projects bulletin contents What is the future for PFI s preferred bidders? Welcome to the Winter edition...

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1 Lawyers to the projects industry projects bulletin Winter 2003 contents What is the future for PFI s 1 preferred bidders? Decent homes initiative 2 Not for profits in the 3 waste management industry Corporate governance update 5 VAT on PFI projects 5 Tax relief on the 5 composite trade structure Excellent construction drive 7 PFI - no longer the only 7 game in town? Who to contact 8 Welcome to the Winter edition... of the projects bulletin. This edition contains a number of articles on a wide spread of topics. What is the future for PFI s preferred bidders? Proposals to simplify the EU public procurement regime were put forward in The reforms are in many respects useful but some aspects of them have worried the UK PFI market. The market is concerned not to lose the current system which, under the negotiated procedure, allows an authority and its preferred bidder to conduct post-tender negotiations. This will change if PFI projects are procured under the new competitive dialogue procedure, for use in "exceptionally complex projects". Under this procedure, final tenders may be clarified at the authority's request but it has not been clear whether this would allow further development of terms and conditions following tender submission. The European Parliament has backed an amendment to allow tenders to be "fine-tuned" at the request of the authority, so long as it does not involve fundamental changes. Being able to make final adjustments to bids in complex procurements was unfortunately not allowed by the Commission, which has made it clear that it considers that dialogue must

2 projects bulletin not be reopened with the preferred bidder (as this would weaken the basic position that tenders must not be changed after submission). So unless the position changes, the competitive dialogue procedure will not be suitable for use in PFI projects, even if it could be argued that all PFI projects (in a now well-developed market) are "exceptionally complex". An amendment setting out an "exclusive" dialogue procedure was on the table, which would have allowed dialogue between the authority and the preferred bidder. Unfortunately the Council (the most powerful of the EU's legislative bodies) rejected this by vote back in March and the Parliament has not reinstated this amendment. The EU seems determined to limit post-tender negotiations, which is bad news for the industry. Interestingly, the negotiated procedure, currently used for most UK PFI, will (on current indications) still stand but of course the EU has never been happy with the UK's use of the negotiated procedure for PFI. Exactly which process will be followed in the UK PFI market in the future will depend on the contents of the Directive and of course any UK regulations issued under it. Much will rest on political debate between the UK and the remainder of the EU. The next step will be for the Council of European Ministers to consider the amendments proposed by the Parliament but it is likely that the Conciliation Committee (comprising members of the Council and the Parliament, aided by the Commission) will have to rule. We will not see any clarity (in the form of the final Directive) until the beginning of next year and the PFI industry will be in a state of uncertainty until then. One hope stems from the fact that the Commission, in its March statement, proposed having specific and separate legislation dealing with public private partnerships and services concessions; the aim being to guarantee operators in the market a better opportunity to take advantage of their rights within the common market. This is out for consultation with Member States and we will have to wait and see. Decent homes initiative The Government has set a target that all social tenants must have a "decent home" by A "decent home" must fulfil criteria, eg. it must be in a reasonable state of repair. The initiative received a boost on 25 September, with an announcement from the ODPM that a further 600 million would be made available through PFI. PFI There are two avenues through which PFI housing projects deliver investment in affordable housing. These are Housing Revenue Account PFI and non-hra PFI. With the former, the local authority retains ownership of the stock and tenants have secure tenancies. A private sector consortium refurbishes the homes and then repairs, maintains and manages them. Financial support is provided through PFI credits. Non-HRA PFI provides new stock via a registered social landlord. ALMOs Another option for local authorities to access extra funding to meet the 2010 target is to use Arm s Length Management Organisations. An ALMO is a 100% local authorityowned company with a board of tenants, councillors and independent members. ALMOs cover over half a million homes, comprising 20% of all local authority owned housing stock. LSVTs Less novel but also important is the Large Scale Voluntary Transfer. Stock transfer began in 1988 and by the end of 2005 it is estimated that one million homes will have transferred to private sector ownership. The upshot of all this is that local authorities can utilise a combination of various investment options (PFI, ALMOs and LSVTs). Consultation is ongoing to devise additional models for funding future housing stock transfers and the ODPM is striving to make it easier for local authorities to refurbish housing stock through PFI. All of this is good news for local authority tenants. 2

3 Winter 2003 Not for profit organisations - a way forward for waste management projects Introduction At present there is a good deal of interest in "not for profit organisations" ("NFPs") being used in PFI projects in a number of fields. Indeed, they may be of particular relevance in the waste management sector. Waste management The public sector, including waste disposal and collection authorities, NHS trusts and the like, is facing considerable challenges in complying with obligations concerning waste disposal and recovery, as identified by the EU Waste Programme and now in course of clarification by the UK Government. In particular, the emphasis on recycling and recovery and the crackdown on consignment to landfill present rigorous tests for the responsible public sector. At the same time innovative solutions are expected to be delivered by both public and private sectors. It is widely agreed in the waste management business that much more progress could have been made if there had been a greater readiness by the British public to accept solutions in the form of waste to energy plants, well managed landfills (perhaps with gas harvesting) and effective treatment plants. These types of projects will be critical in meeting recovery targets. However, there has been a general distrust of them, together with an unwillingness to invest, especially where people are content to use facilities, but "not in their own backyards". With better recognition, the essential solutions may have real public financial benefits. PFI in the waste management field The private finance initiative has certain advantages of general application. Firstly, it may allow the transfer of problems and associated risks to the private sector. As noted above, in the waste management sector, there are a number of significant challenges, including the requirements arising pursuant to the EC Landfill Directive that a greater proportion of waste be recycled and landfills be less relied upon. Local authorities may wish to transfer such matters and (where possible) the risks involved to a private consortium. Those risks include (a) the uncertainty as to what actual amount of waste will need to be dealt with and (b) what new requirements and costs will arise. In the first example above, the imposition of a new housing quota involves a new burden on the existing and proposed waste management facilities. The private sector has the ability to put together consortia which can make significant capital investments in projects. The procuring authority may not be encouraged to do so by central government, or may not be able to do so, and may instead prefer to pay for the services it receives over a long period. The public authority may also find it preferable for significant projects not to feature on its balance sheet. Significant expenditure is needed in waste management. NHS trusts may face similar problems of waste management and there may be cost savings and other synergies of a combined approach that a third party can deliver. The private sector may have levels of expertise in an area and may benefit from private sector disciplines. Innovative waste management, and particularly the design and use of integrated solutions, is clearly an area where specialist practices and expertise are needed. 3

4 projects bulletin Is profit the problem? In some cases outside waste management there have been substantial and unexpected profits generated in the context of PFI. Procuring authorities are legally obliged to pay the agreed unitary charge even if this generates much higher levels of profit than predicted. Refinancing (although now more adequately covered in standard contract guidance) is one factor which can create unexpected "windfall" profits for the private sector. The costs of waste management are set to rise. Recycling and environmentally-aware methods of disposal are being encouraged and indeed required. Landfill taxes are set to rise substantially in support of this initiative, altering the way in which costs are looked at. However, the higher costs will inevitably fall, whether directly or indirectly, on the public. This may itself work to change public perception. The issue of waste management can therefore be expected to attract greater public awareness and concern. As prominence increases and the level of expenditure rises, the risks involved for the local authority also increase. It follows from this that local authorities may consider that they wish to take advantage of PFI whilst avoiding the perceived risk of unexpected profits being made in the private sector. The procuring authorities will have an ever greater awareness of their obligation to deliver services in a cost effective manner but with greater environmental care. Not for profit structures There is a growing recognition that NFPs may potentially offer improvements to traditional PFI structures. This is because NFPs are a means by which public services are seen as being delivered for their own sake, rather than for the purposes of making a profit for their owners. This may be highly desirable from a general political perspective. In the sphere of waste management this may be particularly important as charges increase. In the context of waste treatment, most of the PFI projects that have been done to date have involved the procuring authority taking a shareholding in the project vehicle with the effect that the scope for enhanced profits for the private sector is reduced (or the profits are shared with the public sector). However, NFPs offer presentational advantages over such structures and can provide a more complete protection to the procuring authority. There is also an awareness that NFPs may be used to help ensure that there is an appropriate correlation between service standards and the costs of the services. Since the NFP is not inherently run for profit, any surpluses it generates are not automatically available for distribution to the members of the consortium. Such surpluses may only be used for the purpose of the relevant public service. Therefore, provided the NFP is structured correctly, a virtuous circle can be created of public services being provided efficiently and with cost savings being used for further improvements. However, the structuring of the NFP needs to pay particular attention to the constitution of the NFP and the sub-contracts it enters into. The private sector is entitled to receive rewards that are appropriately linked to risks. This has been apparent from the PFIs in the waste management sector to date, as well as more generally within PFI. The constitutions of the NFPs should also focus on environmental objectives provided that they have a sufficient degree of flexibility to enable projects to be delivered in the best way possible. Fiscal issues will also need to be considered. Companies limited by guarantee are one type of NFP which may have advantages as may trust structures and companies with constitutions limiting profits. The government is also considering proposals for a new type of company called the Community Interest Company, which may provide an appropriate vehicle, particularly for community recycling or recovery programmes. In summary, NFPs may be a method of combining the advantages of PFI whilst taking out some of the political risks (actual or perceived). They can be used in structures for providing environmentally sound solutions to waste management problems. Waste management is certainly set to become an ever more prominent issue in the next few years and NFPs, when properly financed and structured, may offer an answer. An NFP guidance note is available on request. Contact details on p.8 4

5 Winter 2003 Corporate governance update Further to the Higgs Report released earlier this year (on the role and effectiveness of non-executive directors in UK listed companies) the definitive revised Combined Code of Principles of Good Governance and Best Practice has now been published. The new Combined Code will come into effect for reporting years beginning on or after 1 November The principal differences from the current Combined Code are: Board balance At least half the members of the board should be independent nonexecutive directors. There is an exception for smaller listed companies (i.e. those outside the FTSE 350) who need only include two such independent nonexecutive directors. Chairman and the chief executive The same individual should not act as both chairman and chief executive. The chief executive should not become chairman of the same company. The role of the non executive director and the independent director The chairman should hold regular meetings with the non-executive directors without the executives present. A senior independent director should be available to receive shareholders' concerns which cannot be resolved through the normal channels of contact with the chairman, chief executive or finance director. Appointment and tenure The nomination committee should consist of a majority of nonexecutive directors. Any term beyond six years for a non-executive director should be subject to rigorous review. Executive directors should not take on more than one non-executive directorship in a FTSE 100. company, nor become chairman of such a company. No individual should be appointed to a second chairmanship of a FTSE 100 company. Training and performance evaluation The chairman should ensure that new directors receive a full, formal and tailored induction on joining the board. The board should undertake a formal and rigorous annual evaluation of its own performance and that of its committees and individual directors. Although the Combined Code strictly applies only to companies on the Official List, it is anticipated that AIM companies will continue to follow it as a matter of best practice. Compliance is often seen as necessary to meet the high standards of corporate governance required to attract and retain institutional investors. For advice on corporate governance issues please contact our corporate governance team: Kevin McGuinness kevin.mcguinness@ngj.co.uk tel: Elizabeth Dillabough elizabeth.dillabough@ngj.co.uk tel: VAT on PFI projects - traps and opportunities The VAT tribunal has decided the case of West Lothian College SPV Ltd v Commissioners of Customs & Excise. It is rare for PFI cases to reach the tribunal. The taxpayer, a service provider, won, and as readers will note from the comments below there may be an opportunity for other service providers to reclaim more VAT in the future, or even reclaim past VAT. Background West Lothian College ("the College") wanted to replace their Bathgate Campus. HBG Construction Ltd won the tender to construct the new building and provide both hard and soft facilities management services. "Hard" services are those required to maintain the fabric, structure and functionality of the building so that it is continuously 'available' for use. "Soft" services are those by which the 5

6 projects bulletin building is operated, for example, cleaning and catering services. HBG Construction Ltd set up West Lothian SPV Ltd ("the SPV") for the purposes of the project. The College granted a 25 year headlease to the SPV partly in order to provide its funders with security. The SPV granted a sublease back to the College. The College and SPV entered into an Agreement for the design, building and operation of the campus. Instead of the SPV receiving a single unitary charge for its services, the College agreed to pay the SPV two income streams. The first was the "availability charge" which was treated by the parties as exempt from VAT (as being for the supply of the building) and the second was the "facilities management charge" which was payment for the hard and soft services, on which VAT was billed. SPV subcontracted out many of these services and so incurred VAT from third parties both on the construction and provision of services relating to the building. The SPV sought to reclaim its VAT and Customs challenged this. The arguments Customs sought to refuse the SPV recovery of its VAT arguing that there was a single commercial transaction involving the single VAT exempt supply of a custom built college and that the hard and soft facilities management services were merely ancillary to this. In VAT law, no VAT can be reclaimed on costs which relate to an exempt supply. Customs argued that following the case of Card Protection Plan v Customs, where services are ancillary to an exempt supply, they can be effectively ignored. The tribunal disagreed with Customs' argument. Although the facilities management services were supplied as part of a package, they could not be regarded as merely ancillary. These services were substantial and constituted taxable supplies in themselves. Customs then tried to argue that none of the VAT on the construction costs could be reclaimed because all this VAT related to the exempt supply of the availability of the building. Again the tribunal disagreed. The construction costs were a cost component of both the charge made for the facilities management services (taxable) and the College's right to occupy (exempt), and accordingly the VAT on the construction costs constituted residual input tax and was recoverable in accordance with the SPV's partial exemption recovery rate. Comments We believe the case is correctly decided. The decision is important, and may result in additional VAT recovery for service providers. If any service provider has not reclaimed VAT particularly on building costs in the belief that the VAT is a cost component of an exempt supply of the availability of the building, it may be able to take steps to reclaim the VAT subject to the three year deadline for input tax recovery. If Customs' principal argument had been correct, no VAT would have been chargeable on the facilities management services which was an odd argument for Customs to take, seeing that the College is no doubt largely VAT exempt and unable to recover most of its VAT. We think that the case would have been decided the same way if there had been a single unitary charge rather than two income streams. In practice Customs' general view is that the entire package of services provided by a service provider for a unitary charge is standard-rated so that the service provider must charge VAT on the entire unitary charge and can recover VAT in full without needing to opt to tax any supplies of buildings. We do not believe this view can be entirely relied upon, and the provider should opt to tax to avoid making an exempt supply of supplies of buildings with a consequential loss of input tax. Of course this may not always be possible e.g. where the project relates to housing. 6

7 Winter 2003 PFI - no longer the only game in town? Cash-strapped local authority departments have long realised that PFI is the only game in town when it comes to investment in capital projects. This is all about to change. The Local Government Act 2003 sets out a prudential borrowing code for local authorities. Under this code, a local authority will be able to borrow money on the open market without Central Government approval, provided that certain criteria are complied with. Excellent construction drive The Treasury launched Achieving Excellence in March The aim was to reform the procurement practices of government departments and non-departmental public bodies and for them to become "best practice" clients. The initiative, originally programmed to last three years, has been extended for a further two. A key target is to achieve zero defects on the majority of construction projects. OGC launched a new suite of guides on 24 September. These draw on lessons learnt over the past five years and reflect recognised best practice in delivering improved value for money over the whole life of construction projects. The guides are available on the OGC website. Guide 2 provides a recommended framework for project organisation and explains the roles and responsibilities involved. Procurement routes are dealt with in Guides 3 and 6, which put Gateway reviews in focus. Guide 4 is fundamental as it explains the management of risk and value. Risk is to be continuously assessed throughout the procurement lifecycle. It must be examined at each stage in the Gateway and if not assessed properly, finance will not be given to the project. The guides represent a commitment to best practice in procuring government projects. Whether procurement practices will actually change is something which needs to be monitored closely. First, direct borrowing will most probably be cheaper than PFI debt finance borrowing. Second, a local authority will be able to retain inhouse delivery and management, which it cannot do under PFI. It is anticipated that prudential borrowing will be particularly attractive for smaller schemes, for which PFI is less cost-effective (no economies of scale) and less attractive (proportionately high start up costs). However, PFI is likely to remain the vehicle of choice for larger local government capital projects. Local authorities will be pleased to be given this extra freedom to choose how best to invest in capital projects where they do not have enough cash swilling round in their bank accounts. 7

8 projects bulletin A warm welcome to... Sebastian Charles has recently joined the firm. He has advised on the planning and environmental aspects of a number of high profile PFI/PPP and project finance transactions. Sebastian has acted for banks and sponsors in projects in the power, health, education, prisons, waste and defence sectors He advised: Annes Gate Property Plc in connection with an award winning PFI project for the provision of newbuild central London accommodation for the Home Office; in respect of a power project at Shoreham, West Sussex including resolving s36 issues, securing planning consent for a gas pipeline and obtaining consents; a bank on the financing of a large newbuild integrated waste management facility at Neath Port Talbot. Royal Bank of Scotland on the planning and environmental aspects of the 140 million financing of a PFI project for prisons at Peterborough and Ashford; Abbey National Treasury Services on the planning aspects of a 345 million pilot PFI scheme to transform facilities at Tower Hamlets Schools; and Abbey National Treasury Services in relation to the financing of the 50 million development of the new West Middlesex Hospital. For more information contact one of the following partners: Christopher Causer christopher.causer@ngj.co.uk tel: Carolanne Cunningham carolanne.cunningham@ngj.co.uk tel: Stuart Borrie stuart.borrie@ngj.co.uk tel: Nicholson Graham & Jones 110 Cannon Street, London EC4N 6AR The contents of this projects bulletin have been gathered from various sources. You should take advice before acting on any material covered in this publication. Nicholson Graham & Jones