Economic Appraisal Guidance
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NI Practical Guide to the Green Book

APPENDIX 3

PPP/PFI BUSINESS CASES
A3.1  

Introduction
A3.1.1   Business Cases play a vital role in justifying Private Finance Initiative (PFI) and other Public Private Partnerships (PPP) projects. The purpose of this appendix is to clarify what DFP expects to be included in Business Cases for PFI projects, but is also broadly applicable to other PPPs. It replaces the DFP guidance previously given in Guidance on Outline and Full Business Cases (DFP, 1996 and 1998).
A3.1.2   An extensive body of guidance on PFI/PPP has been published through HM Treasury (HMT), the Office of Government Commerce (OGC) and Partnerships UK (PUK). The current guidance is available on the OGC and PUK websites21. This guidance generally applies to Northern Ireland Departments and Agencies. This appendix is not a substitute for the HMT/OGC guidance and must be read in conjunction with it.
A3.1.3   DFP expects Departments to keep abreast of HMT/OGC guidance and to follow it when preparing PFI and other PPP business cases. For example, the supplementary guidance on the taxation of PFI bids and the public sector comparator (PSC) published by HMT in 2003 should generally be applied22.
A3.1.4   Two current guides that are of particular relevance to PFI business cases are:
  • Step by Step Guide to the PFI Procurement Process (April 1998); and
  • Technical Note No. 5: How to Construct a Public Sector Comparator (October, 1999).
A3.1.5   Step by Step Guide to the PFI Procurement Process refers to the need for a Business Case to be prepared at Stage 3 and refined at Stage 9. It also indicates the need for appraisal of bids at Stage 11 and a final appraisal at Stage 12. This appendix explains more specifically what should be covered in the relevant Business Cases.
A3.1.6   A distinction is made between the Outline Business Case (OBC), which is to be prepared at Stage 3 and refined at Stage 9 as indicated in Step by Step Guide to the PFI Procurement Process; and the Full Business Case (FBC), which should include the appraisals required at Stages 11 and 12.
A3.1.7   The HMT PFI policy document PFI: Meeting the Investment Challenge published in July 200323 envisages a number of reforms to the assessment of VFM in PFI cases. These have not been finalised yet but Departments should take them into account as and when they are introduced. The changes proposed are:
  • instituting a new assessment of the potential VFM of procurement options when overall investment decisions are made, to ensure PFI is used in those sectors where it is appropriate;
  • reforming the Public Sector Comparator (PSC) to ensure an economically rigorous appraisal of a project at outline business case stage, prior to its procurement, to allow an alternative route to be chosen at this stage if it offers better VFM; and;
  • introducing a final assessment of competitive interest in a project, and the market's capacity to deliver, at the procurement stage.
A3.2  

DFP Approval
A3.2.1   DFP requires Departments to submit OBCs for approval at Stage 3; and to submit FBCs for approval at Stage 12, before contracts are signed.
A3.2.2   Where the OBC results in a decision to pursue the PFI route, DFP approval at the OBC stage constitutes approval to proceed to tendering and preparation of a FBC, rather than approval of the expenditure associated with the proposed project. Where private finance is rejected in favour of a conventionally funded option, the OBC may provide a basis for approval of the expenditure required for the preferred option.
A3.2.3   Approval at FBC stage will generally sanction the expenditure required to pursue the recommended option, and allow the project to proceed to the award of a PFI contract or traditional procurement, depending on the outcome of the FBC.
A3.2.4   DFP approvals will generally be subject to all the usual terms and conditions applying to the approval of capital projects including, for example, those laid down in Section 9 of the NI Practical Guide.
A3.3  

Summary of OBC and FBC Requirements
A3.3.1   A summary table indicating what is required in both the OBC and the FBC is included in Appendix 4 - Summary of DFP PFI OBC and FBC Requirements. It may be used as a checklist to aid assessment of whether an OBC or FBC covers all the necessary issues. DFP will expect Departments to address all of the issues indicated in Appendix 4 - Summary of DFP PFI OBC and FBC Requirements in their OBCs and FBCs, with appropriate and proportionate effort. The remainder of this Appendix elaborates on a number of key considerations concerning OBCs and FBCs.
A3.4  

Outline Business Case (OBC)
A3.4.1   The OBC provides the basis for a decision on whether to proceed to tendering and preparation of a FBC, or pursue a traditional procurement, or abort the project. It should cover Stages 1 to 3 as indicated in Step by Step Guide to the PFI Procurement Process. The components of an OBC include:
  1. an economic appraisal, which reviews business need and assesses options in accordance with the NI Practical Guide. (See Appendix 4 - Summary of DFP PFI OBC and FBC Requirements, component no. 1);
  2. thorough coverage of the eleven Treasury Taskforce 'signing off criteria' including Affordability, Output Specification, Risk Allocation and eight others. (See Appendix 4 - Summary of DFP PFI OBC and FBC Requirements, components 2 to 12); and
  3. consideration of other relevant issues including the intended approach to tendering, accounting treatment, and arrangements for post project evaluation. (See Appendix 4 - Summary of DFP PFI OBC and FBC Requirements, components 13 to 16).
A3.4.2   The OBC should examine in detail the prospects for a successful PFI solution. The decision whether or not to proceed down the PFI route requires judgement of the potential for VFM, taking account of factors such as
  • private sector interest in the project,
  • previous experience of similar projects,
  • external benchmarks,
  • the estimated potential for risk transfer, innovation and third party revenues, and
  • q the extent to which the project appears likely to meet the favourable preconditions for a successful PFI project (for example, as set out in para 5.8 of the NI Practical Guide).
A3.4.3   All the relevant considerations should be detailed in the OBC. The likely cost of PFI solutions should be indicated where possible, but it is recognised that the comparative VFM of PFI options can not be established in detail until bids have been received and examined.
A3.4.4   An essential element of the Affordability assessment in the OBC is the Reference Project. This is explained at Stage 3 of Step By Step Guide to the PFI Process. In brief, the Reference Project:
  • is a particular possible solution to the output requirement, combining capital investment, operations, maintenance and ancillary services;
  • should be worked up in sufficient detail to provide a full and adequate costing, including quantification of the key risks inherent in the project, including cost or time overruns, and service underperformance;
  • needs to be costed with sufficient reliability that the service appears affordable on a year-by-year basis, and this level of reliability requires a comprehensive estimation of whole life costs and an identification and evaluation of the risks inherent in undertaking the investment.
A3.4.5   The OBC should not become a dead document once it has been approved at Stage 3. It should be refined during the procurement process. In particular, it should be revisited before issue of the Invitation to Negotiate at Stage 10. This is referred to at Stage 9 of Step by Step Guide to the PFI Process, which stresses the importance of reaffirming affordability and funding commitments
A3.5  

Full Business Case (FBC)
 

Main Elements of the FBC
A3.5.1   The final test of VFM, affordability and risk transfer occurs at FBC stage. The FBC's purpose is to inform the final decision on the project and provide a basis for approval to proceed to the award of a PFI contract. The FBC should cover the requirements indicated in the Annex to this Appendix. In brief, it should:
  • report key changes since the OBC, including any changes to the strategic context and the need for or objectives of the project;
  • report the tendering process, including detailed description of private sector bids received;
  • document the development of the PSC, including details of assumptions and calculations;
  • appraise and compare the private sector bids and the PSC using conventional economic appraisal methods;
  • confirm affordability and commitment of funders, and review the extent to which the other Treasury Taskforce signing-off criteria have been satisfied;
  • set out a plan and timetable for final negotiations and award of PFI contract, or traditional procurement; and
  • summarise the results of the appraisal and recommend a preferred option.
 

PFI options in the FBC
A3.5.2   The PFI options will be based on the bids received from private firms responding to the invitation to tender. Each short listed bid represents an option to be appraised. Two categories of options may emerge:
  • Standard Bids: Every short listed proposal should include a standard bid, for appraisal alongside the other standard bids and the PSC; and
  • Variant Bids: In addition to a standard bid, firms may submit variant bids reflecting the scope which PFI allows for innovative solutions and the incorporation of commercial elements. Variant bids should normally meet the requirements of the output specification but offer special features which are additional to, or which vary from, those included in the standard bid. Variant bids should be treated as separate options to be appraised alongside the standard bids and PSC to see whether their special features offer benefits worth pursuing in terms of improved VFM or reduced risks to the public sector.

The Public Sector Comparator (PSC)
A3.5.3   A PSC should normally be developed for appraisal alongside the PFI options emerging from the tendering process. The PSC should usually be a refinement of the Reference Project considered in the OBC. Whereas the main purpose of the Reference Project is to establish affordability, the primary use of the PSC is to help assess VFM.
A3.5.4   Detailed guidance on the development of the PSC is given in Technical Note No. 5: How to Construct a Public Sector Comparator. This defines the PSC as "a hypothetical risk-adjusted costing, by the public sector as a supplier, to an output specification produced as part of a procurement exercise". DFP will expect Departments to construct the PSC in accordance with that guidance.
A3.5.5   As recommended in section 3.1 of Technical Note No. 5, documentation of the PSC within the FBC should cover:
  • an estimation of basic procurement costs, including
    • capital costs, such as purchase, construction, project management (both internal and purchased from consultants), professional fees and fitting out costs;
    • an estimation of operating costs;
  • a report on the approach taken in relation to third party revenues;
  • a section dealing with the approach taken on asset values on transfer, disposal and termination of the contract;
  • a risk matrix showing the various sources of risk, their costs, the likelihood of their occurrence and the consequences for the project;
  • a discounted cash flow forecast showing the timing of the costs (both basic procurement and risks) which are discounted to yield an overall net present value of the costs of the project;
  • sensitivity analyses, showing the consequences of varying key assumptions; and
  • appendices.
 

Appraising the Bids and the PSC
A3.5.6   The VFM testing of the PFI options and the PSC in the FBC should employ economic appraisal principles similar to those applied in the OBC. It should cover, for the PSC and each PFI bid:
  • identification of costs and benefits;
  • calculation of NPVs;
  • analysis of uncertainties;
  • weighing of other factors; and
  • presentation of the results.
A3.5.7   Comparison of the costs, benefits, uncertainties and other relevant factors should inform the selection of the preferred PFI bid; the judgement of whether it or the PSC offers the better VFM; and the decision on whether to proceed to final negotiations and award of a PFI contract, or pursue a conventional procurement, or abort the project.
A3.5.8   Calculation of the NPVs of the costs of the PFI bids and PSC is crucial. The calculation includes:
  • for the PFI bids, the expected NPV of the service payments to the private sector over the life of the project;
  • for the PSC, the expected NPV of the public sector costs required to procure the same service by non-PFI means, typically a capital investment and subsequent annual operating costs; and
  • adjustments to ensure that the PSC and the PFI bids are fully comparable. In particular:
    • the PSC cash flows should be adjusted to take account of the risks that would be transferred to the private sector under a PFI solution; and
    • tax differences need to be stripped out in accordance with the new HMT "supplementary guidance on the taxation of PFI and the public sector comparator", which can be found on the Treasury website at HM Treasury Green Book
A3.5.9   The NI Practical Guide general guidance on NPV calculations is applicable to PFI cases, but does not cover the adjustments necessary to make the PFI bids and the PSC comparable. Departments must refer to the more detailed guidance given in Technical Note No. 5 and the supplementary guidance on taxation referred to above. Identifying the appropriate risk and tax adjustments is not straightforward and specialist assistance may be required.
A3.5.10   Once calculated, the NPVs should be compared to see which offers the best VFM. If there is more than one PFI option, then these options can be ranked, and the lowest NPV of costs under PFI compared with the NPV of the cost of the PSC. Note however:
  • NPVs are point estimates. It is sensible to consider ranges around these estimates, to avoid spurious precision. Sensitivity analysis, involving the recalculation of NPVs for various possible outcomes of key assumptions, can help to achieve this;
  • Not every risk relevant to a project can easily be quantified and included in the straight arithmetic comparison. It may be necessary to make a qualitative allowance for unquantified risks. An element of judgement is unavoidable;
  • Comparison of NPVs is vital, but it is also important to give due weight to non-financial considerations such as how the bids perform against service quality criteria.
A3.6  

Advice and Guidance
A3.6.1   Most Northern Ireland Departments have PFI advisers who will provide general advice on PFI issues.
A3.6.2   Economic appraisal methods are required to prepare PFI business cases. Departmental economists can provide expert advice on these aspects.
A3.6.3   In preparing PSCs, a number of Departments and Agencies have used external advisers, such as actuaries and accountants, in addition to internal resources and other public sector help. Within reasonable cost limits, this use of advisers is encouraged when there is a business case in which value will clearly be added by external experts. This will often be the case where skills and experience (e.g. In financial modelling and risk assessment) are scarce in some areas of the public sector.
A3.6.4   The general guidance on the use of consultants in section 12.2 applies to the use of consultants for PFI/PPP proposals. For example, where consultancy costs are expected to exceed £10,000, an external consultancy business case is required before employing consultants to undertake any work associated with the preparation of an OBC. Separate justification is expected for any consultancy work beyond OBC stage. This should be provided either in a further external consultancy business case, or by including the equivalent information in the OBC itself.

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21http://www.partnershipsuk.org.uk
22 The new supplementary guidance can be found at HM Treasury Green Book
23 http://www.hm-treasury.gov.uk/documents/enterprise_and_productivity/PFI.cfm