Private finance models for infrastructure

Why would the government want to engage private finance for infrastructure?

The government has historically entered into agreements with the private sector to finance, construct and manage infrastructure assets like hospitals, wind farms and roads. Different types of assets bring in different kinds of income for the private sector, each requiring different  partnership models.

There are several reasons why the government might prefer to deliver infrastructure through a public-private partnership, rather than financing, owning and managing the asset directly:  

• The government wants to limit borrowing from gilt markets to finance the upfront costs of infrastructure. Partnerships let the private sector cover upfront costs, and so keep the liability off the government’s balance sheet at first. However, ultimately, the public will pay for infrastructure, either through user charges or taxation.
• Outsourcing the entire project, including finance, to the private sector might prevent the government from changing the project’s specification once work has started. These changes can be a source of cost and time overruns.  
• Giving responsibility for maintenance of the asset to the private sector usually leads to better upkeep, especially when there are clear contractual expectations about the maintenance standards. In contrast, governments have often been tempted to cut back on maintenance spending on publicly managed infrastructure when budgets are tight.
• There might be some emerging technologies – for example in renewable energy – that the government thinks should be privately-owned and run in the long-term. However, the government may decide that it needs to work with the private sector in the short term to kick-start the development of these technologies. In privatised utilities industries, infrastructure is delivered by utility owners, who then also run and maintain the asset. This can be more efficient than having a different entity – like the public sector – construct the asset and then pass on to utilities companies to own and operate.  

What are the main types of risk in developing an infrastructure project?

There are many different types of risk that can lead to an infrastructure project being more or less profitable. The main categories are:

1. Financing risk – will the cost of finance increase or decrease?
2. Construction risk – will the project be built on time and on budget?
3. Demand risk – once operational, will customers use the asset as much as expected?  
4. Operating risk – will the asset generate the quantity and quality of output expected?

In private finance arrangements, the financing risk is generally borne by the private sector. But who bears the upside and downside of other risks depends on the type of public-private partnership. Some models also insulate the private sector from financing risk. These models and their associated risks are outlined below.  

Private finance initiative  

Private finance initiative (PFI) contracts were used to deliver infrastructure in the UK from the 1990s until 2018. At that point, the Conservative government announced that it would no longer use the model. By 2020, there were more than 700 operational PFI contracts, with a capital value of £57 billion ¹⁸ https://www.ice.org.uk/media/jcsdpif3/paying-for-britains-infrastructure-system-briefing-paper_feb-2025-final.pdf . About 50 had expired by 2024/25, with a further 150 due to expire by the end of the 2020s ¹⁹ https://www.nao.org.uk/wp-content/uploads/2020/06/Managing-PFI-assets-and-services-as-contracts-end.pdf . PFIs were mainly used for social infrastructure like schools, hospitals and prisons.

In a standard PFI contract, the private sector is responsible for designing and building the asset, raising the necessary finance, and providing services to maintain the asset for the length of the contract. A public authority – usually a government department – entered into an agreement with a new private finance company called a special purpose vehicle (SPV). These SPVs were consortia of private sector investors, usually including the main construction contractor, service provider and often a bank. The SPV raised finance from debt and equity investors to pay for construction. Once the asset was operational, the authority made ‘unitary charge’ payments to the SPV over the lifetime of the contract – usually 25–30 years. These payments were agreed at the outset but were subject to performance. At the end of the contract, the asset comes back to the public sector.

Alternative models of PFI operate in Wales and Scotland. In Wales, the Mutual Investment Model entails greater public sector involvement. The government provides 20% of the capital at risk and appoints a director to the SPV board. In Scotland, the non-profit distributing model caps the rate of return the SPV can earn, with any extra profits returned to the public sector. However, Scotland is moving away from this model because it has been judged that it keeps the public sector in control of the asset, meaning it is not truly ‘off balance sheet’.

Implicit allocation of risk

• Financing risk depends on the structure of the contract. In many cases, unitary payments are contractually linked to the retail price index, meaning that the costs to the public sector rose with inflation ²⁰ https://salus.global/article-show/surge-in-pfi-payment-costs-hitting-nhs-trusts-hard-in-the-pocket#:~:text=These%20annual%20payments%2C%20known%20as,… . However, the private sector would bear most or all of the interest rate risk.
• Construction risk lies with the private sector because the asset only starts to generate returns once it is operational and the price is usually agreed upfront.
• Demand risk is mostly taken by the public sector because unitary charge payments are guaranteed in advance.  
• Operating risk is borne by the private sector. If the operator fails to meet agreed standards, it will lose part of its payment until standards improve.  

Regulated Asset Base (RAB) model

In privately run capital-intensive network industries with natural monopoly characteristics – like energy, water and rail in the UK – price controls are used to protect consumers from excessively high prices. But these industries also rely on those infrastructure networks being maintained and expanded to meet demand. As a result, the government has  put in place a system that lets private companies that operate these networks to invest in infrastructure with the confidence that they can recoup the costs of that investment in future.

Regulators define a Regulated Asset Base (RAB) as the value of relevant assets (like water pipes) used to provide utility services over their useful lives. Companies are then able to set consumer bills in a way that accounts for the capital and operating costs of those assets, plus an additional financial return. Ordinarily, a new investment will be added to the base when it is operational. From that point on, the company effectively receives a guaranteed return on the asset through bills. The RAB model was initially used in the UK to value existing infrastructure assets as part of the privatisation process, but is now used for the delivery of standalone major investments ²³ https://www.itf-oecd.org/sites/default/files/dp_2016-01_makovsek_and_veryard.pdf . A prominent recent example of a special RAB arrangement was the Thames Tideway Tunnel, which differed from usual RAB agreements in several ways. It included a provision for costs to be added to customer bills immediately – before the asset was operational, and included a government support package with commitments to assist with excess costs and to act as insurer of last resort ²⁴ https://www.infrastructure.cc/_files/ugd/d9a995_eba3de81b02946f8a4976820d84fa721.pdf .

Implicit allocation of risk

• Financing risk is transferred to bill payers over the long term, as the cost of capital is included in calculations of returns to the asset owner. However, any changes  in interest rates between price resets are borne by the private sector.
• Construction risk resides with the private sector in a usual RAB arrangement because the cost is only included in bills once the asset is operational and cost overruns are paid for by the asset owner. But in the case of the Thames Tideway, these risks were substantively transferred to the public sector and bill payers.
• Demand risk is low in these sectors because owners tend to be monopoly providers.  
• Operating risk surrounding the effectiveness of the asset is taken on by bill payers. The private sector receives a guaranteed return  through bills, regardless of whether the asset is less effective than expected.  
• Bankruptcy risk in models like Thames Tideway is taken on by the public sector as insurer of last resort, but this is not an inherent feature of the standard RAB model. 

Contracts for Difference

This model, created to incentivise investment in renewable energy, sees the developer pay the entire cost of constructing the infrastructure asset in return for a fixed ‘strike price’ for output, paid by consumers once the asset is in operation. When the market price for electricity generated by a Contracts for Difference (CfD) generator is below the strike price, the Low Carbon Contracts Company (LCCC) pays the generator the difference. When the market price is above the strike price, the CfD generator pays LCCC the difference. This incentivises investment in projects with high upfront costs and long lifetimes by protecting the investor against volatile wholesale prices, and the consumer against high prices.

To date, CfDs have only been used for renewable energy generation, but the model could in principle be extended to other assets and sectors.

Implicit allocation of risk

• Financing risk is borne by the asset owner.
• Construction risk sits with the private sector developer.
• Demand risk is split between the public and private sectors. The public sector bears price risk by agreeing a strike price, while the private sector bears the risk that demand for energy differs from the original expectation.  
• Operating risk lies with the private sector which bears the risk of how much energy the asset can produce, as the government only pays the strike price while the asset is able to produce energy. 

Concession contracts

Concessions contracts are where the supplier builds an infrastructure asset for a contracting authority and is repaid – at least in part – by charging users a fee, such as a toll. Prices are usually determined through rate-of-return or price-cap mechanisms, designed to allow the firm to earn a fair rate of return on its investment. Examples include the Channel Tunnel and the Silvertown Tunnel.

The asset is publicly owned and control is handed back to the public sector after the contract expires. An important part of the contract is the condition in which the asset is returned. The government then decides whether to allow re-bidding to run the asset.  

Implicit allocation of risk

• Financing risk can vary from contract to contract, depending on how the user fees are set.  
• Construction risk is borne by the private sector because remuneration is dependent on the asset being operational.
• Demand risk is also borne by the private sector to some extent because lower usage of the asset will mean lower income.  
• Operating risk is borne by the private sector which is responsible for issues such as asset wear and tear. 

Debt guarantees

The government offers guarantees to infrastructure projects through the National Wealth Fund (NWF, formerly the UK Infrastructure Bank). The government guarantees that the financer will receive full payment on at least a portion of the loan. For example, the NWF recently guaranteed loans from NatWest Group to providers of social housing to invest in energy efficiency, committing to cover 80% of each loan.1 If the project is unable to repay, the government steps in. Otherwise, the government is not involved in the operation of the project.  

Implicit allocation of risk

• Financing risk is borne by the private sector, unless the change in interest rates makes the project unviable, in which case the public sector guarantee would step in.
• Construction risk is borne by the private sector, unless construction goes so badly as to make the project unviable, in which case the public sector steps in.
• Demand risk is mostly borne by the private sector, and all upside risk resides with the private sector.
• Operating risk is mostly borne by the private sector, but in the extreme where operation is very poor and the project becomes unviable, the public sector steps in. 

Joint ventures

A joint venture is a commercial arrangement between two or more separate entities; in this case one would be a government body. The parties – usually by creating a new company – share resources, expertise and associated benefits and risks.

The NWF has provided equity to several companies in recent years. For example, in 2023, it provided £24 million of a £56m injection into Cornish Lithium for the company to conduct a lithium extraction and exploration project in Cornwall. This investment helped attract private financing for the venture ²⁶ https://www.nationalwealthfund.org.uk/private-sector-case-studies/cornish-lithium-equity-investment .

Implicit allocation of risk

All types of risk are shared by those with equity in the entity, including the public sector.  

Land value capture

Infrastructure, especially transport projects, create value that cannot ordinarily be captured by investors. For example, a new transport hub makes business and other property in the area more valuable. If the project investor – public or private – can capture some of this higher land value, the investment is more attractive.

There are various mechanisms by which a project can capture land value uplift, including through higher property taxes in benefiting areas or separate levies. A business rates supplement on large properties in areas of London benefiting from Crossrail funded 25%–30% of its construction  ²⁸ https://www.itf-oecd.org/sites/default/files/repositories/public-transport-land-value-capture.pdf .

Land value capture can be used in conjunction with the models outlined above – for example a joint venture, a concession contract, or public funding. It provides a guaranteed income stream and so reduces demand risk.  

Implicit allocation of risk

The allocation of risk depends on the specific model adopted.