In what place it has in the UK and

In the wake of the Carillion collapse it is
pertinent to ask whether PFI is still an attractive and sensible option for the
provision of infrastructure and services. Much political debate is centred on
the topic and this report will look at the arguments surrounding not only
Carillion, and the government’s handling of its demise, but also the policies
and doctrines surrounding PFI itself and what place it has in the UK and
beyond, going forward.

 

1         
What is PFI

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According to the Infrastructure and Projects
Authority (IPA) over £300 billion is required to be invested in infrastructure by
2021. There are various ways by which the government can pay for infrastructure.
Historically, most of the finance for investment in infrastructure is drawn
from tax receipts and/or government borrowing, and the government intends to
spend up to 1.2% of gross domestic product (GDP) each year on economic infrastructure
between 2020 and 2050.1 However, a significant proportion of the
planned infrastructure will also be privately financed. One private financing
route is a Public Private Partnership (PPP) such as PFI and PF2. There are over
700 PFI and PF2 projects in the UK. Over the last 20 years capital investment
using PFI and PF2 has averaged around £3 billion a year – this is
relatively small in comparison to publicly financed government capital
investment which currently amounts to around £50 billion a year.

 

The fundamental difference between conventional public
procurement and PFI procurement for capital investment relates to which party
raises finance for the asset’s construction. In conventional procurement
the private sector is still involved (private contractors build the asset) but
the public sector provides the finance. When the public sector procures an
asset using PFI, a private company – a Special Purpose Vehicle (SPV) – is
formed and it raises finance from debt and equity investors to pay for
construction. Once the asset is constructed and available for use the taxpayer
makes ‘unitary charge’ payments to the SPV over the contract term, usually 25
to 30 years. This charge includes debt and interest repayments,
shareholder dividends, asset maintenance, and in some cases other services like
cleaning. These payments will be agreed at the start of the contract and some
or all of them will be linked to inflation. All of these aspects remain in the
PF2 model which replaced PFI in 2012; the costs and benefits of PFI discussed
in this report also apply to PF2.

 

HM Treasury made the introduction of PFI possible in
1989 when it retired the ‘Ryrie-Rules’ (which had discouraged public sector
projects from being privately financed) and announced that it would allow
additional privately financed investment in roads. In 1992, the use of PFI was
extended to other sectors and the name ‘Private Finance Initiative’ was used
for the first time.2 Other changes were later introduced to allow
for PFI to be used within local bodies, for example the Department of
Health and Social Care provides a Deed of Safeguard for PFI health deals which
guarantees PFI payments. (HM Treasury – National Audit Office, 2018)

 

Many countries around the world have adopted PPP’s
and PFI’s in similar forms to that seen in the UK. Paul Drechsler, chair of the
Confederation of British Industry (CBI), however, questioned recently why PFI
“does not work here in the UK but does elsewhere. This may lead us to assume
that issues encountered with PFI in the UK are less an issue with the model
itself and more in its implementation and management by government bodies.

 

2         
How did we get here and
where are we going

 

PFI was created in order to address the belief that
construction engineers are better trained to understand risk in construction
than civil servants in government departments or local councils

 

An early example of PFI being used was for the
channel tunnel, which encountered numerous financial and contractual
difficulties before major restructuring allowed it to eventually operate as
intended. Since then PFI has often been used for hospitals and schools,
projects which typically have large capital costs that struggling government
departments would struggle to meet. During the years of the Blair government,
it became incredibly attractive to Labour to use PFI as a funding model for
many of these projects. PFI allowed large eye-catching construction projects to
go ahead whilst keeping the treasury balance sheets free of huge short term
spending liabilities.

 

The Labour party, under Jeremy Corbyn and John
McDonnell, has made a pledge to nationalise contracts currently under PFI with
the UK government. The National Audit Office (NAO) has just produced a report
giving them plenty of justification, investigating the basis for PFI and finding
it lacking. They reported that they could find no financial benefit for the
taxpayer in PFI. If implemented competently and for the correct reasons, however,
PFI is not in itself inherently bad. Unfortunately, this is far from what has
happened. Due in part as a response to criticism, the number and value of PFI
projects has fallen sharply in recent years.

 

The annual charges for the UK’s 700 operational PFI
deals added up to £10.3bn in 2016-17 (0.5 per cent of gross domestic product).
Even if no new deals were launched, future charges (which will continue until
the 2040s) will amount to £199bn. (NAO 2018)

 

Yet this experiment, which originated with a change
in Treasury rules in 1989 and continued under subsequent governments, is
interesting. It is not unreasonable for government to contract for services
from private suppliers. It is certainly reasonable for the UK and other
governments to attempt to learn from this influential experiment.

 

For PFI to work, the asset being built needs to
generate its own revenue stream that can accrue to the contracting team that found
the money to get the project built. Early examples were: the Channel Tunnel, beset
by difficulties because of a flawed initial project structure and requiring significant
financial and contractual restructuring in order to get it on track; and the
Dartford Crossing, which was successful on almost every front, mostly due to
the tolls levied on users who have little alternative to using it.

 

 

Then the finance teams in the government realised
that with a little creative accounting PFI could be used to shift public
spending off the balance sheet and massage the numbers to meet fiscal rules.
PFI relies on a revenue stream. Spurious revenue streams were produced for prisons,
hospitals, schools and government offices by giving the SPV’s contracts for
20-30 years to stick around and look busy, doing the washing up and emptying
the bins and. Buy now, pay later meant some hefty up-front savings were
ready to be made – but the whole life cost is huge. But the private owners
weren’t even the ones making the money. It was the creditors.

 

The UK treasury is of the opinion that the transfer
of risk away from the public sector to the private can lead to benefits which
may outweigh the increased costs of financing. The private sector has a strong incentive
to construct assets to a tight budget due to the risk it bears for cost
overruns during construction. It is standard practice for the contracts to
include operation of the asset and as such the SPV is incentivised to develop
plans to reduce long term running costs from the outset. PFI also requires
assets to be well maintained throughout the period of the contract which could
have many knock on benefits including longer asset life.

 

In response, however, the NAO finds, that whilst the
SPV has an incentive to deliver the project within budget, increasing cost
certainty, this does not preclude that the lowest possible cost. In reality,
and particularly for complex projects, unforeseen costs are likely to be
covered by higher prices charged by bidders.

 

There is also “no evidence” found by the audit
office that assets are operated more efficiently. Some services may even be
more expensive, possibly due to increased standards.

 

Lastly, standards of maintenance are found to be
higher in projects under PFI. This appears to be because, under budgetary
squeezes, maintenance spending is quickly reduced by government departments,
this is more difficult under PFI. One can argue that it is desirable for
government to have such flexibility. Yet one can also argue that, as is the
case with the palace of Westminster, the government occasionally needs to be
restricted from postponing necessary maintenance.

 

These arguments for PFI, however, are weak. As the
NAO also argues, the cost of capital in a PFI project is far higher than for
the government. An effective counter-argument is that government borrowing is
subject to an implicit subsidy from taxpayers. This subsidy, as with the
implicit subsidy to banks which are seen as too-big-to-fail, represents an
unpriced insurance contract. That government funding looks cheaper due to this
allows us to expose an illusion. In turn, PFI begins to look less unreasonable.

 

There is a politically important and inherently
wrong reason for PFI. This is that PFI is not included in conventional
statements for public debt, in essence, off the balance sheet of the government
department. A “fiscal illusion” is what the Office for Budget Responsibility
and the International Monetary Fund have called this. Just as government
borrowing establishes a long-term contractual liability, so too does a PFI
contract. Another implicit liability is that any publicly owned asset is
obliged to be operated. Accounting procedures which deal with these two methods
of financing services differently are deceitful. It is to the Treasury’s
discredit that it continues to encourage misleading accounting that is likely
to lead to mistaken decisions. The Treasury should make serious attempts to
treat its balance sheet and finances with due rigour and honesty.

 

 

3         
Carillion

 

Carillion was put
into liquidation in January after the money to continue running its wide
spectrum of government contracts, including road building, serving school
dinners and maintenance of prisons, finally dried up. The second-largest
construction company in the UK was also a large beneficiary of the raft of PFI
contracts struck, over the past 25 years, between private companies and the
government. The collapse has cast doubt over the futures of its 30,000
subcontractors, 43,000 employees and the future completion of three decades
worth of government contracts. Carillion’s downfall has led the many detractors
of such deals — notably Jeremy Corbyn et al. — to trumpet the proposal to take
control of PFI projects back in-house. Carillion did not go bust because of privatisation
of public services. If anything, from one viewpoint, it shows that those
contracting out public contracts were getting a good deal. There will always be
public projects contracted out to the private sector. Much of the increase in
public investment planned by Labour if it wins the next election will be
undertaken by private firms. Getting the contracting relationship right is
difficult and fraught with dangers.

It is a tale of
miscalculation and commercial overreach. But also the tale of a political ideology.
Carillion were the embodiment of small state Conservatism, pioneered by
Margaret Thatcher and which swept the world. Where once public services were provided
by governments, now they are commissioned from private companies. The crux is
to expose stale state monopolies to competition and the innovation of the free
market. However, a host of failures across the UK, of which Carillion is only
the latest, means the country which brought “contracting out” to the world is
at risk of becoming a cautionary tale. Now with Labour courting ever more
interest from voters whilst waving the banner of renationalisation the
Carillion affair could be the end, not just of a company but of one of the most
influential ideas of the last 50 years.

 

It can be argued that
Carillion is a good example of how it is better to have a failure of
contracting-out than a public sector failure. Its losses not be borne by
taxpayers, but largely by its creditors and shareholders. However, dig a little
deeper and its demise shows how PFI and contracting-out more generally must
change before it can truly live up to the expectations of its most ardent
proponents.

 

Regardless of whether
Joe Bloggs is picking up the bill for Carillion’s losses, there is still the
provision of vital services, project delays and contract transfers that will mean
costs for the taxpayer of hundreds of millions of pounds. Not to mention the
plight of its subcontractors. The company’s fragility should have disqualified
it from HS2, a monstrously complex rail project. Rather, ministers appear to
have thrown as a lifeline the £1.4bn ($1.9bn) contract. Serious misgivings must
be addressed by the government when we hear that even after various profit
warnings they continued to award contracts. This smacks of ministerial failure.

 

Governmental
shortcomings brings us to a key lesson of Carillion’s collapse: this continued
misplaced obsession with lowest bid over whole-life cost. Prequalification
systems, two-envelope bidding and weighted scoring have gone some way to
reducing unscrupulous bidding practices over the years, but still, the lowest
bid can reliably be found at the top of the pile. Not without reason, government
commissioners are in a tricky position, if they are ever challenged, the lowest
bid is the simplest for government purchasers to justify accepting. They cannot
be seen to be being frivolous with money that is inherently not theirs.

 

Where was the ‘crown
representative’ (who was meant to be overseeing scrutiny of, among others,
Carillion) during all this? The position had been left vacant? The government
should also ask whether companies should be allowed to pay large dividends when
their own pension fund is underfunded. Carillion’s board recently changed its
rules to ensure that, in the event of collapse, managers bonuses could not be
clawed back. This serves in the mind of any onlooker to reinforce the common
image of private greed. Questions must be asked of Carillion’s auditors, KPMG.
How could a company, with a balance sheet showing quite clear signs of stress
be given the all clear?

 

It should be noted
that there is an unhealthy concentration in the marketplace for large
all-encompassing service providers. For example, private prisons in Britain are
operated by just 3 companies. Only two bidders were involved in a billion pound
contract for the redevelopment of a London hospital. Routinely, the government
commissions huge, long-term projects based on fewer quotes than voters would
get for refitting their kitchen.

 

One of the main
benefits of contracting out, as mentioned, is that it can save money. Any talk
of ‘the market’ here is misleading, as, with just one “customer” and only a few
vendors for a contract which is agreed only once every 3-4 years, this can
scarcely be passed off as a normal market. It is incentives faced by workers
and their managers, in realising efficiency and encouraging innovation. Incentive
systems to maximise profits in a private sector firm are clearer for managers,
and that incentive is necessitated by the imperative to make a profit whilst managing
to bid as low as possible. Carillion’s example shows that margins are very
small on the majority of outsourced public sector contracts. In this, Carillion
proves that the mechanism, at least in this sense, is working. Unless it is in
competition with private sector firms a single public sector body would not be
able to match this advantage, competition improves incentives.

 

One important qualification
to this argument involves information. The temptation of a bidding system based
on the lowest price is to cut quality. So the public sector needs a clear means
of not just specifying quality in the contract, but of ensuring fulfilment of
said contract after it has been awarded. Occasionally politics stands in the
way of that taking place. When quality is truly difficult to observe,
contracting out of this kind should never be floated as an idea.

 

4         
Conclusion

 

Where does this leave PFI? Contrary to Theresa May’s
PMQ insistence that the government is simply “a customer, not a manager”, the
government must display effective client representation and perform watertight
due diligence. No customer should walk into a contract blindly and when a
contract extends into the billions of pounds and is looking to provide
essential services such as a hospital or high speed rail link (if HS2 can be
considered essential) then more robust “customer” oversight is crucial. If the
government can specify and monitor the contract, can be confident that the
private sector will deliver, cannot find a superior organisational form and
wants to bind itself to delivering the service over the term of the contract,
then it can make good sense. The argument put forward by some, that direct
borrowing should finance all government spending, because it is cheaper, is far
from faultless: the government’s borrowing costs need to include the insurance
implicitly provided by the taxpayer. However, PFI must not be used simply to
shift a liability off the balance sheet.