PUBLIC FINANCES : A DIVISIVE INITIATIVE / THE FINANCIAL TIMES COMMENTARY & ANALYSIS ( A MUST READ )

August 7, 2011 3:59 pm

Public finances: A divisive initiative

By Nicholas Timmins, Public Policy Editor

Pier pressure: a protest against the private finance initiative during the 2002 conference of the Trades Union Congress in Blackpool. While unions have long opposed such schemes, growing numbers of Conservative MPs are now questioning their value for money

After a decade on the House of Commons public ac­counts committee, Richard Bacon is one of the longest serving members of Britain’s parliamentary watchdog for government spending. One issue has bothered him for years.


“I first really began to worry about the private finance initiative back in 2003,” says Mr Bacon. “I ran into an investment banker who said: ‘I like the PFI. It’s good for business. We make a lot of money out of it. But as a taxpayer, it really cheeses me off.’ That rather woke me up. This was not a trade unionist complaining. It was a City fat cat getting fatter on the proceeds.”

.
Mr Bacon is perhaps an unlikely critic of the use of private finance for public goods. He is, after all, a Conservative – the senior partner in the UK’s ruling coalition government – and his party has traditionally advocated a more limited role for the state than its opponents.

But these days his is just one voice amid a rising chorus of parliamentary scepticism that PFI – which has delivered 700 big items of British infrastructure and services in the past 20 years – is proving value for money. In recent weeks, its practitioners have found themselves accused by MPs from all parties of “ripping off the taxpayer”, making excessive returns and “running a racket”.


PFI works a little like the marriage of a mortgage to a full repairing lease. The public sector decides what type of project it wants. The private sector then designs, finances, builds and operates it – usually on a contract of 25-30 years that includes full maintenance. At the end of the contract, the public sector is handed back the project in full working order. If it is delivered late or over budget, or fails to perform once up and running, in theory the private sector pays.


In the past decade many other countries – including Canada, Australia (which invented it) and significant parts of Europe – have adopted PFI-type approaches. Indeed, it has arguably never been more popular, as countries crippled by debt see it as a way of creating social infrastructure without the need for yet more government borrowing. America is taking an increasingly keen interest.


Why has it proved to be so popular? “For three reasons,” a former Treasury adviser says. “Governments think it transfers risks, and works. Because they don’t have to raise the capital now. And because accounting rules mean it often does not count on the government’s books. You make your own judgment over which is the main driver,” In other words, for at least two of those reasons, governments simply cannot resist it.


Yet in the UK, it has never been more controversial. Since PFI was first devised in 1992, more than £70bn ($114bn) of capital has been raised to provide new hospitals, schools and prisons, new roads and defence projects. These services are being provided now. But payment for them – including their running and maintenance – will cost taxpayers, including children yet unborn, £240bn to 2050. This is equivalent to about one-seventh of current national income.
“The debt will hang over the British taxpayer for decades,” says Jesse Norman, another Conservative MP who is critical of the way it has worked.


It has also, he notes, “created great private fortunes”. Figures from the National Audit Office suggest that at least £2.8bn, and quite possibly more than £4bn, has been paid in fees to financial consultants, lawyers and others to get the projects off the ground – £4bn being the equivalent of building costs for eight large new hospitals. The head of one big PFI investment fund earned £8.6m last year, more than the chief executive of Royal Bank of Scotland, one of Britain’s biggest banks.


So has the private finance initiative vastly improved the UK’s social infrastructure at a price well worth paying? Or is it, as its harshest critics, claim, “perfidious financial idiocy”?


After all, private borrowing costs more than government borrowing. And while any government borrowing would be written off if the school or hospital were no longer needed, under PFI the taxpayer would also have to cover the lenders’ anticipated profit. So once a PFI contract is signed, it is almost impossible to get out except at enormous expense.


In theory the transfer of risk, and the efficiencies gained, more than pay for the extra borrowing costs. But these are not small.
.

.
According to David Metter, chairman of the PPP Forum, the industry’s trade body, private borrowing for PFI has over the years cost on average only about 2.2 per cent more than government borrowing. Calculations by the Financial Times suggest that, on the £53bn capital value of current PFI projects, that translates to the taxpayer having to pay £20bn-£25bn above the government borrowing rate – the equivalent of 40 or so big hospitals. “You need an awful lot of risk transfer or efficiency gain to make that worthwhile,” Mr Bacon says.


We will probably never know for certain whether the theory works in practice. For PFI contains one other element that has attracted governments around the world. Because the borrowing is private, it often does not formally count as public borrowing.


So it makes public finances look better, which means that for a host of projects – hospitals and schools, prisons, waste recycling projects and much else – PFI has been “the only game in town”, according to people on both the public and private sides of these deals. Practitioners readily admit that projects have at times been distorted to ensure they stayed off the government’s books.


As a result, as parliament has been told by Amyas Morse, head of the NAO, “we simply do not have the data” to do a comparison between PFI and conventional procurement. Leading figures from the industry concur.
.
. . .
. 
Two things can, however, be said with some certainty. First, without the off-balance-sheet financing, this vast array of new infrastructure would not have been built. The last Labour government, which left office in 2010 after 13 years in power, was simply not prepared to borrow to fund it. Second, at least part of the PFI theory has worked.


Unlike much conventional procurement, PFI has overwhelmingly delivered to time and to budget. When it has not, the private sector rather than the taxpayer has almost without exception met the bill. Over the years, John Laing lost £68m when designs for the National Physical Laboratory proved unbuildable; £100m was lost on Dudley hospital in the West Midlands; and, when the PFI constructor and service company Jarvis went bust, the costs fell to the banks not the public.


PFI contracts, however, have proved very inflexible. It is not just the many tales of £1,000 charged to move a plug socket, or £900 to install a Christmas tree in the Treasury. It is that significant changes in use have all too often proved hugely expensive, making it costly to adapt to changing needs. Sir Peter Dixon, former chair of one of London’s biggest hospitals, complained to parliament that under the contracts “we just had to cough up”.


Furthermore, some of PFI’s virtues have suddenly become vices. Hospitals were built on the assumption of rising health spending and growing business. But spending is now flat for four years, and care is being shifted out of hospitals and into the community to save money. As a result no fewer than 22 PFI hospitals spend so much of their income on fixed PFI payments – up to 18 per cent – that they no longer look financially viable. The health department is almost certain to have to take some of their debt on to its books.


Equally, the idea that the public sector should not skimp on maintenance, running up much bigger bills for later, is a virtue in a normal downturn. But, amid the biggest spending cuts in decades, that has produced “an insane situation”, according to Austin Mitchell, a Labour member of the Commons public accounts committee. “Virtually every other area of spending is being cut, but the return for PFI investors just comes in guaranteed.” It is, he says, “a racket”.


That has produced demands, led by Mr Norman, for a “rebate” on the deals. But this is not on the cards. First, the private sector refuses to re­open long-term contracts voluntarily signed on agreed terms. Second, the ownership of contracts has become vastly complicated as investors have sold their stakes, both to take their profit and to recycle the cash into other projects.


Pension funds, including local authority ones, now own significant parts of the equity and the debt in PFI because the long-term nature of the payments matches their long-term liabilities. In many cases arranging a cash rebate, in the unlikely event that the requisite 20 or 30 people could be gathered in the same room, would look like robbing Peter’s pension to pay Paul, the taxpayer.


Hence the Treasury’s recent search for operational savings instead. Many of these, however, involve cuts in services, such as less frequent cleaning; the public sector taking back risks; or the “mothballing” of facilities that will still have to be paid for.
..
. . .
.
The repeated sale of PFI stakes has brought other problems. “People just do not like the idea that their local school or hospital is being bought and sold over their heads, with people making money out of that when services are suffering,” Mr Bacon says.


According to the NAO, the holders of equity – which typically makes up some 10 per cent of the finance – have looked for returns of 10-13 per cent a year for their risk. And while there have been some losses, there have also been big headline gains of 60-80 per cent and more when stakes have been sold. Added to that, ultimate ownership of at least 90 projects has been moved offshore, potentially avoiding tax payments when they are sold on again. The taxpayer shares none of these gains.


Egged on by the NAO, which says there is a case for sharing excessive profits, MPs are up in arms. A recent ComRes survey of 158 MPs for Westminster Advisers shows 71 per cent believe such gains should be shared – including more than half of Tory MPs.


“The private finance initiative was, of course, a learning curve,” says Margaret Hodge, Labour chairman of the public accounts committee. “But it has echoed down the years to the repeated sound of the Treasury slamming the stable door after the horse has bolted. It took years to ensure that the public shared in refinancing gains; years to try to build more flexiblity into the contracts; and now we find the private sector making big equity gains in which the taxpayer does not share. It repeatedly feels like a rip-off.


“There is a role for private finance. We just have to find a better way to do it.”

‘Ministers hate PFI but still sign projects, because there is no alternative’“The government’s attitude to the private finance initiative is schizophrenic,” says one recent senior Whitehall insider. “On the one hand George Osborne [UK chancellor of the exchequer] and Francis Maude [Cabinet Office minister for efficiency] hate it. On the other, they are still signing projects because they know there is no alternative.”

In opposition, Mr Osborne described the Labour government’s use of PFI as “totally discredited”. It was a flawed model, which “must be replaced”, he said. “We need to find new ways to leverage private sector investment.”


Since the May 2010 election, however, the Conservative-Liberal Democrat coalition government has signed 34 contracts with a capital value of £1.8bn ($2.9bn), according to the Treasury. At least another £5bn worth of deals, including waste recycling plants and big hospitals in Liverpool, are in the pipeline. In addition, Michael Gove, the education secretary, has just announced £2bn of deals for up to 300 schools.


The schools, it is claimed, have learnt some lessons. They will be bought to more standardised designs. They will, it is said, use the centralised procurement expertise that has seen Canada and some other countries apply the PFI model more effectively than the UK.


There is, in fact, a wide range of alternatives to the UK’s classic approach to PFI. Equity investors could take the initial construction risk with cheaper public sector debt either used for, or replacing, private debt once the project is up and running. Parts of Canada and Australia use similar approaches.


An element of either debt or equity could be guaranteed by the government, reducing its cost. Or much shorter-term finance could be used, with the government taking the risk over the cost of replacing that finance later on.


“The problem,” says one former head of PFI policy at the Treasury, “is that all these require a larger element of public sector capital – and there isn’t any.” Indeed, as part of the deficit reduction, public spending on capital is being slashed by 60 per cent between 2009 and 2016.


In other words, while there will doubtless be some changes, the UK looks to be stuck with the essentials of the PFI for social infrastructure for the foreseeable future.
Even if, as many MPs are demanding, the state takes a share in the gains on equity sales, the private sector is likely to price back in the lost profits from that on future deals as it seeks to maintain its margins.
.
As Dominic Church of Westminster Advisers, a public affairs firm that helps clients grapple with PFI policy, puts it: “It looks to be very much a case of more of the same, but with some tweaking.”
.

Conventional potential
.
Conventional public procurement has had its problems in the UK. The Scottish parliament was estimated to cost £40m to build. When it opened years late in 2004, the bill had risen to £414m. London’s Jubilee line underground extension went way over budget.


But conventional procurement can work, sometimes adapting private finance initiative methods. The Olympic Delivery Authority has completed construction of the venues for next year’s Games under budget, using financial incentives where cost savings are shared. The National Audit Office, to its intense relief, last year completed an £81m refurbishment of its headquarters on time and under budget.

.

Copyright The Financial Times Limited 2011.