests, this legislation concerns the rules and regulations governing the provision of finance for capital projects by local authorities.

Background

Prior to 31st October 1996 a local authority proposing to enter a PFI arrangement for the procurement of capital intensive assets and services was required to provide "credit cover" equal to the entire initial cost of the transaction just as if it were buying the asset outright. There were a number of ways in which it could provide this credit cover. It could be in the form of usable capital receipts or revenue or of "credit approvals" from central government giving permission to borrow to raise the funds required. These regulations meant that it was rare for a local authority to find itself in a position where it could enter into a private finance transaction.

By a series of amendments to the Local Authorities (Capital Finance) Regulations between October 1996 and March 1997, the Government of the day sought to remove this obstacle to the progress of the PFI in the local authority sector by making redundant the requirement to demonstrate full credit cover for certain qualifying schemes. Satisfaction of the qualifying criteria under the Regulations also entitles the sponsoring authority to apply for revenue support for the scheme from central Government. This is of critical importance for the viability of many local authority sponsored PFI schemes.

The Issue

For a local authority to qualify for a reduced or nil credit cover a number of requirements must be met. These include a requirement that the transaction entered into is a "private finance transaction" for the purposes of the Regulations. Precision and certainty in the drafting of this definition is critical as the authority, potential lenders and sponsors will need to be certain that the authority can obtain finance for the transaction.

The need for certainty at the outset of the transaction is made all the more acute due to the role of the district auditor whose opinion as to whether a particular transaction qualifies under the Regulations will only be provided after the project itself is underway. Should the district auditor decide that the transaction is not a "private finance transaction" for the purposes of the Regulations then the transaction may be "ultra vires" and of no effect. Lenders and sponsors may then need to rely on the Local Government (Contracts) Act 1997 to receive compensation.

In practice these difficulties may only be solved by renegotiating the contract.

Definition of "Private Finance Transaction"

The difficulty in drafting a definition of "private finance transaction" is revealed by the number of revisions which have appeared. The legislation which came into effect in March this year introduced the second change to the definition since the original amendments were introduced in April 1997. Under the latest definition, for a scheme to qualify as a Private Finance Transaction:

• the private sector must make available to the authority a capital asset, or carry out works, for the purposes of, or in connection with, the discharge of a function of the authority and provide the authority with services for the purposes of, or in connection with, the discharge of the same function;
• the local authority must not give any undertaking or guarantee in respect of the obligations of the private operator, whether directly related to the particular transaction or not;
• the contract must include the payment of fees from the local authority to the private sector operator by instalments at annual or more frequent intervals;
• fees payable to the private sector operator must be based on standards attained in the performance of the services, or the level of usage of the asset which is made available, constructed, enhanced, replaced or installed under the transaction;
• payments must commence only after the services have started to be provided;
• instalments of fees must only be determined by reference to a specified sum or specified rate of payment; a measure of the amount of work carried out under the transaction; and the factors set out above;
• the contract must not provide for the specified sum or the specified rate of payment referred to in paragraph (f) to change other than to allow for increases in the general level of prices in accordance with certain specified criteria.

Unresolved Issues

The definition describes a number of the features commonly found in most private finance contracts: for example that payment may be dependant upon usage or upon the standard of service provided; but although this definition represents a significant improvement from this point of view over previous definitions there remain a number of elements commonly found in private finance transactions which may not be covered by the definition; for example:

• private finance transactions often provide for increases in the payments to be made by the authority as a consequence of the occurrence of risks which are retained by the authority or shared with the operator. The use of benchmarking techniques and other risk sharing mechanisms leading to changes in payment are becoming increasingly common. These seem to be excluded by the definition and will significantly limit the parties' scope to be innovative in the payment mechanisms used in their particular transaction;
• the restrictions on "undertakings or guarantees" as described above could be interpreted by some district auditors as disqualifying transactions where the minimum total amount payable to the operator meets or exceeds the operator's debt service costs on the basis that this amounts to an "undertaking or guarantee" in respect of the funding commitments; a termination provision which requires the authority to reimburse the private sector borrowings even on a termination on private sector default may also be open to attack;
• in the event that there is a material change in the scope of the services to be provided by the operator or a variation to the works to be carried out which is to be paid for by an adjustment in the monthly payment or rate, it is likely that the district auditor will need to reappraise the whole transaction in the light of the new circumstances. The parties will therefore need to make sure that any such variations do not materially affect the overall nature of the transaction.

Flexibility

The consequences of a private finance agreement failing to fall within the statutory definition can be severe and it is to be hoped that the Government will keep it under review to ensure that it is flexible enough to include the essential features required to ensure that private finance projects are bankable while at the same time not allowing transactions which are not truly private finance transactions to "slip through".

In practical terms it will be necessary for local authorities to work closely with their auditors to ensure that their proposed transaction is structured so as to ensure compliance with the "private finance transaction" definition and the various other tests and requirements of the Regulations. Equally, lenders and equity sponsors will need to monitor the discussions with the district auditor and familiarise themselves with the restrictions within which local authorities must operate. A termination based upon lack of funding or lack of power to contract would be unsatisfactory from everyone's point of view.