Highways Agency - Safe roads, Reliable journeys, Informed travellers

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.

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

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.