Get to grips with your PFI options

New guidance on waste management PFI contracts has recently been issued by Defra. David Kilduff and Richard Holmes analyse its content and implications for local authorities

The number of active players in the waste market is still small compared to other areas of investment in the public sector. This, along with sector-specific challenges such as site assembly, technology risk, planning and consents risk, sets waste management apart from other areas of PFI.

In May of this year, Defra issued a document ‘Standardisation of waste management PFI contracts: Guidance on SoPC derogations’, a standardised set of departures from the standard drafting that applies to other PFI contracts.

One key area covered by the guidance is the extension of compensation events and relief events, in particular whether it is appropriate to extend the standard position on compensation events to provide protection during the service period, and also extend the list of events in the definition of relief event.

Tailor compensation events

While Defra considers that the standard definition of compensation event does still apply, and that a general extension of the compensation event regime should not extend into the services period, in the waste sector the recommended approach is to identify any key obligations of the local authority in the services period and deal with them specifically, rather than offer blanket protection.

In respect of relief events, the list is extended to cover two particular circumstances – firstly protestor action at the site of a key facility during the contract period, and secondly delivery of munitions, hazardous materials or human remains to a key facility during the services period, requiring the site to be closed. The guidance recognises that other relief events may be requested which are appropriate to a specific project.

The guidance recognises that third party income can make waste PFI/ PPPs more affordable and bidders will often include it in their financial model. This needs to be taken into account in various aspects of the contract such as change, supervening events and termination.

However LAs should be aware that over-optimistic estimates of third party income can have a significant impact on the long-term financial stability of the contractor and, as a consequence, on the delivery of the service.

Taking account of the future

During the lifetime of a contract, often 25 years, there are likely to be changes in law which affect the running of the contract. The key issue here is that of foreseeability, where the main concern of bidders is that although this legislation is potentially ‘foreseeable’, it may not be sufficiently ‘foreseeable’ or certain to be adequately priced in a way which represents value for money.

Currently a specific change in law which was not foreseeable at the date of the contract is the risk of the LA, while a specific change in law which was foreseeable is the risk of the contractor. To provide more certainty, Defra proposes that there should be a waste law list which contains a list of foreseeable laws that cannot be priced. Foreseeable laws on the waste law list are at the authority’s risk and those that are not are at the contractor’s risk.

In waste projects part of construction can be deferred, although the construction price is fixed at financial close. The guidance recognises that if the construction period is longer than five years from financial close it may not be value for money to transfer all general change-in-law risks. The derogations propose reset dates in response to this.

Contractor default events

The guidance also considers that to take account of the specific characteristics of the waste sector, additional events of contractor default should be included, these being health and safety breaches and failure to submit planning applications by a specified date. It also recognises that further project-specific issues, if relevant, may be included. Linked to this is the question of what happens if the contractor does default, and what compensation, if any, the contractor is entitled to.

The re-tendering procedure determines compensation for contractor default. In the re-tendering procedure, the market determines the value of the contract and if there are no bidders for the contract, its value is as a result nothing.

This issue is pertinent in waste projects as, due to the specificity of the technology and the fact that there are few common standards in place, it is possible that no other bidder could or would operate it. Funders have therefore looked for compensation under the re-tendering procedure to be at fair value.

The guidance provides two solutions to this issue. If there is no compliant tender under the re-tendering route, then the no re-tendering route can be used to calculate compensation payable. Or there is ringfencing of the senior debt during the construction period from separate facilities. These options are only temporary to allow the market to mature and are only permitted until 31 March 2008.

Guidance also covers the issue of deferred capital expenditure in two different contexts – a short period during which start of construction is deferred, and a relatively longer period of deferral before construction starts.

LATS risk

The guidance also covers ‘LATS risk’ – the financial risk associated with using more than the allocated landfill allowances and either having to purchase further landfill allowances or pay the LATS penalty. In particular, to what extent can this be passed onto the contractor under the contract?

LATS risk may occur where the contractor fails to complete facilities on time or where the service is being poorly performed and as a result, waste that was originally not planned to be landfilled has to be.

This could result in the LA having to buy, borrow or use its allocation of landfill allowances or alternatively pay a fixed penalty. The recommended approach is for the LA to retain LATS risk, but this is mitigated through a number of measures including liquidated damages and the payment mechanism.

Other issues to consider

Meanwhile major problems still remain in a number of areas. These include regulatory consents and the Environment Agency’s attitude towards the purpose and suitability of mixing management of minor facilities and waste haulage with performance management of the sophisticated technology involved, and whether this bestows some economies of scale or purpose to an overall approach to service rather than asset delivery.

There are signs that Defra has some sympathy with this approach but it will bring with it, for councils, the issue of interface between contractors and coherence in overall service planning and delivery.

The upside will be that LAs will no longer have to put all their eggs in one basket for 25 to 30 years, and can look for a more organic approach to the sequential delivery of appropriate technologies – an approach which assists with the management of the volume risks associated with sizing plant capacity for both parties. There will be procurement issues here that will need careful thought if the intent is to use the same contractor.

PFI is not the only way forward. PPPs have much to offer – the opportunity for greater flexibility in commercial terms, the absence of bureaucratic supervision from the centre, and recent changes to the powers of councils to manage waste disposal assets all add up to the potential for a range of partnering and joint venture options in disposal and collection services.

David Kilduff is a partner and head of the commercial group at Walker Morris

Richard Holmes is an associate in the commercial group at Walker Morris

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