PFI Hospitals - Cost model, November 1996

Introduction
The private finance initiative continues to be a source of deep frustration for the construction sector and its clients. Early and widespread support for the initiative from contracting organisations has not been rewarded with workload. Instead it has been dogged by reports of delayed projects and high bidding costs.

The steep learning curve for clients, consultants and service providers has resulted in a series of imperfect pathfinder schemes. Efforts to translate PFI proposals into real projects are being frustrated by delays in final Treasury approval. Also clients and providers have discovered that a high level of commitment and resourcing is required to follow the PFI route. During 1996, contractors have become increasingly disillusioned with the PFI and there has been a series of high-profile withdrawals from schemes. Clients have also experienced difficulties in reconciling high expectations for their projects with the reality of what can be afforded. The health sector exemplifies many of the problems of the initiative, with a £1 billion annual investment programme all but stalled and final Treasury approval outstanding 54 hospital projects.

Not all capital projects are suitable for the PFI route. Limitations on capital expenditure may result in conventionally funded projects being delayed or cancelled. As a consequence, the PFI may become the procurement route of the last resort.

In the near future, it is likely that elements of PFI will filter into the private office market. A long term commitment to an inflexible leasehold tenure will be replaced by a more flexible market in managed and serviced office space. The PFI could have an enormous impact on how office accommodation and facilities management services are designed and procured.

Progress on the PFI
Private finance is not a new concept - the Victorians used it to build the country’s rail infrastructure. The current policy was introduced in 1992 with the aim of using private sector expertise and innovation to provide services.

It was envisaged that the government would benefit from being released from the responsibility and risks that go with the capital financing and provision of services. Under the PFI, the public sector’s role in service provision will be increasing restricted to planning and management. The responsibility for actual services will eventually be cut back to core functions such as clinical care.

It was expected that £14 billion of capital investment would have been made in partnership with the private sector by 1999. There has been some success in design-build-finance-operate schemes such as the QE2 bridge at Dartford. But to date, there have been no purre, large, construction-based schemes let under the PFI. Many schemes, particularly in the health sector, such as the Oxford Radcliffe infirmary, are stalled or failing because of problems of affordability and constraints on trusts’ budgets.

Problems in the health sector
The health sector highlights many of the problems experienced on PFI projects:

The National Health Service has had to make year-on-year efficiency savings for the past 17 years. Therefore, the scope for making further value-for-money gains within the current service provision is limited.

Health service developments are often complex and demanding projects. They can be difficult to define fully or accurately in performance terms at an early stage without prescribing a deisgn solution. Innovation is being constrained by having to use standard documentation such as NHS Health Building Notes.

The services trusts provide are dynamic and likely to change considerably over the typical 25-30 year life of a PFI project. Part of this risk will be carried by the providers and will be reflected in the cost.

Trust income streams are uncertain because of the unpredictability of some aspects of health care and the complexities of the NHS internal market. The decision of some private hospitals to concentrate on a limited range of elective surgery illustrates the selective approach to medicl services already taken by private sector investment.

Health Authorities are able to withdraw contracts at 12 months’ notice. For example, the Anglian Harbours NHS Trust is currently facing the loss of two-thirds of its £26m income. The government has acted to increase the security of investment via the NHS Residual Liabilities Act 1996, but the risks are higher in healthcare than in other areas such as transport. As a result, project finance is relatively expensive and value-for-money criteria are harder to achieve.

The difficulties faced on many projects, particularly those relateing to affordability, show there is a limit to the number of schemes that can be procured successfully using the PFI. The difficulties of risk tansfer and the high procurement costs will reduce the relevance of the PFI to low-value projects and to schemes where the private sector is required to price for higher levels of risk exposure. Large, relatively simple schemes, such as roads and bridges that serve a dependable, expanding market are more attractive to private finance. In view of the cost of putting together a PFI project, it is important to be able to identify a viable project at an early stage.

Characteristics of projects that are less suited to PFI procurement include:

• prescriptive or complex output specifications
• uncertainty over long term patterns of use
• limited opportunity for additional income generation
• extensive refurbishment work
• extensive and complex decanting works
• absence of guarantees to funders

Under the PFI, the public sector contracts to buy services on the basis of the definition of output requirements. The conventional pattern of procurement is inverted, with the purchasing body no longer being responsible for the detail of the production, management and finance of the fixed asset. As a result of the separation of the public sector client from the design and specification process, early procurement activities have greater potential impact on the final outcome than with conventional schemes. At the outset of a project the client has to determine certain key issues, namely:

• the role and appointment of advisors

PFI projects are procured on the basis of output specifications. Predicting these is complex and results in high bid costs for providers (the bidding costs for 30 PFI hospital projects to date total £100m). The level of detail of an output specification will vary widely, from an extensive space planning document to more loosely defined statements concerning demand patterns, demographics and broad environmental conditions. In health schemes, separate output specifications will be developed for design, faciliteis management and medical planning. A less detailed output specification may allow for innovative design and service solutions, but these will be less easy to appraise at tender and harder to monitor in operation.

The documents should also identify additional revenue-generating elements that enhance a scheme’s viablility. For healthcare, these might include a private patients’ wing, a patient/visitor hotel facility or provisions such as retail or car parking. An assessment of the potential for shared and joint venture use of services (scanning, incineration, clinical waste) and the sale of surplus services to third parties should also be identified.

Risks
Risk management strategies PFI projects are designed to encourage the effective management of risk and to place risks under the control of parties best able to deal with them. However, balancing the risk has been a significant problem and project financiers have not been willing to accept the transfer of all demand and client/supplier default risks. Many of the risks involved are difficult to price. The limited track record of PFI schemes further reduces the ability of providers to predict accurately price the risk economically. The preferred generic distribution of risk between client and supplier is shown in the table below.

Balancing the risks

• demand risk - where use of the service is partially determined by service quality, risk is shared
• specification risk - risks of the definition of inappropriate output requirements or changes to output needs are not transferred
• residual value risk - assets do not revert to the public sector at the end of the contract and risk is transferred to the provider
• technology/obsolescence risk - risks are shared where technological developments cannot be defined in advance
• regulatory/legislative risk - risks related to general legislation, such as a minimum wage, are transferred to the provider
• regulatory/legislative risk - risks related to specific legislation affecting the service, are not transferred
• taxation risk - risks are transferred to the provider
• planning risk - risks are transferred to the provider , except in circumstances where the client is required to intervene in the consent process.
• project finance risk - risks are transferred to the provider but risk exposure is negotiable up to the stage of best and final offer.

The focus of risk management and transfer in PFI schemes invariably involves downstream risks being transferred to the provider. The greatest project risk is likely to be the client’s exposure to the consequences of its changing requirements.

The near certainty of the client’s changing over time represents a potentially huge upstream risk. This may give the private sector providers the opportunity to break away from their long-term commitments, even at an early stage of the project. Other upstream risks that need to be considered include increased spending by the provider or falling running costs. Therefore, a robust system for controlling changes and resolving disputes is needed to protect the clients should the upstream risks change.

The comprehensive identification and allocation of all project risks is therefore essential. A risk that is not identified under the PFI agreement could potentially be considered as unallocated and expose the client to uncontrollable risk. Experience from early PFI schemes has confirmed that negotiating an acceptable balance of risk is necessary if project finance is to be obtained.

Payment and value for money
Payment: This is based on a unitary includes elements for availability (numbers of beds available or capacity to perform medical treatments), use (number of actual medical treatments) and quality (reliability and consistency of food service for example).

Availability is established as a benchmark in the legal agreement. The definition of the required standard of service (in quantity and quality terms) is used to trigger the payments after completion of the operational commissioning of the facility. Availability is then used as a benchmark against which penalties for any fluctuation in service provision can be assessed.

Where usage risk is retained by the client, no adjustment is made to the availability charge. Where the risk is shared, an element of the unitary charge will relate directly to volume.

Quality issues can be measured directly and incorporated into the unitary charge through the use of a performance-related penalty system. Under a penalty regime, percentage deductions to the monthly unitary payment are made as a result of the substandard provision of services such as life safety systems, M&E services or FM services. Deductions are made on the basis of an agreed tariff set out in the legal agreement.

Value for money: This is a relative term, but achieving demonstrable value is fundamental to the approval and long-term success of the PFI. Currently, there are a number of PFI projects which have demonstrated value for money but which cannot be afforded. Principal ways of enhancing value for money are shown in the table to the left.

Ways to enhance the value

• economies of scale
• shared usage of facilities
• incorporation of commercial elements - sale of surplus services to third parties
• enhancement of residual value/potential for reuse

Advisers, business plan and tendering
Advisers: The role of advisors to a PFI client is critical. The client requires considerable input from financial and legal advisers who must develop sound, bankable proposals and a bespoke legal agreement. The advisers should act to protect the client’s position, generate compliant bids that provide a sound negotiating platform, and negotiate the best deal in accordance with the client’s requirements. The client’s team will provide advice in the following broad areas:

• developing output specifications for design, construction and FM services
• developing tender evaluation criteria
• developing payment and risk transfer mechanisms
• shortlisting of tenderers
• risk analysis and management
• evaluation of bids
• developing the procurement programme
• design management
• negotiating
• developing performance monitoring regimes
• controlling changes and resolving disputes

The complexity of PFI projects and the client’s direct role in negotiation place a premium on the management capabilities and experience of the client. The time and money committed by the client’s senior management is considerable and is often underestimated at project inception. Therefore, the client should consider appointing an independent management firm to maintain control over progress.

Business Plan: An outline business case is used in the public sector to select viable projects. It will:

• include a PFI execution plan and timetable

The outline business case will confirm the viability of a project, its suitability for the PFI and will define the main output, quality and value-for-money criteria for project assessment. The appraisal element of the OBC can be used to give bidders an affordability benchmark. Changes to the project scope should be referred back ot the OBC benchmark to ensure that the project continues to meet its objectives

Tendering: The process is generally in two stages. Early projects such as the PFI prisons demonstrated that compliant bids were difficult to obtain using a fully competitive tender. Consequently, the use of negotiation has been recommended after completion of a competitive first stage, although it does put up the costs.

Tendering is costly for both client and provider. The client’s apparent savings on design fees will be more than offset by the fees of specialist advisors and the deep involvement of high-level in-house staff. Attempts to reduce bid costs by minimising tender lists and standardising some elements of the legal agreement will only have a limited effect. Tendering costs can be reduced only if the client prepares unambiguous and comprehensive details on output specifications, functional requirements and relationships between all the parties. This will also raise the client’s profile in the eyes of funding institutions.

However, providers tend to submit the minimum documentation possible in order to retain maximum flexibility for negotiation and reduce bidding costs. Notification about the tendering process must be published in the Official Journal of the European Union. Competitive tenders will ideally be called from three or four bidders with the aim of identifying a preferred bidder with whom negotiations can then start. The documentation used at tender and negotiation stages must be checked against the OBC to ensure the proposals are affordable and compatible with the original definition of need.

The tender should be accompanied by the following documentation:

• Viability benchmarks - obtained from a comparable public sector scheme
• Comprehensive schedule of information required
• Providers should be made aware of the outputs and risks that are negotiable and that alternatives can be put forward.
• Negotiation and full business case
• Negotiation: The PFI is deal-driven but the temptation to do a deal should be resisted. The negotiation stages could be used by the provider to modify the position it took during the competition. Crucially, issues of risk balance relating to funding, detailed design, specification and payment proposals are likely to be challenged by the provider, while design changes to meet revised client needs or affordability criteria may also be introduced. Some of the following difficulties encountered during negotiation are shown below:
• Negotiation difficultiesco-ordination of all client activitieslimited availability of design and cost information
• unrealistic programme for negotiation
• ongoing monitoring of affordability
• control of client’s wants and needs during design development consultation
• misunderstanding of the balance of risk
• Negotiations must also comply with the objectives and assessment criteria set out in the original notice in the Official Journal, or clients could face legal action.
• Full business case
• This is prepared in parallel with the negotiation procedure. The FBC is a process used by the Treasury to confirm value-for-money and risk transfer objectives against a detailed public sector comparator. The comparator is a notional investment appraisal of the full costs and benefits of a publicly funded development option. During the Treasury approval stage, the preferred bidder enters into a contract with the client to proceed with the project on the basis of the final offer, if and when Treasury or other government approvals are obtained. Some 545 health projects are at this stage, but none to date has received final approval. Until final approval, providers have no guarantee of success and no right to recoup abortive tender costs.
• Cost Model: Day-care unit
• Introduction
• Day care has become the preferred option for the delivery of elective surgery, endoscopy and other treatments in the NHS. The Royal College of Surgeons has stated that day care is the best option for 50% of elective surgical procedures.
• The expansion of day-care procedures since 1991 has coincided with the emergence of the PFI as the preferred procurement route for NHS expenditure. Day-care units are good candidates for the PFI as they are self-contained units and enjoy a relatively reliable income stream. Day-care units also have considerable potential to support additional revenue-generating activities, such as car parking or catering. The capital value of day-care units is, however, unlikely to offer a hospital-wide facilities management contract on the basis of the relatively small capital asset gain obtained from a day-care unit.
• Design
• Day care units provide treatment and surgical procedures that do not require overnight stys for either preparation or recovery. Typical surgical operations take from two-and-a-half to four hours from arrival to discharge. So reducing the time the operating hteatre is empty is crucial to maximising throughput.
• Design is necessarily focused on the operational requirements of the unit, particularly the flow of patients from one stage of treatment to another. Design also has to strike a balance between the number of treatment facilities provided (operating theatres, endoscopy rooms) and the preparation and recovery accommodation required to service them. Self contained day-care units tend to be designed to a high degree of efficiency but it is recognised that there is scope for a reduction (of 10% plus) in the space allowances recommended by NHS Estates. Sources of value-for-money savings come from reduced space allowances and FM costs, but are unlikely to be found in modifications to processes or functional relationships.
• NHS trusts are required to prepare output specifications to maximise the flexibility available to PFI bidders. It is widely considered that output specifications based on floor area requirements reduce bidders’ options. However, it is worthwhile using Department of Health/NHS Estates guidance, such as the Health Building Notes and Health Technical Memoranda, to establish technical and qualitative benchmarks. While some of the published guidance is mandatory, much can be applied selectively. Where alternative proposals are made, bidders are expected to show that they have met published design principles.
• The design and specification of day-care units is detailed in Health Building Note 52. It defines the technical requirements for a day-care unit in terms of:process flowsinterdepartmental functional relationships
• detailed functional requirements for accomodation and services
• service demand levels and basic service requirements
• design standards
• functional area allowances
• ergonomic studies
• IT strategies.

Tendering
Tenderers are required to give details on how the services offered relate to the output specification requirements, proposals for the transfer of risk, and the establishment of value for money based on the revenue charge for the service.

As a minimum, the information required at the first stage of tender should include:

• benchmark specifications for design and construction
• room data sheets for key areas
• management programmes up to and including occupation
• financial models detailing the cost build-up to the unitary charge
• capital cost summaries
• life-cycle cost plans
• proposals for project and service management
• proposals for charge control systems
• source of finance
• proposals for risk transfer
• FM services method statement.

Many sources of improved value for money - elimination of over-specification, reduction in operating costs or improved FM performance etc - will not be fully developed at tender and the bidder will retain the flexibility to develop these aspects through the tender and pre-construction phases. As a PFI scheme is developed, there is the potential for conflicts of interest to emerge between the trust and tenderer. Areas of potential conflict include issues such as enhancement of the trust’s accommodation requirements or the detailing of external elevations that do not form part of an output specification.

Investment appraisal
Investment appraisal is used at the full business case stage to demonstrate that the PFI represents the best value-for-money solution. It embodies the principles of life-cycle costing, examining the whole life cost and benefits of alternative project options.

To allow the comparison of optins with differently timed clash flow, discounted cash-flow techniques are adopted. Use of discounting enables dissimilar project options to be compared on a single measure, the net present value, which represents the sum of all costs and benefits discounted to the present day. Government procedures for the use of investment appraisal are published by HMSO in Economic Appraisal in Central Government, otherwise known as the Green Book.

On a PFI project, comparison of the bid and an assessment of its benefits (service levels, risk transfer etc) is made with a public sector alternative, either a real project option, or a notional model, the “public sector commparator”. In reality, if PFI projects are not approved, a comparable large-scale capital investment is unlikely to occur. The full business case should therefore also include an assessment of the costs of doing nothing, such as higher maintenance costs and poorer healthcare service.

The effective use of investment appraisal depends on the options being genuinely comparable. Areas of particular difficulty include ensuring that public sector options set realistic values for risk exposure and backlog maintenance. It is also important that the public sector comparison excercise incorporates all modifications to the trust’s proposals that are introduced during the processes of design development and negotiation.

Project Programme
The main sources of programme delays are negotiation, integration of design changes and the time taken to get Treasury approval. Delay to the start of work will lead to claims for additional costs because of price increases. Design changes can also increase costs.

The pricing structure of PFI projects means providers need to get the facilities built and operational as soon as possible to minimise finance costs. But, invariably, insufficient time is allocated for consultation over the service proposals. Approval times during construction are cut to the extent that clients will inevitably be exposed to claims for delay. Therefore, allowances for adequate negotiation and approval time should be built into the tender documentation at the earliest opportunity. Management of the programme and of the approvals/requests for information process will be essential if claims for delay and disruption are to be disentangled. The development of a slimmed-down approvals procedure will also be necessary to limit construction delays.

Risk management and transfer
The essentials of risk management and transfer are increasingly well understood in the UK construction industry. However there are specific issues related to risk under PFI that benefit from further consideration:-

Risk identification
It is recommended that all potential risks are allocated in the agreement if a comprehensive transfer of risk exposure is to be achieved. The client should prepare a risk register detailing all known risks, their causes, poetential impact, likelihood of occurrence and ownership.

Risk analysis
Private sector providers are required to be able to price accurately for their long-term risk exposure. Evidence from the marketplace is that a detailed analysis of construction risks is prepared as part of the bid, but that the analysis of operating and life-cycle costs is more limited. While some consortia may take the view that the gains from upside risks, resulting from client changes or growth in demand, will balance less favourable outcomes, the adoption of more rigorous techniques of risk analysis using computer models will increase as data from live projects becomes available.

Risk management
is fundamental to the achievement of value-for-money in the PFI. Active management focuses on the selection of appropriate strategies for the control and mitigation of risk, once ownership has been identified. The PFI embodies the risk management benefits of explicitly allocating responsibility for risk to the private sector and, in turn, providing the priate secotr with considerable control over design, FM and service provision. The potentially solid platform of risk management provided by PFI contracts is however, likely to be undermined if client changes are introduced during the contract life.

No payment is made to the provider until the facility is commissioned and available for use. Payment is made by means of a unitary charge, the value of which is related to availablilty and use of facilities and the achievement of defined quality standards.

Studies of life-cycle costs of office buildings show that staff salaries, energy and maintenance costs account for the bulk of expenditure over the occupation cycle of a building (92% over a 25-year life). The life-cycle cost of a PFI project is the total cost of the service up to the end of the contract term and will include initial capital costs, finance, annual running costs, annual non-clinical staff costs and costs of short- and long-term maintenance. The life-cycle costs will also include the value of asset disposals during and at the end of the contract term.

Analysis of the model
The cost model is based on a self-contained day-care unit offering day surgery, endoscopy, medical treatment and investigation facilities to an existing district general hospital. The PFI bid also includes construction of a 300-space, multistorey car park to generate additional revenue.

The day care unit is a single storey unit with a gross floor area of 2400m2 housing two theatres, two endoscopy rooms and a six bed treatment and investigation unit. The bid includes all facilities management and non-clinical services required to support the unit. Capital costs of self-contained day care units range from £1,000/m2 to £1,400/m2. At £1,089.75/m2 the cost of the model scheme is at the lower end of the range. Additional cost savings are achieved through a 10% reduction in gross floor areas compared with NHS guidance.

Multistorey car parks range in cost from £165/m2 - £250/m2. The cost of the model’s car park is £176.32/m2 and savings were achieved through the use of a raft foundation. The project is located on a green field site in South East England. For other projects costs may need to be adjusted to take account of different location, site constraints, or procurement route. Day-care units and car parks have been examined in fuller detail in cost models published in Building on 10 June 1994 abd 17 December 1993, respectively.

The cash flow analysis details the principal components of the unitary charge of £1,988,200 a year. This build-up of the unitary charge includes a 15% target return on capital and operating costs.

Commentary
The PFI has created an integration of partnership funding and resourcing of public sector services that is so radical and complex that it is no surprising that so few schemes are going ahead. Current PFI projects are pioneers and are procedding at considerable risk to both clients and providers. Therefore, the lessons learned from these schemes will be invaluable. An increase in the speed of procurement for the second wave of prisons and a developing project database in the health sector are examples of an imperfect but developing understanding of the whole PFI process.

However, the long-term effect on public revenue expenditure will not be understood until enough projects are in operation. The PFI could also limit the ability of the public sector to find further year-on-year efficiency savings as control over services passes to the private sector. In the long term, there are fears that the influence of private sector finance over the availability of funding will determine the selection of projects rather than social need.

For the PFI to become established as a credible procurement route, more commitment is needed from the government together with a more soundly financed and flexible response from the private sector. The emergence of investor/operator companies, set up to manage and spread the risk over a portfolio of projects, will be a significant step in the development of a more robust and consistent PFI market