Highways Agency

Value in Roads

Chapter 1 - Executive summary

1.1 Introduction

The purpose of this case study is to give an overview of the structure of, and process used for, the first Design, Build, Finance and Operate (DBFO) road projects and to show how the DBFO concept is evolving as the Highways Agency (Agency) proceeds with further DBFO projects. The Agency acts on behalf of the Secretary of State for Transport (Secretary of State) as an executive agency of the Department of Transport (Department).

At the time this case study goes to print eight DBFO projects have been brought successfully to financial close. Six further DBFO projects have been announced, and one joint project between the Scottish Office and the Agency is in procurement. In total, the estimated capital value of the road schemes within the DBFO programme is just less than £1.3 billion. The DBFO projects are:

		miles	estimate of capital value (£m)
Tranche 1
	A69 Newcastle to Carlisle	52	9.4
	M1-A1 Motorway Link, Leeds	18	214
	A1(M) Alconbury to Peterborough	13	128
	A417/A419 Swindon to Gloucester	32	49
Tranche 1A
	A50/A564 Stoke to Derby Link	35	20.6
	A30/A35 Exeter to Bere Regis	63	75.7
	M40 Junctions 1-15	76	37.1
	A168/A19 Dishforth to Tyne Tunnel	73	29.4

Projects announced
	A6/A43 South Midlands Network	155	116
	A65 (M6) Cumbria to Bradford	65	104
	A21/A27 Weald and Downland	72	142
	A36/A303 Wessex Link	124	105
	A13 Thames Gateway	23	146
	A40 West London Approach	15	75
	M6 Junction 44 to Guardsmill ^*	6	42.3

(^* This project is being procured by the Scottish Office, on behalf of the Agency, as part of the M6 DBFO project. The Junction 44 to Guardsmill scheme is subject to completion of the statutory procedure and authorisation by the Secretary of State.)

DBFO Projects

Figure 1.1

The map at Figure 1.1 shows the distribution of DBFO road projects. To the road user there are no significant operational features to distinguish a DBFO road from the rest of the trunk road network. The principal difference is that it is now the private sector, rather than the Agency, which bears most of the risks attached to designing, constructing, financing and operating the road. The Agency pays the private sector for the road service delivered, such payment being linked directly to the number and type of vehicles using the project road, up to an agreed cap.

1.2 History & Objectives Of DBFO Projects

The Department announced in November 1992 that private sector companies might be invited to tender for DBFO road contracts. Some discussion of the DBFO concept was included in the Green Paper, Paying for Better Motorways, which was published in May 1993. The Department carried out further detailed consultation with a number of potential participants in Spring 1994.

The Agency formally launched its use of the Private Finance Initiative (PFI) to procure a road service on parts of the motorway and trunk road network in August 1994. The Agency's objectives for each DBFO project were:

to ensure that the project road is designed, maintained and operated safely and satisfactorily so as to minimise any adverse impact on the environment and maximise benefit to road users;
to transfer the appropriate level of risk to the private sector;
to promote innovation, not only in technical and operational matters, but also in financial and commercial arrangements;
to foster the development of a private sector road-operating industry in the UK; and
to minimise the financial contribution required from the public sector.

The service includes assuming responsibility for the operation and maintenance of a length of existing road (where relevant) and ensuring that specified construction scheme(s) along the length of road are constructed and made available for road users. The private sector is subsequently responsible for the operation and maintenance of the new sections of road.

The main benefit of PFI is that, by transferring to the private sector responsibility for designing, constructing, financing and operating road scheme(s), the private sector will consider its obligations as a whole, over the 30-year life of the contract, taking full account of the risks inherent at each stage of the project. (There is, of course, the contractual requirement that the project road will be of economic use for much longer than 30 years and will be handed back to the Agency with a specified life expectancy.) For example, there is a direct relationship between the way a scheme is designed and constructed and its whole-life operational costs. The private sector chooses how to provide the service to the level specified by the Agency. Allocation to the private sector of project risk, which it is capable of managing, leads to an efficient service and a lower whole-life cost for the Agency.

For Agency employees, the introduction of the DBFO programme has resulted in their role changing from procuring the design and construction of a scheme, to compiling the output specification for the road service, reviewing the bidders' proposals for the design and, following contract execution, monitoring performance. In addition, the procurement skills within the Agency have changed as a result of using the negotiated procedure. The review process, in particular, is critical. The Secretary of State cannot delegate his responsibility for providing a safe and efficient road network. The Agency engineers therefore have to satisfy themselves that the bidders' solutions meet the Agency's requirements for a project. It is also vital that the private sector solution ensures that all environmental, safety or other undertakings made by the Agency in relation to a road scheme are honoured.

1.3 Previous Method Of Procurement

The previous method used by the Agency for procuring construction and maintenance of a road was to let contracts for separate tasks. For example, there would be a design agent, a contractor and a maintenance agent. Although each party may have been performing its specified task efficiently, there was insufficient incentive for the parties to collaborate to maximise overall value for money for the Agency, especially in terms of whole-life costs and quality.

The Agency would let a construction contract which required the contractor to build to the Agency's design. (More recently, the Agency has let design and build contracts which link these two functions.) Payment would be made by the Agency on the basis of measured progress in construction. Fixed rates were agreed on the basis of a detailed specification. However, the assumptions on which the contractors gave fixed rates often led to numerous claims. Once a contract was let and the contractor was on site, claims could be made against the Agency for additional costs. For example, claims would be made for unforeseen ground conditions, necessary variations to the works for carriageway and structures or measurement variations. A National Audit Office report stated an average increase of 28%, between tender and out-turn price, based on a sample of 42 road construction contracts each worth over £0.5 million (although a proportion of the cost increase quoted resulted from the Agency's required changes). Increase of this magnitude has a significant effect on Agency budgeting.

Cars One of the objectives of DBFO procurement is to minimise claims by transferring certain risks and responsibilities to the private sector in order to achieve better value for money. As a consequence there are very few circumstances in which the Agency's liabilities under the DBFO contract, agreed at the outset, can be increased.

1.4 Key Messages

The key messages of this case study are:

DBFO contracts have accelerated the introduction of cost efficiencies, innovative techniques and whole-life cost analysis into the design and construction of road schemes and the operation of roads (although the Agency had started to review these possibilities in the context of traditional methods of procurement).
The full potential of efficiencies, innovation and whole-life cost analysis inherent in PFI is likely to be fully unlocked only when the private sector is involved in the outline design of the road scheme, which they are then obliged to construct, operate and maintain under a DBFO contract. This requires the private sector to assume some planning risk. Some of the DBFO projects announced introduce the concept of planning risk and will test the proposition that this will deliver better value for money.
The risk allocation on DBFO contracts has been encouraging. Two areas where transfer of risk to the private sector has delivered good value for money are protestor action and latent defect risk. The Agency will continue to look for risk transfer to ensure that the DBFO contract liabilities remain off-balance sheet.
DBFO contracts have delivered value for money. Cost savings (compared with the public sector comparator) have ranged from marginal to substantial; for Tranche 1 and 1A DBFO contracts, the average cost saving is 15%.
Use of a model contract as the basis of negotiation for each DBFO contract saves bidders time in preparing their bids and provides significant efficiencies for the Agency, both in negotiation and in operating the contracts. The updating of the model contract is welcome as it will reflect changes to provisions arising from negotiation.
Training in negotiation for project teams and dissemination of accumulated knowledge on DBFOs - and PFI generally - within the Agency continues to improve the quality of DBFO projects delivered.
When devising the payment structure, the contracting body should determine what its objectives are for the service being provided, and the payment mechanism should be designed to incentivise the private sector to achieve those objectives.
With eight contracts let and expressions of interest received for further projects, it is clear that a road-operating industry is developing. The same consortia (with a few changes in composition) have appeared as bidders on projects within each group.

Chapter 2 - The DBFO contract

2.1 Overview

By the time of contract award each successful consortium had formed a special purpose vehicle company (DBFO Co) to enter into the DBFO contract with the Secretary of State. Although the Secretary of State is the counter-party to the DBFO contract, the Agency has executive responsibility for its administration. The DBFO is principal legal relationship between DBFO Co and the Agency. Broadly, the DBFO contract fixes the outline design for the road schemes in the project; specifies the with the construction works must comply and gives a date for completion of construction; and specifies the operational service requirements for any existing road and any new road, once constructed. In return DBFO Co receives a payment from the Agency based on the number and type of vehicles using the project road (shadow tolls). The payment mechanism is explained in greater detail in 2.2.

References throughout this case study to the DBFO contract(s) refer to the eight contracts signed on Tranches 1 and 1A, although the case study should not be read as an interpretation of those contracts or any clause within them. The signed DBFO contracts differ in their treatment of certain provisions although the description of the contract terms is generally accurate. The terms of the DBFO contract are not set in stone. In some instances the italicised sections refer to proposed changes to the model DBFO contract (which forms the starting point for negotiation). Nothing in this case study precludes the possibility of future change to the model DBFO contract, or the procurement process, as the Agency and bidders develop the application of PFI to DBFO road projects.

The DBFO contract period is for 30 years from the commencement date. That period was selected because finance for this type of project generally has a maximum repayment period of around 20 years and the payment mechanism had to be structured to allow repayment of debt over a similar timescale (making allowance for a reduced payment stream in the initial years until the road scheme(s) are completed and a 'buffer' period after anticipated debt repayment in the event that cash flows are less than, or come on stream later than, anticipated). Since 30 years is currently beyond the range of conventional debt, the choice of period also encouraged financial innovation, use of alternative sources of funding and the possibility of re-financing after the completion of construction, all of which can provide financial benefits to the Agency. It was also important that the contract period was sufficiently long to allow DBFO Co to apply whole-life costing to the project road.

Bank funders are now prepared to look at longer repayment periods and bonds may have a repayment period of up to 25 years or more. For the next DBFO projects the Agency will allow bidders to provide variant bids based on their preferred contract period. A longer period may allow DBFO Co to introduce further cost savings, because it has greater freedom to take a strategic view on the method, and prioritisation, of road maintenance. The introduction of road schemes which have not obtained final statutory approval at the time of tender invitation (contingent schemes) may also mean that longer contract periods are attractive. As contingent schemes will take time to complete the statutory process, revenue from them will only come on stream later in the contract period. A longer contract period will allow more time for full cost recovery.

Because the DBFO contract represents a long-term obligation on DBFO Co, there is recognition that circumstances existing at the start of the DBFO contract may change. Some specified change situations represent risk which DBFO Co is asked to assume; and where the contract is silent, DBFO Co bears the risk of change. However, the Agency reserves the right to change the technical or commercial requirements under the DBFO contract. Where such a change alters DBFO Co's costs or the traffic flow on the project road, the shadow tolls are revised. The change mechanism is discussed in more depth at 2.6.

DBFO Co takes responsibility for financing the construction costs. The risk of being able to finance the costs of the project is for DBFO Co. However, because the availability of funds is so fundamental to the success of the project, the Agency was not prepared to enter into the DBFO contract without evidence of formal commitment from funders. When DBFO Co is referred to as bearing the financing risks, (ignoring the obvious risk of cost increases) this should be interpreted as bearing the risk of movement in the interest rate after contract award (which can be mitigated by the use of financial derivatives) and the risk of default under the debt and derivative facilities.

2.2 Payment Mechanisms & Incentives

Payment is made for the provision of the road service. The Agency pays DBFO Co an amount which is based on the number and type of vehicles using the road, with adjustments made for lane closure and safety performance. The payment mechanism was structured to meet Government policy objectives for the trunk road network and PFI requirements. It incorporates payment based on the following three criteria:

Usage/demand - shadow tolls involve payment per vehicle using a kilometre of the project road, in accordance with a tolling structure. They are referred to as 'shadow', as opposed to real, tolls because the payment for usage is made by the Agency, rather than the road user. The shadow tolls increase over time in accordance with an indexation formula.

Different payments are due for traffic within different traffic bands and dependent on the length of vehicle. Bidders were asked to bid the parameters of traffic levels for a maximum of four, and a minimum of two, bands, with the proviso that the top band - anything exceeding X vehicle kilometres p.a. - must have toll levels set at zero to ensure that the maximum liability of the Agency under the DBFO contract is capped.

Within each traffic band the bidders specified a toll for two categories of vehicle; long vehicles (over 5.2m - which, most importantly, includes HGVs) and short vehicles (less than 5.2m). There is no available method of differentiating between the weight of vehicles, and therefore length measurement was used as a proxy for weight.

Bidders set the bands and tolls from their own assessment of traffic levels. Most bidders opted for four bands with the lowest band representing a cautious view of traffic and tolls within that band set at a level that would cover debt service requirements (but would not provide a return on equity). Figure 2.2a shows a typical banding structure proposed by bidders.

Figure 2.2

Availability of service - where the project road consists of an existing stretch of road with one or more construction schemes along its length, then (prior to the completion of any construction scheme) shadow toll payments will be made at a reduced level representing the cost of operation and maintenance for the existing road. This level varies substantially depending on the nature of the DBFO project. In the case of the M1-A1 project, which is virtually all new build, no payment is to be made until the Permit to Use is issued for the road to open to traffic.

Generally, once the Permit to Use is issued for a construction scheme and the road is open for traffic, DBFO Co receives 80% of the full level of traffic payment. When the construction works are completed and the Agency has issued the Completion Certificate, DBFO Co receives 100% of the traffic payment.

In most cases the toll payments step down again at the time when it is anticipated that the third party debt will have been fully repaid. This reflects the fact that revenue in excess of operating and maintenance costs at that stage is solely return on equity.

Figure 2.2b shows a typical payment profile, assuming no variance in traffic or adjustment for lane closure or safety performance. The increase in payment over time during each 'step' results from indexation of tolls. Issue of the Permit to Use is marked 'A', issue of the Completion Certificate is marked 'B', and 'C' shows the point at which third party debt is anticipated to be repaid.

Figure 2.2b

For future DBFO projects, bidders will be asked to bid a fixed payment for the availability of any existing road, prior to the completion of the construction of the schemes. This will be easier to administer, given the number of possible schemes within a project, and recognises that payment reflecting availability is a sensible component of the payment structure. To incentivise scheme completion, fixed payments will be capped below the costs required to maintain the existing road.
Performance - There are two aspects to performance payments: safety performance payments and lane closure charges.

One of the Agency's key objectives is to reduce accident levels on the trunk road network. In order to incentivise DBFO Co to address safety it is encouraged to suggest safety improvement schemes for Agency approval. If these improvements are agreed, DBFO Co constructs and pays for the scheme and is recompensed by receiving 25% of the economic cost of each personal injury accident avoided in the following five-year period. Accidents avoided are determined by comparing the actual statistics with data over the three years prior to the implementation of the scheme.

Disturbance and delay caused by lane closure is a significant performance issue to both the Agency and the road user. A deduction is made from the toll payment when lanes are closed. The size of the deduction is dependent on the number of lanes closed, the duration of the closure, the expected traffic at the time of closure (which encourages scheduled closure for maintenance at off-peak times) and the economic value of user delay which can differ between business and leisure use. Lane closure charges are only made for closure within the control of DBFO Co, for example no deduction is made for closures required by the police (in the case of accidents and emergencies) or utilities.

In Tranche 1 and 1A DBFO contracts safety payments act as a bonus. To ensure that DBFO Co actively addresses safety, this payment criterion will be strengthened for future DBFO projects. The safety payment will act as a bonus and as deterrent. If the trend of road accidents on a project road is worse than national trends for a similar type of road, deductions will be made from payments due.

For future DBFO projects, DBFO Co will also be required to deliver five-year rolling operational plans setting out their view on how best to operate the project road. The plans must contain proposals on issues such as safety, facilities for pedestrians and environmental protection. Although the plans will be set by DBFO Co and have no payment attached to their performance, the Agency will reserve the right to publish them so that the road user will be able to monitor performance against expectations. This is another example of the potential movement towards operational performance as the most important test of service delivery.

The issue of whether shadow tolls provide the most appropriate basis for payment is highlighted on urban DBFO projects, such as the A13 and A40 projects, where traffic is consistently heavy and there is consequently little traffic risk. Therefore, in relation to these urban projects, the Agency intends to refine the payment mechanism in order to improve the incentives on DBFO Co to optimise the road space, to improve safety performance and generally to take steps to improve performance of the route to the benefit of the road user.

2.2 Service Specification

When drawing up the service specification, the Agency's engineers examined the processes which they would go through and the considerations which the Agency would have to bear in mind when designing a road scheme and procuring its construction, operation and maintenance. The engineers had to identify only the fundamental requirements for design, construction, operation and maintenance of the project road (core requirements) so that, wherever possible, the bidders would be allowed to innovate and add value. The core requirements are part of the output specification for the DBFO projects.

Core requirements for construction included compliance with the undertakings of the Agency given at Public Inquiry, adherence to the Orders made and meeting the objectives of any Environmental Statement. The Agency also provided standards, design data and its own design proposals (existing design) which would be one option for meeting the core requirements (illustrative requirements) with the Invitation to Tender. The illustrative requirements were not mandatory, but served as a benchmark for evaluation. Bidders were encouraged to offer alternative proposals and consult with the Agency's project team throughout the tender process to ensure that their proposals would be capable of delivering the same, or better, level of service as the illustrative requirements.

For the first DBFO projects full statutory approval had been gained for all road schemes before contract award. This meant that the outline design had been put to a Public Inquiry and fixed in statutory Orders which are necessary to construct the schemes and acquire the necessary land. Although the outline design was fixed, there was still scope for innovation and cost savings in working up the detailed design.

Bidders varied in their approach to proposing changes to any existing design. Some bidders seized the opportunity and proposed numerous departures from the Agency's illustrative requirements and existing design.

Some bidders also applied value engineering techniques throughout the procurement process to reduce construction costs by optimising the Agency's design. The changes to any existing design could not require any change to the land required for construction, as the acquisition of land and settling blight claims remained the responsibility and risk of the Agency. However, DBFO Co could acquire additional land, through negotiation with private landowners, to reduce construction costs.

In response to bidders' calls for more scope to innovate, the Agency is introducing with some future DBFO projects contingent schemes with a degree of planning risk attached. Some contingent schemes will have completed the approval process by the time of contract award; others are at an earlier stage, in some cases with only a preferred route announced. The Agency will set out in the Invitation to Tender its assessment of how the risks attaching to these types of schemes should be allocated between the Agency and DBFO Co. The basis for that allocation will be an assessment of which party is best able to manage the risk in question.

2.4 Penalty Points & Monitoring

Road One of the main operational issues for the Agency is how to ensure that DBFO Co complies with the terms of the DBFO contract post-award. Under the terms of the DBFO contract the Agency appoints representatives to monitor the construction, operation and maintenance carried out by DBFO Co to ensure that it complies with its contractual obligations. The Agency has expressed its desire to remain as 'hands-off' as possible in monitoring the contract.

Mentioned in 2.2 is the concept of operational plans, which requires DBFO Co to set its own operational standards. The requirement for delivery of operational plans is intended to ensure that DBFO Co continually addresses how best to operate the project road. The Agency reserves the right to publish the plans, so that road users will be able to monitor performance against expectation.

The DBFO contracts contain a penalty point mechanism which attributes points to failure to perform under the contract. The allocation of penalty points above a specified threshold triggers increased monitoring requirements. Once a specified number of penalty points has been exceeded, the Agency has the right to terminate the contract.

The Agency also has a number of other remedies arising from non-performance, including the right to remedy any default itself and invoice DBFO Co for its costs.

2.5 Change Procedure

The DBFO contracts represent the Agency's current approach on how to meet demands on each project road, but circumstances will change over the 30-year contract period. Therefore the Agency needed to reserve the right to change the service specification during the contract period, because it retains responsibility for strategic management of the whole network.

However, the bidders would not enter into an agreement where there was the possibility of the Agency changing the specification at extra, unanticipated cost to them. The solution was for the DBFO contract to contain scope for possible changes required by the Agency, and for the method of adjusting the payment mechanism to allow for the change in costs or effects on traffic flow. The main changes that the Agency can require are:

change to the agreed specification of the design, construction or operation and maintenance of the project; and
additional works on the project road (ie. in addition to the road schemes included in the DBFO project). The additional works may be procured either by DBFO Co, as project manager for the Agency, or by the Agency, in which case DBFO Co can compete for the construction works.

The method of calculating the adjustment in tolls is set out in the DBFO contract. First, the party raising the change identifies the change in costs and/or traffic. Generally, the effect of the change, either on its own or cumulatively with other change costs, must exceed a specified threshold before the toll revision mechanism is operated. If the changes or the issue of whether the threshold has been exceeded cannot be agreed they are referred to a disputes resolution process. The revised costs and/or change in anticipated revenues, caused by a change in traffic, are put into the financial model of the project to establish a revised Net Present Value (NPV) of net cash flow. Adjustment is then made to future toll levels (either up or down) to ensure that the NPV of net cash flow (as shown in the financial model) is the same as before the eligible change.

2.6 Termination Of The DBFO Contract & Step-In Rights

The DBFO contract sets out the events of default, in relation to each party, which give the other party rights to remedy and terminate. In relation to DBFO Co, events of default include:

insolvency (which also applies to a sub-contractor or shareholder, if its insolvency would have a material effect on the ability of DBFO Co to perform its obligations under the DBFO contract);
change of control in DBFO Co without the consent of the Secretary of State;
serious breach of obligation, for example, abandoning construction of a road scheme or failure to complete construction by a long-stop date; and
exceeding a maximum number of penalty points awarded within a given period.

The Agency will consider requests for consent to alter control of DBFO Co, in light of current guidance (which is to allow greater freedom on transfer of equity) and the merits of each case. The Secretary of State must also act reasonably when considering whether to approve a change of control. The Private Finance Panel generally recommends that change of control in the equity of DBFO Co should not be a default trigger, cf. HM Treasury and Private Finance Panel guidance referred to in 2.8.

If an event of default has occurred, the Agency has a range of remedies of increasing severity. The remedies include the right to suspend payment to DBFO Co, the right to call for DBFO Co to present a programme for remedy and the right to terminate the DBFO contract in full without compensation.

The events of default, in relation to the Agency, which allow DBFO Co to terminate the DBFO contract with compensation include:

sequestration of the project road and/or facilities by the State;
the Secretary of State ceasing to be the highway authority; and
failure to pay amounts due to DBFO Co within a specified period.

In addition to the rights of termination above, there are the following 'no fault' termination rights:

either party has the right to terminate after a consultation period if there is a continuing force majeure event, such as war, which materially affects either party's performance of its obligations for a specified period; and
either party can terminate if there is a change in law rendering it illegal or impossible for DBFO Co to perform its obligations.

Once either party has served a termination notice, there is a period for challenging the notice. If the project road is not being run safely, the Agency has the right to take over its operation almost immediately. Termination of the DBFO contract does not release DBFO Co from any accrued obligation under the DBFO contract.

On termination of the DBFO contract, DBFO Co hands the project road (and any uncompleted works on it) back to the Agency. DBFO Co must transfer its interest in any construction, operation or maintenance contract let for the project road to the Agency. Once the transfer is complete, DBFO Co must vacate the project road and clear all unwanted movable equipment from it.

If termination results from DBFO Co's default, no payment is due from the Agency to DBFO Co or its funders. Figure 2.6 shows the circumstances in which the Agency will pay compensation on termination, who is compensated and what for.

Figure 2.6

^*costs/liabilities include adviser costs, liabilities to sub-contractors and internal management costs.

2.7 Expiry Of Term

Throughout the life of the DBFO contract the Secretary of State retains ownership of the road and underlying land. DBFO Co has a right of access to the road and necessary land. At the end of the term the project road and all fixed facilities on it must be handed over to the Agency and DBFO Co's right to access terminates, without cost to the Agency. This is because the Secretary of State cannot legally dispose of the road.

The DBFO contract specifies the standards which the project road must meet at the time of handback. Simply, the standards require the project road to be handed back to a specification based on the residual life of the different elements of the project road. Towards the end of the term there is a mechanism for inspection and agreeing the action which is needed to ensure that the handback criteria are met at expiry. The first joint inspection of the road surface and all structures takes place five years before expiry. A programme of works is agreed, if necessary. The second joint inspection of all the project road facilities takes place around 18 months before expiry. If the criteria are met on the expiry of the contract period, then the Agency's representative can issue the handback certificate.

From five years before expiry, the Agency can withhold 40% of payments due to DBFO Co, up to an amount equal to 40% of the estimated value of remedial works necessary, and apply these funds to remedy defects if handback criteria are not met at expiry. The Agency retains the risk that, at expiry, the funds retained are not sufficient to cover the cost of remedial works which have not been carried out (although DBFO Co would remain liable for the balance of the cost).

2.8 Bidders' Structural & Financing Issues

Equity

Bidders are required to disclose, both at the prequalification stage and in their bids, details of the proposed equity ownership of DBFO Co, including identity and percentage stake of each shareholder. The purpose of asking for this information is to enable the Agency to select bidding consortia on the basis of their members' track record, experience and commercial strength.

There were several occasions during the procurement period when the commercial identity of the members of the bidding consortia changed. One example was on the M1-A1 project where the preferred bidder was a consortium initially comprising Trafalgar House and Wimpey. Trafalgar House was subject to a take-over bid by Kvaerner, and Tarmac and Wimpey carried out an asset swap (including Wimpey's roads business). Trafalgar House had to find a partner to replace Wimpey, and Balfour Beatty joined the consortium as the replacement. There was delay but, by allowing the consortium to reassemble in a form acceptable to the Agency, the Agency retained the consortium's Best and Final Offer, which was good value for money.

Difficulties of this sort within the private sector can potentially make the procurement process more difficult for the procuring body. However, the M1-A1 example demonstrates how the public sector can handle such situations and still achieve a good value for money contract and maintain a fair competition.

The equity position is crystallised at, or before, the time of contract award when the consortium members subscribe for equity in DBFO Co. Unless DBFO Co has obtained the consent of the Secretary of State, a shareholder cannot transfer any of its equity. Although the DBFO contract initially confers absolute discretion on the Secretary of State, he is always expected to act reasonably in the exercise of any discretion.

Some contractors have indicated that they do not wish to retain a long-term involvement with a DBFO project once it enters the operational phase. They have argued for greater freedom to dispose of their equity, releasing funds to invest in other projects. Some parties argue that a maturing road-operating industry should allow for recycling of equity, with investors who are looking for a lower risk, lower return investment buying out the contractor shareholder's equity once the construction risks have passed. The argument for greater freedom on transfer of equity is set out in HM Treasury and the Private Finance Panel's guidance 'Transferability of Equity'.

Sources of finance

The sources of finance for the costs of DBFO projects are equity and debt. To date, all pure equity contribution has come from project sponsors. However, some quasi-equity, in the form of subordinated debt, has been contributed by third party investors. In future, equity may come from investment funds which have been set up to provide equity for PFI projects. So far, the nature of the commercial arrangements (particularly restriction on the transfer of equity) has either not required, or not been suitable for, third party equity.

Debt finance has been raised through commercial bank debt, funding from the European Investment Bank (EIB) and the proceeds of a bond issue. As funding costs are built into the unitary payment as a project cost, healthy competition amongst funders to reduce funding costs is to the Agency's advantage.

The bank facilities provided have had a repayment period ranging from 15 to 20 years and margins of between 120 and 140 basis points. The facilities are 'limited recourse', as the debt is serviced out of cash flow generated by the project road and the banks look only to the assets of their borrower, DBFO Co (although in certain instances the banks have taken specific shareholder guarantees).

EIB has provided funds on three projects at financial close. EIB's function, as a lending institution backed by EC member states, is to finance projects which will contribute to the balanced development of the EC. The DBFO roads programme has been designated as within the scope of its objectives. EIB is non-profit making and can therefore lend at a reduced margin above its costs of funds. It will not take construction phase risk, and therefore bank guarantees need to be in place to support its loan during the construction phase. In practice, the time and internal approval processes required by EIB to provide funds meant that it was difficult for bidders to blend EIB and commercial bank or bond funding. Some bidders found that the difficulty involved with EIB funding outweighed the potential cost saving.

A guaranteed, secured bond worth £165 million was issued by Road Management Consolidated PLC (RMC) - a company formed by the Road Management Group - to fund the construction costs of two DBFO projects (the A1(M) and A417/A419). The DBFO contracts were awarded to two subsidiaries of RMC. The repayment of the bond is to be spread over the last 20 years of a 25-year term. The bond was supported by an unconditional guarantee of principal and interest payments from AMBAC Indemnity Corporation and consequently received an AAA rating. The coupon on the bond was 9.18%.

Funders require security over the assets of the project company. In the case of DBFO Co, the principal asset is its rights under the DBFO contract. In the event that DBFO Co fails to perform, the Agency has allowed the funders 'step-in rights'; these provide that if the Agency is in a position to terminate the DBFO contract, it will first allow the funders to take over operation themselves for a limited period during which they may try to find a replacement operator. The relationship between the funders and the Agency on step-in rights is set out in the Direct Agreement.

2.9 Contract Structure

A typical contractual structure is shown in Figure 2.9. The diagram shows how DBFO Co - by means of the construction, and operation and maintenance sub-contracts - allocates a large proportion of the performance of its contractual responsibilities and risk assumed under the DBFO contract.That risk allocation is not, of course, binding on the Agency, which continues to look only to DBFO Co for performance of the service. The construction sub-contract is typically let on a fixed price, turnkey basis. The construction sub-contractor is, in turn, able to let fixed-price sub-contracts for the majority of the construction work undertaken by it.

There is no fundamental requirement for DBFO Co to have a construction company amongst its shareholders, provided that it can demonstrate an acceptable method of procuring the construction work in accordance with the core requirements.

In the UK there were no existing private sector road operators before the DBFO initiative began. Continental private sector road operators have been involved with bidding consortia and, in some cases, have taken an operation and maintenance sub-contract from DBFO Co (either solely or as a joint venture with other shareholders). The operation and maintenance contractor has, in some cases, let a contract for routine maintenance to either a company or local highway authority with maintenance agent experience. The terms of the maintenance contract are similar, in respect of winter and routine maintenance, to existing Agency maintenance arrangements. Because the maintenance contract specifies work required at fixed rates, the operation and maintenance contractor retains the real operating risk. A statutory instrument has been made to allow local highway authorities (which have traditionally provided maintenance services to the Agency) to be sub-contractors to DBFO Cos, subject to competition, provided that the sub-contract is for no longer than five years.

For the first DBFO projects there was no experience of how well the private sector would achieve the risk allocation and sub-contract management. The Agency has taken the view that it should ensure that the terms of the sub-contracts are acceptable at the time the DBFO contract is awarded. However, if the DBFO contract is structured so that payment is at risk if the service is not available or is sub-standard, then this should motivate DBFO Co to manage its sub-contractors to comply with the service levels required. The Agency expects to review its position in the light of continuing experience.

The Agency has not asked for shareholder guarantees and collateral warranties from sub-contractors. This is in line with the PFI principle that the Agency should look only to DBFO Cos to perform the DBFO contract obligations and to remedy a default situation. The Agency has required a performance guarantee from DBFO Cos in the form of a bank guarantee for an amount varying in accordance with the value of the construction costs of the project. The performance guarantees are released when a specified milestone in respect of the construction is satisfied.

Figure 2.9

Chapter 3 - Risk transfer and value for money

3.1 Public Sector Comparator

For each DBFO project, the Agency needs to decide whether the proposed contract offers value for money compared with conventional procurement. To assist in this decision the Agency prepares a public sector comparator (PSC), which is calculated by costing what the public sector would have had to pay to procure the construction of the relevant schemes and the operation and maintenance of the project road over 30 years by traditional means. The calculation includes an assessment of the risk resting with the Agency under conventional procurement.

The Agency prepares an assessment of NPV of the PSC, and compares this with the NPV of the projected payment under the DBFO contract (although the Agency has also to take into account other value for money considerations which may not be quantifiable but may be significant, for example, environmental considerations or other policy objectives).

Taking into account all these considerations, both the Agency's Accounting Officer (the Agency's Chief Executive, who is answerable to Parliament for the Agency's commitments) and the Minister approving the contract need to be satisfied that value for money is best achieved by means of the DBFO contract.

3.2 Risk Allocation

Project risks should only be transferred to the private sector if, and to the extent that, the private sector is capable of managing such risk. DBFO contracts have transferred to the private sector a substantial degree of responsibility for constructing, operating and maintaining the project road and financing the relevant costs. Transfer of responsibility increases the scope for innovation by the private sector. The risks associated with those obligations are transferred to the private sector, so that even if a risk materialises, the specified service has to be provided to the Agency at the price agreed at the outset. The private sector is thought to be better able to manage certain risks.

A motorway and a road under development The Agency carried out an analysis of the risks attaching to a project by drawing up a risk register setting out in detail the risks relevant to each stage of the project, the likelihood of those risks occurring and an estimate of the financial impact of occurrence. This analysis helped the Agency to establish what type, and the quantum, of risk that they should ask the private sector to take. The DBFO contract is drafted so that DBFO Co bears all risks associated with an area of delivery, such as operation, unless the Agency is specified to take a risk, either through the payment mechanism, change mechanism, termination events or other contractual mechanisms. Therefore any unanticipated risk will be borne by the private sector.

3.3 Discussion Of Specific Risks

Under a PFI contract, the private sector will generally be asked to take the following risks:

construction and operational cost overruns;
delay in delivery of the service;
design of the underlying asset not delivering the agreed service; and
changes of law, including tax law changes, which impose additional or increased costs on the operator (other than any change of law which discriminates against private sector operators).

DBFO contracts are structured to leave these risks with DBFO Co. The allocation of risks which may be unique to DBFO contracts include:

Traffic risk - The number and type of vehicles using a road affect the cost of constructing a road with a reasonable life expectancy, and the cost of maintaining it to the required standard. The Agency has its own traffic projections for the project road, which are updated forecasts based on traffic models devised for the initial investment decision for individual road schemes within the DBFO project. The updated traffic forecasts are kept confidential. The Agency developed a probability distribution for traffic based on analysis of actual traffic against traffic forecasts for a large number of different schemes. The Agency's updated forecasts were used during evaluation to calculate how much risk each bidder's payment structure would place on its revenue stream at the Agency's 'most likely' traffic forecast.

The Agency's forecasts are kept confidential to encourage the bidders to take their own view of traffic growth. The Agency provides the underlying data such as the existing traffic counts, to facilitate bidders' forecasts. If the Agency had disclosed its forecasts the bidders might not have put the same emphasis on forming their own view of traffic.

Bidders whose traffic forecasts underestimated traffic, compared with the Agency's forecasts, attached little risk to the payment stream, resulting in poor value for money. Bidders which overestimated traffic growth and weighted return in the higher bands, attached more risk to the payment stream and therefore provided better value for money. A bidder's assumptions on traffic growth may be so optimistic that, in the Agency's view, the proposed structure is financially unstable.
Protestor risk - The increase in direct action to delay construction of new roads has placed extra cost on the Agency. On some DBFO projects there is the possibility of protestor action. The Agency recognised that value for money might, in some circumstances, be adversely affected if the bidders were asked to bear all the costs of protestor action. However, DBFO Co would be in control of the works and therefore in the best position to determine the strategy to deal with problems. Bidders were asked to price three risk-sharing options - risk transferred, shared and retained by the Agency.

The end result of negotiations was generally a project specific, risk-sharing arrangement between the Agency and DBFO Co, with much of the risk transferred to DBFO Co. This provided encouraging evidence of the bidders' willingness to accept new types of risk.
Latent defect risk - Where a DBFO project requires DBFO Co to take over responsibility for operating an existing length of road, bidders had to take a view on the state of the road and any structures on the road. Their technical advisers carried out investigations but there may be problems which could not be detected or 'latent defects', such as the spalling of concrete or a structure component not meeting the expected design life. Bidders were asked to bid on the same three risk-sharing options as for protestor action. It is evident from negotiations that bidders were prepared to take a large measure of latent defect risk. In light of this, the future allocation of risk for latent defects will not be a biddable option and bidders will be required to bid on the basis that they accept this risk.

The bidders were prepared to take latent defect risk because of the background of the consortium members. All consortia contained experienced contractors who had previously carried out road maintenance for the Agency and therefore had an appreciation of the risks involved.

3.4 Other Risks

In addition to the risk of changes in cost or delay caused by Agency action under the change procedure, described in 2.6, the Agency retains the risk of any change(s) to costs or traffic caused by failure or delay by the Agency to give DBFO Co access to the site. In the event of such occurrence, the Agency is obliged to compensate DBFO Co through the change mechanism.

To date bidders have not been asked to take planning risk, as all the schemes in Tranche 1 and 1A projects had been through Public Inquiry. This meant that schemes had made Orders, in most cases before tender documents were issued and in all cases before contract award. This made the procurement process shorter and less complicated for bidders but, as discussed above, because the statutory approval process fixes the outline design within the Orders, innovation by the bidders is limited.

For the reasons given in 2.1, possession of the underlying asset reverts to the Agency automatically at the end of the contract term. Bidders are only likely to take a significant degree of residual value risk when the underlying asset to the service remains with the private sector at the end of the contract. However, DBFO Co does take an element of the residual value risk as it is obliged to hand back the project road to a pre-agreed standard.

3.5 Pricing Of Risk

In order to build up a genuine public sector comparator, it was necessary to attribute a figure to the risks previously taken by the Agency (where traditional methods were used to procure the underlying asset) which would be transferred to DBFO Co. In respect of the likely cost overruns on a construction contract, the Agency has access to relevant data on traditionally procured contracts. In other cases risk was priced by the Agency's own experts giving their best estimate of possible costs and likelihood of occurrence. For Tranche 1 DBFO projects, risk-adjusted prices were prepared both by the project team and independently by risk consultants. There was a high degree of consistency between the two sets of results.

3.6 Accounting Process

Aerial view of a road under development The Agency needed to consider how each proposed DBFO contract would be accounted for in the resource accounts currently being prepared by the Agency and the consequences for public expenditure. The accounting treatment of the DBFO contract simply reflects whether the private sector did indeed bear the risks and responsibilities akin to delivering a service rather than an asset. Off-balance sheet accounting treatment should not be an aim in itself.

The Agency developed a strategy for taking a view on the accounting treatment before contract award. The Agency's accounting advisers devised a mechanism for testing the risk allocation in a DBFO contract which was agreed by the Agency's auditors, the National Audit Office (NAO). In addition, the NAO gave informal indications in relation to specific DBFO contracts throughout the negotiations.

Chapter 4 - The process

4.1 Project Approval

Before entering the procurement process a DBFO project has already cleared the following hurdles:

Identification of the projects - Once the decision was made to progress road schemes using PFI, the Agency put together proposals which would meet the objectives set, and be attractive to bidders. The Agency's proposals were put to Ministers who took the final decision on which schemes to progress as DBFO projects. Tranche 1 was also used as an opportunity to test a range of projects typical of the trunk road network, ranging from bypasses to new four-lane motorways, to find out which types of project were more likely to deliver value for money. All the construction schemes included had to have obtained final statutory approval.
Conclusions can now start to be formed on the type of DBFO project which can deliver best value for money. The Agency will draw on this knowledge when devising future DBFO projects.

DBFO is likely to be an important procurement option for the Agency in future, and therefore subsequent DBFO projects will be focused on the strategically important lengths of the road network with the greatest need for investment.
Affordability - The Agency had to consider the affordability of the potential liabilities in respect of the projects against the overall provision made available by HM Treasury.
Business case - No separate business case for the DBFO project as a whole was developed. The Agency relied on a cost/benefit analysis (COBA) which is specific to road schemes and gives economic value to the non-tangible benefits which schemes are designed to deliver, such as reduced journey times, reduced vehicle operating costs and reduction in accidents. Each of the schemes included in the project had successfully passed a COBA analysis as part of the admission criteria to the National Road Programme. Project proposals which include schemes with higher COBA ratios are more attractive as they deliver greater benefits for money spent.

4.2 Timetable

Figure 4.2 shows a Gantt chart of the stages in a typical DBFO project. The chart shows that the average time taken, from placing the Official Journal of the EC (OJEC) notice to contract award, for Tranche 1 and 1A projects was 16 months. The issues involved are complex and these projects were some of the first PFI projects to come to the market. There was a steep learning curve for all involved. This is a substantial period for both the Agency and bidders to commit resources, and the Agency is looking at ways of reducing the time taken by the Agency, bidders and lenders at each stage. Neither side has anything to gain from delay, yet a lot to lose in proceeding to unrealistic timetables. The most likely casualty of reduced time for bid preparation would be innovation by the bidders.

Figure 4.2

The process, prior to the receipt of Best and Final Offers, is best managed by setting a timetable acceptable to both the Agency and bidders. After that stage, negotiation with one preferred bidder cannot be subject to a date for completion as that could prejudice a satisfactory outcome.

If future DBFO projects followed the same template as the projects in Tranche 1 and 1A, the Agency would expect to reduce the procurement time significantly. It is essential to the future success of PFI to reduce both the bidding time and cost for the private sector. However, it is acknowledged that where specific projects introduce significant new ideas, such as contingent schemes, additional time may be required to allow for the private sector to get to grips with the issues involved.

Once the Agency was certain that it would proceed with the DBFO projects, external advisers including lawyers, financial and technical advisers were appointed, following competition.

There was a substantial amount of work to be done to establish the programme prior to inviting prequalification. Perhaps the task of greatest importance initially was to establish market appetite. A market research exercise was carried out by the financial advisers on behalf of the Agency before the projects were advertised, in order to ascertain the private sector's interest in applying PFI to road construction and operation and their attitude to the risks involved.

The model contract - a complex document - was drafted in collaboration with all the relevant areas of the Agency, the Department of Transport and HM Treasury. Although this was a major exercise, the Agency considered it important to lay out, in the Invitation to Tender, the contractual structure around which it was prepared to negotiate - a decision which greatly assisted in later negotiations.

Statutory hurdles had to be identified and remedied, where possible. These included issuing regulations to permit local authority maintenance divisions to act as maintenance sub-contractors.

Road works Grouping the procurement of the projects into tranches has both advantages and disadvantages. The main advantages are the economies of scale for the Agency and the opportunity to compare issues being raised by bidders across the various projects. The main disadvantage is that running four procurements in parallel has strained the Agency's resources. The Agency is attempting to reduce this problem for future tranches by staggering the date for release of tender documents and return of bids. Staggering release should reduce procurement times for each project.

As DBFO develops, the advantages of grouping are likely to decrease. However, there may still be management reasons for grouping for example, where two or more DBFO projects test out a new concept (such as the A13 and A40 projects which are the first urban, rather than inter-urban, routes).

4.3 Project Management

The Agency used the same reporting and team structures for each of the DBFO projects. Figure 4.3 shows this structure. The nucleus of the project team was from the regional office responsible for the project road. The project director led the negotiation and was responsible for keeping the project on track. Special training in negotiation was given to the project directors and their teams to prepare them for the issues, and negotiating techniques, that they would encounter.

Figure 4.3

The negotiation training proved very effective and the Private Finance Panel recommend that all public sector project teams consider similar training.

The project teams were given a negotiating brief which gave them the authority to negotiate and set out the parameters to agree changes to the model contract terms. Fundamentally unacceptable changes to the model contract were clearly identified in the negotiating brief. If the project teams thought it appropriate to move outside this brief, they referred the decision initially to the central DBFO support team which could, in turn, refer it up the decision chain.

The central DBFO support team developed policy, ensured that a consistent approach was taken to all projects and acted as a sounding board for the project teams.

Cross-fertilisation of ideas between project teams was important. This was achieved by external advisers advising more than one project team and through regular meetings held during the procurement process, which the project directors, external advisers, central DBFO team and representatives of the Department of Transport and Private Finance Panel attended.

The Highways Agency Confirming Committee (HA CC) - a committee of the Agency's board of directors - was set up to give final approval to key decisions such as selection of bidders at prequalification, selection of short-listed bidders, selection of preferred bidder and contract award, and to approve procurement strategy following those decisions. HA CC was also consulted if major changes to the model contract were proposed by the project team.

The Agency reported progress to Ministers throughout the procurement process, and Ministers approved the award of each DBFO contract.

4.4 The Procurement Route

As a public sector body, the Agency has to comply with the EC procurement regime when procuring contracts. The projects were advertised under the Public Works Contracts Regulations 1991 (Regulations) using the negotiated procedure. The projects were classified as works contracts because, although the DBFO contract would be a mixed contract for works and services, on balance the predominant purpose of each DBFO project was to procure the road schemes included in the projects.

Guidance on the use of the negotiated procedure for procuring PFI projects has been developed by the Private Finance Panel in consultation with HM Treasury's Central Unit for Procurement.

4.5 Bidder Selection Procedure

Following publication of a Prior Information Notice, an advert was placed in the OJEC, briefly describing the projects and inviting those interested to apply for a prequalification pack containing more details of the projects, a description of the information required in order to be considered for prequalification and the criteria to be used to make the prequalification decision.

For each project the Agency had responses from, on average, eight interested consortia. It would have been impractical to negotiate in detail with that number of consortia (and few consortia would have wanted to proceed with only a 1-in-8 chance of being successful). In order to reduce the numbers, a prequalification process took place. The Agency took the view that four was the optimum number of bidders to promote a healthy competition and to give those chosen a sufficient chance of success to ensure their commitment to what is a long and expensive procurement exercise.

The Regulations are prescriptive regarding the background information which can be required from candidates and the criteria which can be used for prequalification. The criteria can be described as an evaluation of the technical, financial and economic track record of the bidding consortium (or its constituent members) on similar infrastructure projects involving construction, maintenance, operation and financing responsibilities (including any DBFO contract which they have won). In addition, candidates were judged on their understanding of the issues involved, their expected approach to the project including issues such as design, quality control and safety, and their organisational, managerial and technical ability.

4.6 Invitation to Tender (ITT)

Once the bidders were selected, the Agency issued the tender documents. These included:

the model contract;
more detail on the road schemes in each project and any existing road;
the core requirements for both construction and operation and maintenance phases;
the payment structure and details of what had to be bid in relation to it;
the contents list for the standard bid which had to be returned by each bidder;
areas where variation from the standard bid would be considered; and
the criteria by which the bids would be evaluated.

The bidders were asked to return their bids by a set date. If there were any queries on the tender documents, clarification was made to all bidders to ensure a level playing field.

4.7 Negotiations & Due Diligence

The period between return of bids and contract award can be divided into four stages as outlined below.

Bid clarification - The first one/two month(s) following bid return were spent by the Agency and advisers reviewing the technical solutions, ensuring that the core requirements were satisfied and, where necessary, obtaining clarification of the bids.

This review was made easier by the technical appraisal procedure followed during the preparation of the bids. Bidders were required at prescribed times to deliver information on their technical solution and to identify departures from the illustrative requirements. This procedure was designed to prevent bidders delivering a technical solution which would have been fundamentally unacceptable.

Simultaneously with the technical review, the financial advisers reviewed the financial model, proposed shadow tolls and financial package, and the legal advisers reviewed contract qualifications and other commercial aspects of the bids.

Variant bids were received. They were addressed shortly after response to the tender documents by bidders. It was decided quickly whether they were viable alternatives and worth pursuing. The most interesting variant bid related to the use of bond financing described at 2.8.

First negotiation - The initial negotiation focused on risk allocation and whether the expected NPV of the payment stream was likely to be lower than the public sector comparator. This commercial negotiation was designed to ensure that the bidders delivered proposals offering value for money. Once both parties understood each other's position on risk allocation, a re-bid was sought which formed the basis for selecting a shortlist of two or, if bids could not be meaningfully separated, three bidders.

Now that policy has developed and risk allocation is better understood and accepted, the Agency intends to save time by shortlisting without a requirement for a second re-bid.

Second negotiation - There then followed a second round of negotiation. This was an intensive phase, including significant legal input. By this stage the bidders had delivered a detailed mark-up of the model DBFO contract which formed the basis of negotiation. Following this second period of negotiation, the shortlisted bidders were asked to return their Best and Final Offer (BAFO). The BAFOs were evaluated by the Agency and the provisional preferred bidder (PPB) was selected. The runner-up was asked to keep its BAFO on the table in the event that negotiations could not be concluded with the PPB.

The Agency required all BAFOs to be backed by funders because debt funding was necessary to meet the majority of project costs. The level of commitment required from funders at BAFO stage was not detailed. Full commitment at this stage would be impractical. Firstly, funders would not want to carry out due diligence when the success of their borrower was far from certain. Secondly, full commitment has a price. To save bidding costs, only the PPB was required to secure committed funding.

It is necessary for the Agency to conclude negotiations on key contractual provisions and price before BAFO, while bidders are still subject to competitive pressure.

Negotiations with PPB - After selection, negotiations proceeded with the PPB and its funders to finalise the terms of the DBFO contract and the Direct Agreement between the Agency and the funders. The Agency did not negotiate on principles during this stage. It bore in mind the necessity of holding the BAFO terms and making no substantial concessions which might have undermined the reasons for selecting the PPB. It remained open to the Agency to return to the bidder which was runner-up at BAFO, if agreement could not be reached with the PPB. The Agency was prepared to exercise that right if negotiations with the PPB started to deteriorate significantly from the terms of the BAFO which was the basis of the PPB's selection.

At this stage the PPB had to obtain committed funding and to finalise any specified contractual issues with the Agency before it could be considered preferred bidder. When all terms were agreed and the Agency was satisfied with the background contractual arrangements, such as the sub-contracts to be put in place, financial close could take place.

Negotiations with the PPB are the most detailed and lengthy part of the negotiations. The purpose of the final stage should be to finalise minor details, within the context of the terms of the PPB's BAFO. The Agency's view is that in time, as the bidders and funders become more familiar with the terms of the model DBFO contract and Direct Agreement, it is likely that less negotiation will be necessary. The Agency is currently reviewing the model DBFO contract in light of negotiations on Tranches 1 and 1A. The fundamental structure of the model contract will not change, but changes will be made to reflect a more flexible approach to issues such as change of control and the requirement for a specified date for completion.

4.8 Communications

The Agency has an obligation to keep the public informed about developments relating to the road network, which includes providing information on the progress of road schemes. This responsibility continues throughout the procurement process. Once the contract is awarded, the primary responsibility for dealing with enquiries from the media and the public passes to DBFO Co.

The first DBFO contracts were silent on responsibility for communications, although in some cases there were informal arrangements for handling media issues. In future, DBFO Co will be required to formalise these arrangements by developing a liaison procedure for dealing with publicity.

Chapter 5 - Learning points

5.1 Payment Structures

One of the main reasons for using shadow tolls was that they offered a workable method of acclimatising the private sector to the concept of payment per vehicle as a precursor to the introduction of user paid toll roads. There are good reasons for paying by usage, as explained in 2.2, and it is not inconsistent with wider Department of Transport aims to reduce the need to travel and optimise the use of the existing network. There is little DBFO Co can do to increase traffic usage. In addition, the way that DBFO Cos have structured their toll levels results in a reduced payment per vehicle in the higher traffic range. Ultimately (because of the zero cap on the top band) additional traffic will not receive a toll payment and the increase in traffic will only result in extra maintenance costs for DBFO Co.

In the absence of overriding policy reasons to link payment to usage, there are benefits to contracting bodies in determining the ultimate objectives for a service (which may predominantly relate to availability or performance) and linking payment to the delivery of a service meeting those objectives. The current lane closure charges and safety performance payments have identified two areas of operational importance to which payment may be linked. Lane availability (together with volume of traffic) is a key factor in journey time reliability, which research has shown to be one of the main criteria by which road users judge performance of a road. In the longer term, the development of route strategies (which are currently being trialed by the Agency with a view to determining the principal performance criteria for individual routes) should assist in determining other areas where financial payments might be linked to performance.

5.2 Opportunities For Innovation

If there is to be more innovation in the method of delivery, bidders must become involved in the outline design of the underlying asset. It is more likely that there will be cost saving in operation if the private sector has designed the asset they are going to operate. All road schemes included in Tranches 1 and 1A had the parameters of the outline design fixed by the made Orders. Although, in theory, DBFO Co could propose alternatives to the Agency's existing design, few bidders exploited the opportunity. Therefore cost savings were solely to be found in the detailed design and value engineering techniques. In addition, as the Agency itself is now using value management and value engineering as part of its design criteria, savings delivered by the private sector on design may reduce in the future and innovation will be the key to future success.

The involvement of the private sector in the planning process is a difficult issue. Some private sector contractors have expressed unwillingness to become involved and do not want to bear the risk that they are committed to provide an asset which, as a result of the planning approval process, may never obtain approval or may have to be delivered in a substantially different form or much later than anticipated. However, the Agency's view is that in order to obtain maximum innovation and value for money the private sector must take some of this risk.

Realistically, transfer of the risk to the private sector will not be instantaneous. An evolutionary approach is being adopted. Familiarisation with the process and the risks involved will be gradual. The DBFO projects now in procurement contain some small schemes (which would not jeopardise the viability of the overall project if unsuccessful at Public Inquiry) which have not started the statutory process, and larger schemes which have almost completed the statutory process and where delay of final approval is the main risk for the private sector. The Agency has avoided including major schemes which are at an early stage in the statutory process because it considers that, at the moment, bidders would be unwilling to assume that degree of risk.

5.3 Output Specification

PFI requires the client to focus on the 'what' rather than the 'how' in relation to service provision. The first DBFO projects came with a high degree of specification stating how the service had to be delivered - in other words the project brief was not a true output specification. Bidders had to conform their design to the scope of the outline design fixed in the made Orders. The Agency's view was that it would not be productive to re-open the planning debate and invite bidders to submit an outline design which would require new Orders.

Some of the DBFO projects currently in procurement contain contingent schemes which have not been through Public Inquiry. These schemes provide the Agency with the opportunity to devise output specifications which align closely with the Agency's own policy objectives for the scheme. It will be DBFO Co's responsibility to flesh out how those objectives are going to be achieved through the design of the scheme and any environmental or other undertakings made by DBFO Co during the statutory process.

5.4 Evaluation

DBFO roads posed an interesting policy issue for the Agency - what service standard should be attached to the private sector's obligation to operate and maintain? The Agency identified the minimum service standards or core requirements, but above that there was discretion for the private sector to offer higher standards. If a bidder offered a higher standard with no additional cost attached, the bid would be attractive. But where the higher standard is offered at a higher cost than other bids there is a dilemma as to how to evaluate the offer.

The Agency's approach is that, provided minimum standards are met, price should be the principal determinant. If prices bid are in the same area, standards offered in excess of the minimum will decide between bids.

5.5 Enforcement

Ensuring that the Agency has adequate remedies to enforce the terms of the DBFO contracts is a key issue. The primary enforcement tool is the penalty points system which is used to signal to the DBFO Co (and their funders) that the Agency believes that they are in breach of a provision of the DBFO contract.

Following non-performance, the DBFO contract also allows the Secretary of State to take remedial action and invoice DBFO Co for the Agency's costs, to set-off payment of those costs and, in certain circumstances, to suspend payment.

If non-performance continues unremedied, ultimately the Agency will have the right to terminate the DBFO contract. This is a significant deterrent to non-performance as it results in the loss by the DBFO Co of future cash flow to repay debt and make equity return. The Agency will keep its remedial and enforcement structure under review in the light of experience on let contracts to ensure that it performs as intended.

5.6 Funder Involvement

Given their significant role, it is not unreasonable that funders, who may be providing 90% or more of the total funds required, should demand a significant input into the terms of the commercial deal. All bidders have had significant discussions with their funders by the time that their Best and Final Offer is made.

On Tranche 1 and 1A projects the most significant input on the terms of the funding and due diligence on the DBFO contract occurred after selection of preferred bidder. At this point timing difficulties have been encountered because funders' due diligence had not commenced at an early enough stage.

As the financial community becomes more familiar with the DBFO contract and technical and traffic issues, the funders' lending decision should become more streamlined.

There has been particular debate over the terms of the Direct Agreement between the Agency and funders. In order to minimise future erosion of the Agency's position, the model Direct Agreement is being reviewed by the Agency and its advisers in the light of their experience on the first eight projects.

Chapter 6 - Impact on operator market

One of the objectives of the DBFO programme was to foster a private sector, domestic road operating industry. At the start of the DBFO programme there was no such industry in existence, as the Agency had been the operator of the motorway and trunk road network and the local authorities were responsible for the road network in their regions. There were a number of private companies and consultancy firms which had acted as contractors and advisers for the Agency and local authorities on maintenance of roads, but their role was to work to a fairly specific brief for an agreed price. They were not required to make strategic decisions on the timing and type of maintenance required.

Interested companies formed consortia to bid for DBFO contracts. With one or two exceptions, the consortia have stayed intact and sought to prequalify for projects on each of the tranches. Listed below are the winning consortia for each DBFO project:

DBFO Projects	Winning Consortia
A69	Roadlink (Henry Boot, Christiani & Nielsen, Cogefarimpresit, Morrison Construction, Pell Frischmann and ASTM - SINA)
M1-A1	Yorkshire Link (Trafalgar House and Balfour Beatty)
A1(M)	RMG (Amec, Alfred McAlpine, Brown & Root and Dragados)
A417/A419	RMG (Amec, Alfred McAlpine, Brown & Root and Dragados)
A50/A564	Connect (Balfour Beatty, WS Atkins and Philipp Holzmann)
A30/A35	Connect (Balfour Beatty, WS Atkins and Philipp Holzmann)
M40	UK Highways (Hyder, John Laing, Tarmac, Caisse des depots et consignations and Transroute)
A168/A19	Autolink (Amey, Sir Robert McAlpine and Taylor Woodrow)

It is interesting to speculate on how the road operating industry will develop. From the Agency's perspective, competition has to be sustained to ensure good value for money. Fresh competition may come from various directions: bidding consortia comprising foreign companies, or new bidding consortia consisting of UK companies led either by construction companies or by an operator-type company.

The DBFO road contracts have created new opportunities for traditional contracting and consultancy organisations to develop stable, long-term businesses, providing and maintaining the UK's road infrastructure. This will be of benefit to those companies which can develop their expertise in this area to bid for further DBFO projects in the UK, and to search for emerging opportunities overseas.

DBFO contracts benefit not only the private sector participants, who are provided with a long-term business opportunity, but also the State and, ultimately, the taxpayer who receives better value for money spent, and the road user who has the benefit of road schemes being delivered earlier than would have been anticipated under traditional procurement methods.

If you wish to discuss any of the issues raised in this case study, please contact:

Angela Brewis
Private Finance Panel Executive
3rd Floor
61-71 Victoria Street
London
SW1H 0XA

Tel:0171 468 6500
Fax:0171 222 3470
E-mail:brewis@pfpe.demon.co.uk

Produced by:

Highways Agency
St Christopher House
Southwark Street
London SE1 0TE

Private Finance Panel Executive
3rd Floor
61-71 Victoria Street
London SW1H 0XA

Highways Agency - Safe roads, Reliable journeys, Informed travellers