Briefing: Improving the operation of PFI in the waste management sector Free

The Institution of Civil Engineers' (ICE's) State of the Nation report 20041 reported that the UK must procure over £10 billion of new municipal waste treatment facilities over the coming decade to meet its obligations under the EU landfill directive. Of particular concern were the difficulties being encountered by both local authorities and bidders in delivering private finance initiative (PFI) deals. PFI is a major source of funding for new waste facilities. The UK Government's 2004 spending review (covering the period 2006/7 to 2008/9) allocated an additional £275 million of PFI credits for waste PFI projects, over and above the £355 million available from the 2002 spending review.2 A number of high profile PFI projects have run into significant difficulties, however, creating delay and additional costs, and undermining market confidence.

As a direct consequence of the State of the Nation report 2004 ICE facilitated a stakeholder group, on behalf of the Department for Environment, Food and Rural Affairs (Defra), tasked with finding ways to improve the operation of PFI in the waste sector. This group first met in January 2005 and reported to Defra in April 2005.

The report's recommendations were examined in detail by Partnerships UK (P-UK), the body part-owned by the Treasury and tasked with supporting the development of public/private partnerships for infrastructure and public services. P-UK's response to ICE's report, alongside information from live procurement exercises, formed the basis for a consultation paper issued by Defra in October 20053 on waste sector specific derogations from the Treasury's mandatory guidance Standardisation of PFI Contracts version 3 (SoPC3).4 

This briefing examines some of the key issues for procurement in the waste management sector, identified by the ICE stakeholder group and how they could potentially be resolved. While the immediate effort is focused on PFI and efforts to alleviate an immediate logjam, many of these issues apply to any procurement of waste facilities. This includes longer-term concerns that need to be addressed to ensure the UK has a waste management infrastructure that is capable of coping with social and demographic change and is able to take advantage of advances in technology.

The issues affecting procurement of waste facilities examined in this briefing are

• planning

• waste composition and volume

• waste technology and bankability

• markets for refuse derived fuel (RDF)

• weight-based recycling targets

• landfill allowance trading scheme (LATS) permits

• deferred capital expenditure

• compensation and early termination

• insurances

• foreseeable changes in law.

Issues surrounding planning have created the biggest barriers to the successful application of PFI to the waste management sector. While a host of problems have arisen, the two most significant sets of issues are the below.

• The complexity of planning policy and the subsequent unpredictability of timescale and outcome of individual planning applications. This is a policy issue which is currently being tackled by Defra and the Office of the Deputy Prime Minister (ODPM) through a review of Planning Policy Statement 10 (PPS 10).5 The consultation on proposed changes ended on 11 March 2005 and new guidance should appear in 2006. This new guidance will be crucial in speeding up the flow of deals for waste facilities. The deferred capital expenditure implications of planning delay are discussed below.

• Apportionment of planning-related risk in PFI contracts. The apportionment of these risks is addressed in guidance issued by the Public Private Partnerships Programme (4Ps), discussed in more detail below. As a general rule authorities can mitigate planning difficulties by early identification of sites for waste management facilities in their local development frameworks. Consultation with industry can ensure any sites identified are fit for purpose. Authorities can also play a role in the acquisition of sites.

A range offactors including demographics, legislation/regulation, cultural changes and technological development may significantly reduce or increase tonnages of biodegradable waste or alter its composition over the life of a 25 year PFI contract. In these circumstance the contractor could be faced with declining gate fees and excess capacity. Equally the authority could be locked into a contract based on facilities that had become technologically unsuitable for dealing with the waste produced. A contract model is therefore required that ensures that ‘pain and gain’ from changes in composition are shared equitably.

With regard to changes to waste composition, technology is likely to be a complicating factor. Certain technologies are more sensitive to change and therefore present a greater risk. A possible solution would be for compositional change to be resolved by a variation on the banding mechanism already used to deal with volume changes. In this method a ‘waste composition envelope’ would be agreed at contract close including a change mechanism triggered when actual waste composition changed to the extent that it fell outside the envelope.

Contractors' risk in relation to changing waste volumes is more manageable where they have exclusive rights to the waste stream and are thus able to manage the risk of failure to meet landfill diversion or recycling targets. In two tier local authority areas the ideal solution is for the waste disposal authority (WDA) to enter into a legally binding agreement with waste collection authorities (WCAs) to deliver all collected waste to the contractor. On this issue it should be noted that the current procurement pack issued by the 4Ps, a body funded by the Local Government Association, does include the concept of compensation adjustments in the event of failure by WCAs to collect materials. There remains, however, a practical issue of ensuring that WCAs deliver on their obligations.

Choice of technology is a key factor in the ability of waste contractors to secure finance for a PFI project. There is broad acceptance in the sector of the principle that risk related to the performance of technology should lie with the project sponsor. Banks, however, have consistently indicated that they are not prepared to accept risk on unproven technologies and will ensure that any performance assumptions in a contract have a sound technical basis backed up by credible operating plans. In addition checks will be made to ensure that any third party guarantor is able to meet its obligations. This clearly counts against smaller providers of new technologies, unable to draw on their own balance sheets or provide acceptable corporate completion and performance undertakings.

This situation throws up several possible scenarios each with their own problems.

• A contractor might choose to fund an unbankable technology on balance sheet. The authority then faces the risk of a failing technology and failing contractor, which if realised will lead to significant additional expenditure to secure a workable solution.

• A contractor may propose off-balance sheet financing for a technology whose unbankability only becomes apparent at an advanced stage of procurement. As bidders are unlikely to commit to funding their bank's due diligence process prior to best and final offer (BAFO), there is a danger of authorities being left with a reduced number of credible bidders.

• An authority may ‘guide’ bidders to a particular technology which it becomes apparent is unbankable. Given the above it seems likely that if the authority continued to insist on a particular technology it would have little option but to underwrite at least part of the risk.

In addition to the bankability of a technology, authorities need to be realistic about the ability of a technology to enable them to meet their LATS target for diverting biodegradable waste from landfill (see discussion below on mechanical and biological treatment). In addition political leadership will be required to ensure that robust, bankable but currently unpopular options such as moving grate or fluidised bed energy from waste plants are not rejected out of hand.

Finally, anecdotal evidence suggests that some authorities, in an effort to embrace new technologies, have entered into contracts requiring them to deliver a tightly defined feedstock to contractors. If true this exposes an authority to a situation where it has no recourse against the contractor in the event of technology failure but will still need to procure further facilities to meet LATS targets.

It may therefore be wise, early in the procurement process, for authorities to make realistic assessments, of

• any proposed technology's ability to ensure the authority meets annual limits on the amount of biodegradable waste that can be landfilled under the LATS

• any proposed technology's ability to cope with changes in waste composition

• the authority's ability over the life of the contract to deliver waste that meets the input specification underpinning any performance guarantee offered by technology providers.

Also, while bankability of a technology is an issue for the contractor, it would be advisable, at invitation to negotiate stage or earlier, for authorities to take steps to assess contractors' ability to secure finance for any proposed technology.

A particular issue arising from technology choice is the need for a contractor operating a mechanical and biological treatment (MBT) plant to find markets for the RDF that it will produce. As it is legally defined as a ‘waste’ the markets for RDF are limited. Any power plant taking it as a fuel will have to comply with the standards set down in the EU Waste Incineration Directive,6 which for existing coal-fired power stations would require an expensive upgrade. Other outlets, for example cement kilns, are not subject to such onerous standards, however a range of alternative fuels are available in what is a very competitive market, making it unlikely that a contractor will be able to secure long term contracts from operators to take RDF. This is an unusual situation and there are no obvious parallels in other PFI markets.

Banks are unlikely to accept uncovered RDF disposal risk and in the absence of long-term RDF offtake, contracts will normally require protection for their senior debt. This could be achieved in a number of ways, though it may take the form of recourse on a project-by-project basis to contractors' balance sheets for the uncontracted cost of RDF disposal. As a result MBT project sponsors will need to have sufficient financial strength and credit standing or projects will not be financed. Larger contractors may accept this degree of recourse but this in turn will limit the number of projects they can undertake, limiting the number of bidders when local authorities go to the market.

There is no consensus in the market on the extent of the problems this situation creates and it is certainly true that major projects involving MBT have been able to secure finance. In addition the production of RDF creates opportunities in other areas of policy, notably renewable energy generation and meeting greenhouse gas emissions targets. However, the Department of Trade and Industry's (DTI's) confirmation in its September 2005, 2005/6 Review of the Renewables Obligation Statutory Consultation7 that it would not extend eligibility for renewables obligation certificates (ROCs) to mainstream energy from waste technologies may create a barrier to realising these opportunities. This consultation paper does however commit DTI to working with Defra to, ‘actively explore further options to promote and support the delivery of additional energy generation from the biomass fraction of residual, post-recycling waste as a renewable energy source as part of the ongoing review of waste strategy’. This commitment is a welcome recognition of the need for government to give a clearer steer on the role of intermediate technologies such as MBT in delivering the national waste management strategy.

Waste contractors have expressed an unwillingness to enter into contracts containing weight-based recycling targets on the grounds that they are unable to control the volume of separated waste delivered to them by WCAs. A way out of this impasse may be for contractors to accept an obligation to recycle or compost all separated waste delivered to it by a WCA and an agreed proportion of material delivered by the public to civic amenity sites (subject to it falling within a named list of recyclables). On this model a contractor would take the risk on the performance of individual facilities rather than failure to meet authority-wide recycling tonnages.

In general, further work is needed to assess if contractors can reasonably be expected to take a view on levels of public participation in recycling and manage that risk. In practice all parties do need to recognise that recycling and composting targets are currently strong political drivers in the Government's overall waste strategy.

An underlying principle of the Treasury's guidance in SoPC3 is that private sector capital should be at risk over the long-term delivery of the key performance outputs specified by the public sector. It could be argued that meeting annual LATS targets limiting the tonnage of biodegradable municipal waste that can be landfilled is an output of this nature. The Environmental Services Association (ESA), the trade body for the waste industry, has however consistently made it clear that its member companies will not currently take the risk of failure to meet LATS targets in a given year. The ESA's justification of this position is that its member companies

• cannot quantify the value of a LATS permit (beyond the government-defined upper limit of £150)

• cannot compel an authority to bank or borrow LATS permits

• derive no benefit from any surplus LATS owned by the authority.

The following model could offer a means of overcoming this barrier.

• An authority provides contractors with its LATS targets for the contract period and requires contractors to design their facilities to ensure that on the full service commencement date the authority will meet its LATS target.

• Bidders submit bids detailing the number of LATS certificates required if their facilities perform to the specified standard. Once the plant was operational, any LATS actually required above this figure will be the contractor's risk (subject to compensation events or changes).

There are two distinct cases where deferred capital expenditure (capex) is an issue for the procurement of waste facilities.

The principal facility is required as soon as possible but capex is deferred due to delay caused by planning and/or licensing. In these circumstances, contractors are concerned that construction and civil engineering inflation has been rising significantly above the retail price index in recent years, opening up the potential for margins to be eroded or destroyed in the event of any significant delay to the construction of a facility. In the event of a delay of this nature LAs may wish to consider accepting an indexation adjustment using appropriate objective and independent construction indexation for the period of the delay. This would allow authorities to make a judgement on the value for money impact of asking contractors to hold a fixed price over a (potentially) long period. If authorities believe that a fixed price that represents value for money is achievable in the face of this risk, they will need to give recognition to bidders who do not require such adjustments.

In these circumstances pre-committed project finance will not be available on value for money terms given the uncertainties highlighted above. The resolution of this problem is closely linked to the strategic level ability of the UK's waste infrastructure to cope with significant changes to waste composition and technological advance.

One approach identified by the ICE stakeholder group was

• at contract close, contractors commit in principle, within an upper limit, to provide equity for a second facility at an agreed review point

• any new facility to be market tested for value for money

• the unitary fee paid to the contractor to be revised, on the basis of an agreed formula, at the point when new waste processing capacity was brought on line.

Two issues arise in relation to compensation on early termination.

• Issue 1: compensation on termination for corporate financed projects. SoPC3 is neutral on the form in which funding is deployed (i.e. corporate or project finance) therefore the relevant provision in this guidance can be used for corporate financed projects. In addition for the refinancing of a genuine corporate financed deal (for which a stringent test applies in SoPC3), base case refinancing is recognised in SoPC3 and is exempted from authority consent and gain sharing up to the amount included in the financial model.

• sIssue 2: contractor default – retendering route (liquid market). There has been concern in the waste industry that many of the new technologies employed in the waste sector are unique and it cannot be assumed that on termination of a contract, third parties will be operating in the market that are willing and able to take on the contract. While there are precedents where contractors have accepted the liquid market provisions of SoPC3, it seems likely that given the wide range of potential technologies available in the waste market, a case-by-case approach will probably be required.

In addition where a contract has been terminated due to the failure of a technology to deliver diversion targets, a period of a year or more may be needed to procure and bring into operation alternative plants capable of meeting the required performance standard.

Authorities need to identify at an early stage risks to a project that are insurable. At present the insurance industry is advising that given the nature of the waste sector, project specific insurance policies may be needed, made up of a complex mix of environmental impairment liability insurance and business interruption insurance. Authorities should thus take advice from insurers at or before the invitation to negotiate stage.

There is consensus in the sector that as waste facilities are normally designed for specific legal, regulatory and commercial circumstances, changes in law may have impacts beyond any foreseeable risk allowance in a contract. ICE is currently working with Defra and other sector stakeholders to explore the possibility of producing a schedule of specific changes in law that could be appended to SoPC3. Such a schedule will need to be broad in scope and encompass regulations related to areas such as incineration and emissions, and legislation driven changes to pollution prevention and control, or waste management licensing conditions.

All of the issues above were highlighted in the report of ICE's waste PFI stakeholder group, which was delivered to Defra in Spring 2005. In October 2005, Defra issued, Standardisation of Waste Management PFI Contracts: Draft Guidance on SoPC Derogations,8 its proposals for how some of these issues could be translated into waste specific derogations from the Treasury's standard procurement guidance. These derogations are expected to be finalised during 2006. This will go some way to relieving the current logjam of waste PFI deals but government and industry will need to keep a close eye on a process that is currently struggling to deliver the infrastructure the UK vitally needs.