Difference between Quantitative and Qualitative VfM Criteria

Owain Ellis12 June 2008

Contents

• Pros and Cons

• Qualitative VfM Criteria

• Quantitative VfM Criteria

• Challenges

Why Assess VfM ?

• Starting Point:

– Major capital investment

• Desired End point:

– Optimum and enforceable risk allocation to the private sector partner

When is the VfM assessment made?

• Programme level

– Suitability of using private finance

• Project level – pre market launch

– Important decision point

• Procurement level

– Check that procurement will deliver the forecast VfM benefits

Qualitative assessment - Viability

• Measurable and definable outputs, clear scope

• Operational flexibility

• Inclusion of soft services

• Equity/efficiency reasons for private sector service provision

• Strategic/ regulatory issues

Qualitative assessment - Desirability

• Risk Management

• Innovation

• Duration, requirement and asset life

• Lifecycle costs

• Do the benefits outweigh the costs?

Qualitative assessment - Achievability

• Market capacity and interest

• Timing

• Procurement time scales

• Value

• Procuring authority skills and resources

Balanced Approach

• Balanced qualitative and quantitative assessment

• Evidence-based approach

• Generic VfM model

VfM Quantitative analysis

Identify cost inputs

Adjust costs for Optimism Bias

Factor in finance cost assumptions

Adjust for:

•Flexibility

•Tax

•Life cycle investment

Measuring VfM - Public Sector Comparator (PSC)

• Same outputs specified under PFI

• PSC helps to determine:

– indicative costs (as benchmark)

– risk transfer

– VfM of private sector bidders’ solutions

Public Sector Comparator

PSC PFI

NPV of PFIcash flows

Risk retainedby Authority

NPV of PSCcash flowsN

PV

of

PS

C

NPV of PSCrisk transfer

Risk retainedby Authority

NP

V o

f P

FI

Typical Profile of Net Present Cost of PSC vs. PFI

Risks retained, that are transferred under PFI

Total value of public sector delivering same outputs over life of contract

– Design and build costs– Operating costs

Total net present value of PFI Co’s unitary charges, over life of

contract

Measuring VfM - Public Sector Comparator (PSC)

• Key considerations:-

– sensible costing

– proper use of advice

– benchmarking with similar schemes

– recognition of risk and uncertainty

– optimism bias

– established public sector discount rate

Technical Adjustments

• Unbundled discount rate - time preference rate of 3.5%

• Optimism Bias factored in to investment appraisal

• Monetisation of non financial benefits and costs

• Material tax differentials recognised and monetised

VfM Analysis – Input Sheet

General PFI FundingTimings (Yrs) Rates - Escalators & Discount Rates (%) Base Year Gearing (%) 90%Contract period 29 CapEx escalator 4.5% 0 Sterling swap rate (%) 5.15%Initial CapEx period 5 OpEx (non employment) escalator 2.5% 0 Credit spread (bps) 12Year when OpEx is first incurred 5 OpEx (employment) escalator 3.5% 0 Bank margin (bps) 100

Unitary charge escalator 50% 0 Tail for bank debt (yrs) 2Real discount rate 3.5% NA Commitment fee (bps) 50

Upfront fee (bps) 90

Costs Grace period (yrs) 1

Whole Life PSC OB Pre (%) OB Post (%) PFI OB Pre (%)

Initial CapEx (£'000) 65,250 10% 30% 71,775 10% Unitary Charge

Lifecycle costs at each LC date (£'000) 6,535 10% 30% 1,076 10% Initial CapEx period payment (%) 50%

Lifecycle intervals (yrs) 10 NA NA 1 NA

OpEx (non employment)(p.a.) (£'000) 1,075 10% 20% 1,183 10% Pre Tax IRR Targets

OpEx (employment per person) (p.a.) (£'000) 20 NA NA 20 NA High 18%OpEx (employee number) 25 NA NA 25 NA Medium 15%Transaction Low 13%

Public sector (£'000) 1,958 10% 10% 1,435 10%Private sector (£'000) 0 0% 0% 1,077 0%

Third Party Income PSC OB Pre (%) OB Post (%) PFI OB Pre (%)Income ( p.a.) (£'000) 475 10% 10% 575 10%

Flexibility PSC PFI

Scope change year 10 10Probability factor (%) 50% 50%Level of scope change (%) 50% 50%Premium flexibility factor (%) 0 10% bps Basis Points

CapEx Capital ExpenditureIndirect VfM Factors PSC PFI LC Lifecycle Costs

Amount (Npv)(£'000) 0 2,000 NA Not Applicable - no input required

OB Pre Pre-FBC Optimism BiasTax PSC PFI OB Post Post-FBC Optimism Bias (for PSC only)

PSC adjustment factor (%) 6% NA OpEx Operational ExpenditurePSC Public Sector Comparator (i.e. conventional procurement)

Lifecycle Related Adjustments Input required

PSC lifecycle VfM adjustment 40% Hard-wired Assumption - no input required

Residual cost benchmark 50%PSC residual cost factor if lower than benchmark 70%PSC residual cost factor if higher than benchmark 35%

#END

VfM Model - Challenges

• Timing: Decision making tool or demonstrator?

• Optimism Bias: availability of a reliable evidence base (PFI & PSC)

• Data management - double counting

• Limitations of a standardised approach

• Care over presenting numbers

Conclusions

• Qualitative VfM Assessment assists with decision at Programme and Project levels

• Quantitative VfM Assessment assists with demonstration of VfM at Procurement level

• Limitations - Part of Business Case approach