Relative to its size and population, Scotland has one of the largest public-private partnership-based infrastructure investment programmes in Europe. Since 1992, private finance has been the main source of funds for large government projects in Scotland. According to a recent report from the Scottish Government, some £5.4 billion ($8.4 billion) of private finance has been committed under signed contracts, mostly for new schools, hospitals and water infrastructure. The annual cost of these projects to the Scottish Government was around £660 million in 2009–10, and that figure is expected to rise year each year until 2032.

Before coming to power in May 2007, the Scottish National Party had been a consistent critic of PFI. In December 2007, the SNP administration published draft proposals for a Scottish Futures Trust (SFT), which it presented as an alternative to PFI. This document outlined proposals for the establishment of a new government-owned company that would fund projects through ‘bonds and other appropriate commercial financial instruments at rates which would be cheaper than PFI’. This role was later reimagined with the SFT becoming an organisation that advised the Scottish Government.

Peter Rekkie, director of finance and structures at the Scottish Futures Trust, categorises the role of the SFT as, “essentially to manage the deal pipeline and ensure that each project is able to offer the most efficient and effective service possible.” The 2011/12 Scottish budget gave SFT the responsibility for delivering an additional £2.5 billion pipeline of projects in partnership with the Scottish Government, local government, NHS boards and other public bodies. The entire £2.5 billion pipeline will use the non-profit distributing (NPD) structure with delivery risks transferred to private entities under capped profit arrangements.

NPD: The new and the familiar

NPD does not specify any particular contract or company structure, but private sector profits to returns on fixed-interest subordinated debt rather than equity. There are no stipulations that limit the funding options available to the private sector except that it upholds this “no dividend-bearing equity” principle. Typically a project’s special purpose vehicle will include a public interest director on the board to promise greater financial transparency, while attempting to maximise the public sector’s benefit from the project. “Having a public sector director on the board. “It makes certain that projects are deriving the highest benefit for the public sector and maximises efficiency. The director has the power to instigate refinancing of debt and as such retains a large element of control; in short the structure improves public confidence.”

The creation of the NPD model did involve changes to risk transfer arrangements, at least in comparison to the classic private finance initiative (PFI) model. The public sector has retained or taken on risks relating to title, capital expenditure from change in law during a project’s operational phase, energy usage and price. Insurance premium risk sharing in relation to market changes has been removed so that insurance premiums become mainly a pass-through cost. “Changes to risk transfer in the project agreements were things we were keen on,” continues Rekkie. “We looked at existing agreements and found that public authorities weren’t really getting the best value for money. Historically little or no risk was actually being transferred in practice and instead the risks being transferred were being fully priced by the private sector and paid by the public sector – regardless of whether the risk actually occurred. What we’ve attempted to do is strike a lot more of a balance in terms of risk and extract a better value for money through doing so.”

The NPD pipeline

As of April this year the SFT deal pipeline stands at £2.5 billion, spread over transport, health and education projects. Chief among these is the £500 million M8, M73, M74 motorway improvements scheme, to manage and maintain a section of the central Scotland motorway network. The scheme includes the construction of a new junction on the M74 at Raith, the upgrading of the A8 between Baillieston and Newhouse to complete the motorway between Glasgow and Edinburgh, and widening improvements to sections of the M8, the M73 and the M74.

The Scottish Government hopes that the deal will benefit from assistance under the Europe 2020 Project Bond Initiative, which is set to roll out in a pilot phase over the next year. The initiative will benefit from support from the European Investment Bank, which provides credit enhancement to project companies raising senior debt to finance infrastructure projects.

The pilot phase will have a budget of Eu230 million ($285 million) – Eu200 million drawn from the TEN-T budget line, specifically from LGTT, Eu10 million from the TEN-E budget line, initially intended to be used exclusively for grants, and up to Eu20 million can be drawn from the ICT budget. Construction on the M8, M73, M74 project is scheduled to start in 2013, with a decision on the proposed project bond initiative financing due later this year.

Movement on the largest education project in the NPD pipeline –the Glasgow College estate – is also underway. BAM, a Laing O’Rourke–GP4L consortium and a Robert McAlpine–Glasgow Learning Quarter consortium have been shortlisted for the £200 million modernisation. The SFT is set to name a preferred bidder for the 25-year concession early in 2013, with construction expected to start in the middle of that year.

The NPD healthcare is more diverse, though its projects are smaller in size, with a range of primary care and partnership projects from £5 million to £30 million, bundled and batched under the hub initiative. The hub initiative is split into five geographical territories, with the total value of projects to be financed expected to amount to more than £1.4 billion over the next ten years. Under the initiative public sector organisations in a specific hub territory will group together with a private sector entity in a joint venture company called hubCo. The SFT launched the first of the hub schemes last year – the Hub North programme – to deliver £435 million of projects over the next 10 years , and awarded Alba Community Partnerships (comprised of Cyril Sweett Investments and Miller Group) the contract in March 2011. Scotland has awarded a further three programmes, with the remaining Hub South West program set to be awarded later this year.

Project	Project description	Procuring body	Estimated value (excl VAT)	Ojeu timing	Site start date	Approx construction period	Sector
M8 M73 M74	Upgrade of section of the central Scotland motorway network	Transport Scotland	£415m	30th March 2012	Late 2013	42 months	Transport
Aberdeen Western Peripheral Route	Upgrade of A90 Balmedie to Tipperty	Transport Scotland/Aberdeen City Council	£450m	TBC	TBC	36 months	Transport
Royal Hospital for Sick Children /Dept. of Clinical Neurosciences	Construction of c50,000 sq m hospital facility at the Royal Infirmary of Edinburgh site	NHS Lothian	c. £154.9m	Spring/Summer 2012	Late 2013	36 months	Health (Acute)
Ayrshire & Arran Acute Mental Health	Inpatient acute mental health services at North Ayrshire Community Hospital	NHS Ayrshire	c. £45m	Autumn 2012	TBC	18 months	Health (Acute)
Scottish National Blood Transfusion Centre	New build blood processing centre in Edinburgh Options for the delivery of this	NHS National Services Scotland	c. £35m	Business Case Summer 2012	TBC	18 months	Health (Acute)
Dumfries & Galloway Royal Infirmary	Options for the delivery of project via NPD being assessed	NHS Dumfries & Galloway	c. £200m	Early 2013	TBC	30 months	Health (Acute)
Balfour Hospital, Orkney	Development of Balfour hospital and Kirkwall dental centre in Orkney	NHS Orkney	c. £60m	TBC	TBC	24 months	Health (Acute)
Various	Bundled primary care projects. The hub pipeline is to be delivered between 2012 and 2015	Hub territories	c. £250m	N/A (To be delivered through hub partnerships	2012-2015	12-18 months	Health (Hub)
Glasgow College Estate	Modernisation of the Glasgow College estate	City of Glasgow College	c. £200m	ITPD stage	Spring 2013	36	Education (Colleges)
Inverness College	Provision of a new campus for Inverness College	Inverness College	c. £50m	ITPD stage	Spring 2013	24	Education (Colleges)
Kilmarnock College	Provision of a new campus for Kilmarnock College	Kilmarnock College	c. £50m	PQQ stage	Summer 2013	24	Education (Colleges)
Wick High School	DBFM Secondary School in the Highlands. Procurement route is via North hub	The Highland Council	£18m	N/A	Q4 2013	18-24	Education (Schools phase 1)
Brechin High School	DBFM Secondary School in Angus. The preferred procurement route is via East Central hub	Angus Council	£15m	N/A	Q3 2013	18-24	Education (Schools phase 1)
Dalbeattie High School	DBFM Secondary School in Dumfries & Galloway. The preferred procurement route is via South West Hub	Dumfries & Galloway Council	£8m	N/A	Q3 2013	12-24	Education (Schools phase 1)
Garnock Academy	DBFM Secondary School in North Ayrshire. The preferred procurement route is via South West Hub	North Ayrshire Council	£20m	N/A	Q3 2013	18-24	Education (Schools phase 1)
Clyde Valley High School	DBFM Secondary School in North Lanarkshire. The preferred procurement route is via South West Hub	North Lanarkshire Council	£20m	N/A	Q3 2013	18-24	Education (Schools phase 1)
Ayr Academy	DBFM Secondary School in South Ayrshire. The preferred procurement route is via South West Hub	South Ayrshire Council	£15m	N/A	Q3 2013	18-24	Education (Schools phase 1)
James Gillespie High	DBFM Secondary School in Edinburgh. Procurement route is via South East hub	The City of Edinburgh Council	£20m	N/A	Q3 2013	24-30	Education (Schools phase 1)
Dunoon/Kirn/ St Mun’s Primary	DBFM Primary School in Argyll & Bute. Procurement route is via North hub	Argyll & Bute Council	£7m	N/A	Q3 2013	12-18	Education (Schools phase 1)
Boroughmuir High School	DBFM Secondary School in Edinburgh. Procurement route is via South East hub	The City of Edinburgh Council	£20m	N/A	TBC	18-24	Education (Schools phase 2)
Campbeltown Grammar	DBFM Secondary School in Argyll & Bute. Procurement route is via North hub	Argyll & Bute Council	£9m	N/A	Q3 2013	12-18	Education (Schools phase 2)

Source: Scottish Government

The Scotland Government claims to have learned lessons from similar initiatives such as LIFT and building schools for the future (BSF) in England by making the hub bid process more streamlined and less costly. It asked bidders for the private portion of the hubCo bundles to submit as part of their bids prices for preliminaries, professional fees, main contractor overhead and profit and construction costs of sample projects. For each individual project, a comparator project is selected from the priced projects against which the new project pricing will be compared. The tendered prices are adjusted to reflect the specifics of each new project (for instance inflation, complexity and scale) and these figures then form pricing caps for the relevant elements of the new projects.

The joint venture company must always operate open book pricing, and 85% of construction work packages are competitively tendered within the supply chain of the hubco constituents. The procuring authority can also require that any project or elements of it are competitively tendered in the open market.

“Hub has been a long time in gestation” says Peter Rekkie. “We wanted to make sure that there was equality between local health authorities, health boards and hub.” Under the hub programme, the procuring authority retains ownership of the land and anything that a sub-hubco builds on it. This means that the sub-hubco does not lease the land to the procuring authority, instead the procuring authority grants the sub-hubco a licence to occupy the land to the extent required to perform the services, leaving the procuring authority free to grant sub-leases of the facility to other bodies.

Funding arrangements

In the absence of an equity component, junior lenders have to accept the equivalent of equity risk to protect their investment and achieve their target returns. To preserve this link between investment risk and control, the shares in the project company are stapled to the junior debt so that the ownership and control of the project company always transfers with the junior debt (and vice versa). Junior funding has so far been exclusively provided as subordinated debt, although alternatives, including mezzanine debt, preference shares or a single tranche of blended rate debt, are gaining traction.

According to a response to a recent review of PFI financing the SFT has given consideration to altering project gearing, encouraging the creation of a third tier in projects’ capital structures, and using external credit enhancement. Decreasing gearing and increasing senior debt coverage ratios to reduce the risk to senior lenders, and potentially facilitate a higher rating on senior debt, might make projects more attractive for institutional investors. The SFT notes, however, that the larger junior tranche would be more expensive, and as it would tend to be in place for the whole life of the project, would significantly increase overall financing costs. Introducing an additional tranche of mezzanine debt between risk capital and senior finance might reduce gearing without increasing lifetime costs.

Finally, the SFT notes that there may be a role for some kind of financial guarantee provider, which would extend credit enhancement over the entire term of the contract, manage information flow and act as controlling creditor. It stresses, however, that given the limited market available, the value of a wrap during the operational phase would have to be clearly tested against its cost.

The most effective way to encourage private sector participation in infrastructure while providing the best value for public authorities is an eternally delicate balancing act. Scotland’s NPD structure, with its emphasis on eliminating excessive profit returns while offering clarity for investors has so far excited considerable bank and sponsor interest. A lot depends on whether it can remain attractive to investors in spite of current market conditions. Rekkie, however, remains optimistic: “We are working proactively in terms of how best to arrange our financing and reactively to how the market is responding.”

The Scottish NPD structure