Following publication of the revised Green Book on investment appraisal in April 2003 and PFI Meeting the Investment Challenge in July 2003, the Treasury has recently issued new draft value for money assessment guidance for government departments and local government.
The guidance provides a framework for evaluating the suitability and value for money of proposals for procurement under PFI, and replaces Treasury Taskforce technical note 5.
Changes introduced in the revised Green Book include:
- a change in the discount rate to be used in appraisals from 6% (real) to 3.5%(real);
- the requirement for an explicit empirically based adjustments to redress the tendency for appraisers to be overly optimistic (optimism bias); and
- an emphasis on quantifying all benefits that a choice of procurement may bring, especially if they were previously subject only to qualitative assessment.
The guidance aims to address these matters and ensure a fair comparison by setting out the timing and scope of the assessments, particularly by including specific criteria to manage optimism bias which will be essential to redress the significant advantage that the change to the discount rate would deliver to traditionally procured projects.
Assessments
The guidance stresses the importance of assessing value for money at the earliest possible stage using a revised Public Sector Comparator (PSC) and outlines an approach to appraisal, which is designed to ensure that PFI only goes ahead when it provides value for money. The framework that has been developed comprises a user manual and a value for money financial model. The model is intended to assist with quantifying the expected value for money of procurement under PSC and PFI.
The guidance recommends that the financial model and user guide be applied throughout, although it adds that the outputs of the model should not be considered in isolation as either for or against PFI. The model is best suited to projects which form part of a programme, although it is possible for it to be applied to large, unique projects.
It is recommended that both qualitative and quantitative assessments of the PFI route be made as part of the appraisal. The quantitative assessment involves estimating the costs and capital required for a project and the benefits that it may bring, and making any necessary adjustments for known risks. This assessment will rely on an evidence base built up and maintained from experience of all types of procurement, including PFI and a key part of the development of the investment appraisal will therefore be the collection of accurate information on past projects. Departments will be required not only to retrieve and collate such data, but also to share it with other departments, in order that they may learn from each other's past experiences.
The qualitative assessment requires that the accounting officer should be satisfied that:
- a flexible operable contract can be constructed (viability);
- the benefits brought by PFI would sufficiently outweigh the expected higher cost of capital (desirability); and
- the procurement programme is achievable (achievability).
Assessment stages
The department or authority considering the PFI route must apply three stages of assessment. The first stage, at programme level, serves as an early assessment of value for money and should also give an indication of the most appropriate method of procurement. It should form part of the annual budget round when an authority is considering any programme of investment for which the PFI procurement may be appropriate. Applying stage 1 assumes that PFI is suitable for the investment programme. Stage 1 would not apply in the case of a one-off project.
The second stage, project level assessment, tests the assumption made in the first stage that PFI is the most suitable procurement route. Assumptions made in the programme stage, both qualitative and quantitative, should be re-examined in the light of details that are specific to the individual project. The affordability calculations made at this stage should be included in the Outline Business Case (OBC).
Stage 3, the procurement level assessment, will apply throughout the procurement period. The cost assessments submitted at OBC must be realistic in order to establish with confidence the likely cost at financial close. The aim is to provide continuous assurance that the PFI route represents value for money, taking into consideration current market conditions and the likely quality of the competition. The ability of the project to attract bidders of a sufficiently high quality should also be assessed at this stage.
Stage 1 is effective from the 2004 spending review, although it may be revisited, and Stages 2 and 3 currently remain open for consultation.
An ongoing and realistic affordability calculation is fundamental to the assessment of the project. At all stages the project should proceed along the PFI route only when the appraiser has "a high degree of confidence" that it is affordable. This affordability calculation is particularly important at the programme stage, before a procurement is undertaken, in order to provide a better understanding of the procurement route best suited to each programme, by taking into account the capacities and capabilities of the procuring authority.
Optimism Bias
The introduction of the optimism bias factor is intended to account for the tendency of appraisers to ignore unknown requirements and risks, which is usually greatest in the early stages of a project. Risk-management choices, particularly the method of procurement, can also influence optimism bias. The financial model uses different optimism bias factors for the period before contract award and the period following contract award. This is because it assumes that before entering into the contract there is no difference between PSC and PFI in terms of the ability to manage unforeseen risks and cost increases.
It is also assumed that the optimism bias will vary for the construction period and this view is supported by such statistical evidence as exists about the low incidence of cost overruns on projects procured under PFI as compared to traditionally procured projects. It is assumed that if accurate factors are introduced, this will be a key area of advantage where PFI projects have an opportunity to make up ground given the lower cost of funding of traditionally procured schemes and the revised discount rate.
An optimism bias factor is also applied during the operating period and this is intended to reflect the difference between the fixed service charges under PFI as opposed to the estimation of costs under the PSC. It is also intended to address the estimation of unavailability and service payment deductions which will arise under PFI.
Comments are requested by 1st April 2004, particularly on Stages 2 and 3 and on the User Guide. A "Value for Money" seminar has been organised at HM Treasury at 2.30 pm on 26 March 2004, in order to discuss the application of the guidance.
For further information please contact Trevor Butcher at trevor.butcher@cms-cmck.com or on +44 (0)20 7367 2517
