The West Middlesex University Hospital Project was chosen as a case study for two reasons. First, it is a recent example of the conventional NHS approach to PFI, which reached financial close on 30 January 2001 and came on-stream in April 2003. Second, the case study illustrates the considerations that are involved in determining whether a PPP/PFI project offers value for money.
But we begin by outlining the background to the project.
As many of the old hospital buildings dated back to Victorian times and were in bad condition, the Trust, the local Health Authorities and the NHS London Regional Office (LRO) all considered that a redevelopment of the West Middlesex hospital site was essential and long overdue. The 35-year PFI deal for the redevelopment of the West Middlesex Hospital is for new build- ings along with facilities management and maintenance services for all of the buildings on the site. This particular project is the culmination of a series of plans to improve the site that have been circulating since the 1970s, and its aim is to alleviate the problems created by the sprawling layout of services and the poor, unsafe condition of some of the buildings. Much of the building stock on the site is over 100 years old and in recent inspections the site as a whole has failed to meet statutory fire and health and safety requirements. The general layout and conditions make the site unsuitable for modern, high quality health- care.
In fact, the PFI procurement process, which was well advanced, was
stopped in 1997 when the Department decided to make it a priority to complete the existing schemes. West Middlesex Hospital was fourteenth on a list of urgent projects, the first 13 of which went ahead. The project was included in the next wave of PFI hospital projects brought forward in 1998.
LRO indicated that the project remained a priority and it would have been taken forward through conventional procurement if a PFI solution was not deemed appropriate. Thus the decision to proceed with the PFI route was not undertaken because PFI was ‘the only game in town’.
The West Middlesex University Hospital NHS Trust let the PFI contract to a private consortium called Bywest. Figure 6.2 sets out the contractual arrangements for the project, which requires Bywest to redevelop the Trust’s site at Isleworth, West London and then to provide ongoing maintenance and facilities services. The project involves demolition and replacement of the most dilapidated Victorian buildings. Bywest will also carry out extensive refurbishment of newer, existing buildings. This work will be funded from land sales, rather than by unitary payments under the PFI deal. Contractors to the Bywest consortium comprised Bouygues for construction and Ecovert, part of the same group, for facilities management. This linkage provided a unified approach to bidding. Competitive bidding was also aided by the financing arrangements. Both bond financing and bank loans were examined for the project, but bank financing was chosen. Abbey National seemed keen to be involved in the financing of PFI hospital deals and offered finance at very competitive terms, according to the Trust’s advisers.
Advisers to the NHS Trust were appointed after a competitive tendering process which saw KPMG selected as the financial advisers, MacFarlanes as the legal advisers and James Nisbet and Partners as the chartered surveyors. In its report, the NAO (2002) adjudged the financial advisers as having ‘exten- sive experience of hospital PFI deals’, the legal group as having ‘extensive knowledge of the Trust’, and the chartered surveyors as providing ‘excellent analysis of the bidders’ proposals’ (p. 14). This is just as well because, in total, the cost of the advice amounted to £2.3 million.
In line with other NHS PFI projects, Bywest is responsible for design, re- development, building, financing and operating the hospital facilities for 35 years, with the possibility of extending the term to 60 years. Support services are also to be provided, such as catering, portering, security, cleaning, main- tenance and provision of supplies. For its part, the Trust continues to manage the hospital, fund its financial obligations from public sector resources and supply health care services such as nursing, clinical staff, drugs, treatment, diagnostic services, and so on. These health care services are free to individ- ual users (all UK citizens).
When the contract was put out to tender there were 39 expressions of inter- est, generating a ‘longlist’ of nine entities, and a ‘shortlist’ of six. Three
bidders were given a final invitation to negotiate. In order to save time and costs, the Trust elected to go from three bidders straight to a single preferred bidder without an intermediary step involving two final bidders. The Trust chose Bywest in February 2000 and reached financial close nearly a year later on 30 January 2001. Bywest offered a slightly lower price than the other bidders, and the Trust concluded that the bid offered the best value for money with perceived strengths in design, proposed timetable and personnel issues.
Some features of the PFI transaction are given in Table 6.1, with costs based on an annual unitary payment of £9.8 million that did not commence until April 2003 when the Trust began to operate from the new hospital. The payment mechanism is geared towards ensuring that the Trust receives the services agreed in the contract to meet its business needs. Bywest has the incentive that if the level of service provided falls below that required by the Trust, the Trust will make deductions from the unitary payment. For example, should one of the six operating theatres be unavailable for 24 hours (one week- day), the payment deduction on the contractor is approximately £1400.
Provisions are contained in the contract for regular monitoring to ensure the contractor is delivering the required level of service. The Trust is emphasizing
Source: NAO (2002).
Figure 6.2 Contractual arrangements for the West Middlesex University Hospital project
West Middlesex University Hospital
NHS Trust
Funders Abbey National
Treasury Services Ltd Project Agreement
Equity Investors West Middlesex Hospital Projects Ltd/
Charterhouse
Bywest Shareholders
Ecovert/Bouygues UK
West Middlesex Hospital Projects Ltd
Design and Build Contractor Bouygues
Facilities Management Service Manager/Provider
Ecovert
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PFI deal as contracted Conventional procurement alternative
Final deal cost at 2001 prices £125 million – 35 years £130 million – 35 years (discounted over 35 years
to April 2001 and excluding £130 million – 60 years £140 million – 60 years
excluding clinical costs)
(Based on annual unitary payment of some (Risk adjusted)
£10 million)
Cost profiles Annual unitary charge of some £10 million plus Full capital construction and refurbishment costs of refurbishment costs of £12 million under some £62 million (cash estimate) over first four years, separate arrangements followed by ongoing maintenance and ancillary services Risk allocation
• Remaining with public • Clinical service provision Most risks retained by the public sector
sector • Change in Trust requirements
• NHS specific regulatory/legislative changes
• Passed on to private sector • Construction design (except changes due to external NHS requirements)
• Meeting specified performance standards and operating cost risk
• Non-NHS specific regulatory/legislative changes
Cost of advisers used in £2.3 million The Department has suggested a range of between
procurement (actual prices) 2 to 4% of capital value for schemes over £20 million.
This would give between £1.2 million and £2.4 million in this case
Original estimate of deal cost (based on 30 year contract):
• Invitation to negotiate
(1998/99 prices) £91 million £93 million
• Selection of preferred bidder (February 2000
prices) £95 million £98 million
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additional benefits of its chosen procurement over
conventional procurement Incentivizes contractor to complete development on time as full payment only starts once the
building is ready for use and occupied
Payment linked to delivery of service which Only recourse for poor performance is to terminate the incentivizes the PFI contractor to deliver the contract which can also lead to payments from the quality of service which is specified over the Trust
contract period
Same contractor designs, maintains and operates Design, maintenance and operation of building is dealt building under one contract and is therefore with under separate contracts
incentivized to adopt whole-life costing Source: NAO (2002).
a partnership approach to making this project work over the next 35 years, with the Trust and Bywest establishing a PFI Monitoring Group, including user representatives, that will meet regularly to assess performance. The key objectives of the group will be to ensure delivery of agreed quality standards and to resolve issues that may prevent this from happening.
In line with PFI guidelines, the Trust undertook a prior financial comparison of the costs of the PFI bid as against the estimated costs of providing the same level of service using conventional procurement. It compared the net present value (NPV) of the unitary payments under the PFI deal to a public sector comparator (PSC), adjusted for risks transferred under the contract. The final comparison showed that the estimated cost of the PFI deal is slightly lower than the PSC, as set out in Table 6.2. In NPV terms, the pre-risk adjusted NPV of the unitary payments is £123.8 million as against the PSC of £129.3 million.
Obviously, the comparison covers a 35-year period so there are inevitable uncertainties in forecasting future values; for example, costs of construction and service provision and changes in design or service requirements. The esti- mates of the value of risks transferred under the deal are especially subject to unpredictabilities and involve a lot of judgement when estimating the likeli- hood of a chance risk event occurring over the life of the deal in order to put a money value on these risks. This is significant in this case since the final comparison is clearly dependent on the estimated value of the risk transfer assessment.
Table 6.2 Value-for-money test for the West Middlesex University Hospital projecta,b
Public sector
PFI deal comparator
(£ million NPV) (£ million NPV)
35 year pre-risk 984.1 976.5
adjusted
Risks transferred –0.6 12.5
Total risk adjusted 983.5 989.0
Total difference 5.5
Notes:
a Financial comparison of PFI deal and PSC by the NHS Trust in January, 2001.
b Clinical services are outside the scope of the deal, but the Trust included identical clinical costs on each side of the calculation in line with the Department’s guidance. The pre-risk adjusted NPV of the unitary payments for the project over 35 years is the £123.8 million. The public sector comparator was £129.3 million.
Source: NAO (2002).
In point of fact, for this project the Trust’s initial comparison showed the PFI price slightly higher than the cost of conventional procurement. According to the NAO, both the Trust and its financial advisers were convinced of the overall value for money of the deal, taking all factors into account. But there were doubts about the accuracy of this initial financial comparison, and going forward to the Department of Health with an estimate showing the PSC cheaper than the PFI deal might well have jeopardized the case. Because the risk analysis was seen as incomplete, the figures were revisited. Risk work- shops were held and adjustments to cost and risk estimates were completed before seeking Departmental approval, which resulted in the PSC becoming slightly higher than the PFI price. The final calculations showed a risk- adjusted saving from using the PFI of £5.5 million compared with a PSC, including project costs and clinical costs, of £989 million over 35 years (net present values). The reassessed cost comparison therefore reinforced the value-for-money case for the PFI deal, without in itself constituting conclusive evidence.
It is important not to forget that the exercise of assessing the PFI relative to the PSC calculation is not one that compares like with like. The PSC calcula- tion is a hypothetical one of what the project might cost using the public procurement route, with many uncertainties attached to the costings, particu- larly with respect to the evaluation and treatment of risks and the likelihood of cost overruns resulting. By comparison, the PFI figure is actually a firm bid, put on the table by a consortium willing, able and ready to do the job and with a desire to start delivering the infrastructure services as quickly as possible in order for the revenue flows to begin. Also, in this case, the bid was supported by confirmation in writing from Bywest at the selection of preferred bidder stage that it would hold its proposed price, assuming that the specification remained unchanged. As is normal in such cases, some specifications and other elements related to the site buildings did change, but the ‘deal drift’ was, in the view of the Trust and the NAO, ‘controlled’, and the annual price in the event increased by less than 10 per cent during this period, mainly due to infla- tion and the decision to use land sale proceeds to fund other work (NAO, 2002, p. 16).
In view of the uncertainties inherent in such cost estimation, particularly in respect of the PSC, it is probably fair to conclude, as the NAO does, that ‘there was little to choose between the PFI and the traditionally procured options in terms of the financial comparison alone’ (p. 22). Somewhat ironically, in view of the concerns of the Trust’s advisers on this point, the Department told the NAO that it would not necessarily withhold approval for a PFI project that appeared slightly more expensive than conventional procurement if there were convincing value-for-money reasons for proceeding with the deal. Indeed, as the NAO noted, the attention given by the Trust to the juxtaposition of the
figures in the value-for-money comparison may have diverted attention away from the wider benefits that the PFI approach was expected to secure. These benefits are summarized at the foot of Table 6.1 and relate to (1) the incentives given to the contractor to finish on time and within budget, (2) the incentives built into the payment mechanism for services to be of the appropriate quality, and (3) incentives for the designer and contractor to take account of whole-life costing implications. Other important considerations for the Trust were the certainty of pricing and the transfer of responsibility for the assets, enabling it to focus on the delivery of core services.
Of course, there are also possible ‘disbenefits’ in the Trust tying its hands by entering into such a long-term service delivery contract. Business needs change over time, so there is the risk that the contract may become unsuitable for these changing circumstances during the contract life. There is some allowance for this event in the contract which has some inbuilt flexibility to accommodate such uncertainties. Up to six additional wards (170 beds) can be provided or alterna- tively bed numbers could be decreased. The Trust believes the contract provides sufficient leeway to address future changes in long-term health care.
Overall, this case illustrates a situation that may be typical of many large, complex PPP/PFI projects in that the financial comparison between the PFI transaction and the public sector comparator was not clear cut, but this comparison did not take account of many of the potential benefits and costs associated with a long-term PFI contract. These other elements must be harnessed and managed effectively to ensure that the deal offers value for money. The Trust believes it has managed the potential disbenefits and risks effectively in the West Middlesex University Hospital contract, while there are benefits from doing the project as a PFI because of the incentives to the private sector to deliver the project on time, and to provide continuing infrastructure services at a fixed price and to a satisfactory quality.
NOTES
1. In this way, the operation of PPPs can be seen as paralleling the growth of networking and
‘virtual corporations’ formed by creating groups of contracting partners and taking advan- tage of digital technology (see Lewis, 2003).
2. In general, the separation between principal and agent gives rise to problems of asymmetric information and hidden actions. Effectively, the principal does not know how good the agent is, and cannot easily observe the agent’s actions. Sappington (1991) provides a relatively recent survey.
3. See, for example, Oliver Williamson (1996) and Mark Casson (2000, Chapter 5) for analy- ses of the role of transactions costs and information costs. Economies of scale and scope are examined by Alfred Chandler (1990), as is indicated by his title Scale and Scope.
4. In the words of Brealey et al. (1997): ‘in the presence of complete capital markets, in which the pay-offs to all projects are spanned by existing securities, taxpayers can shed any risk that accrues from the undertaking of a project by the government by trading in the capital
markets. The risk premium demanded by the capital markets is the cost of shedding this risk.
It is therefore the risk premium demanded for both public and private sector projects’ (p. 23).
5. The standard references are Brealey and Myers (2003) and Copeland and Weston (1988).
6. PFI had mixed results when it was first introduced to the NHS, as it was then mandatory for all capital schemes over a certain value to be market tested. This resulted in a banking-up of incomplete deals, a number of which were, in hindsight, either inappropriate to tackle under PFI, or unaffordable for the NHS. Also, many of the schemes coming to the market faced the following issues: their focus tended to be on acquiring an asset rather than providing a service; some key stakeholders did not fully accept or understand the PFI concept; and risk allocation was sub-optimal – either too much or too little risk was transferred to the private sector. The UK Labour government has applied the PFI model much more selectively by devoting the resources needed to make the selected PFI schemes a success; addressing the way PFI projects were structured; moving towards optimizing risk and value; seeking to place risk with the party best able to manage it; and tight project management to ensure the investment required by both public and private sectors is kept at an acceptable level.
7. According to the Green Book, social time preference is defined as the value society attaches to present, as opposed to future, consumption. The social time preference rate is a rate used for discounting future benefits and costs, and is based on comparisons of utility across differ- ent points in time or different generations. It has two components. The first is the rate at which individuals discount future consumption over present consumption, on the assump- tion that no change in per capita consumption is expected. Second, there is an additional element, if per capita consumption is expected to grow over time, reflecting the fact that these circumstances imply future consumption will be plentiful relative to the current posi- tion and thus have lower marginal utility. This effect is represented by the product of the annual growth in per capita consumption and the elasticity of marginal utility of consump- tion with respect to utility. With the first component estimated at 1.5 per cent per annum, and the second at 2 per cent per annum, the social time preference is valued at 3.5 per cent per annum in real terms.
8. Exceptions are where projects exceed $500 million in value, making it worthwhile to calcu- late an idiosyncratic project risk discount rate, or when the systematic risk profile is an unusual one. See Partnerships Victoria (2003).
9. Brealey and Myers establish the linkage as follows: ‘CEQ1can be calculated directly from the capital asset pricing model. The certainty-equivalent form of the CAPM states that the certainty equivalent value of the cash flow, C1, is PV = C1– lcov (Cˆ
1, rˇm). Cov (Cˆ1, rˇm).is the covariance between the uncertain cash flow, Cˆ
1, and the return on the market, rˇm. Lambda l, is a measure of the market price of risk. It is defined as (rm– rf)/ sm2. For example, if rm– rf= .08 and the standard deviation of market returns is sm= .20, then λ= .08/.202= 2’
(p. 240, n. 24).
10. Systematic risk is a measure of the extent with which a particular project’s returns are likely to move when compared to the ‘market portfolio’, i.e. fluctuations in the economy. The measurement of systematic risk is known as beta and the beta of a project or asset determines the returns that an investor would require to invest in such a venture. Where beta is equal to one the project will move the same as the market portfolio. Where it exceeds one the project is more risky than the market, and conversely it is less risky if its beta is below one.
11. One attempt to estimate benchmark betas for PFI projects using observable market data for regulated utilities in the UK was undertaken by PricewaterhouseCoopers (2002) in a report discussed later in this chapter.
12. An example may illustrate the calculation required. Suppose a cashflow outlay where there are three possible outcomes: a budget outcome where the cost is, say, $1000, a downside case where the cost is, say $1600 and an upside case where the cost is, say $800. If we assume that both the downside and the upside cases each have a probability of 25 per cent, then we can calculate the expected value of the cash flow to be equal to
$1000 + 25 per cent x ($800 – $1000)
+ 25 per cent x ($1600 – $1000) = $1100.