Government rhetoric in promoting PFI does not emphasise macro economic incentives. Much is made of the transfer of risk, previous overspending on public projects in the past and the involvement of private sector expertise and efficiency. The concept of risk is indicative of the way in which government policy has been tailored to meet private sector funding requirements. Initially, PFI was promoted on the understanding that the private sector would take responsibility for all the risks associated with building and running the facility within agreed performance criteria. This was discussed in a paper written in 1997 (Gallimore et al. 1997); ‘The government’s view has been that it is reasonable to expect a project consortium to take on systematic risk, such as a future change in Civil Service accommodation policy. . . the interviews suggested that contractors appear comfortable with risks with which they are familiar (e.g. construction), this is less so for longer-term risks such as usage’. Problems were experienced in funding PFI schemes where private sector consortia were expected to carry systematic, or demand, risk. The result is that in PFI schemes this risk is retained by the public sector. This is reflected in a survey by Akintoye et al. (1998), where demand risk was ranked second in importance from a list of 26 risk factors in PFI projects.
In many types of PFI projects, the carrying by the private sector of demand risk is not considered as a viable option by the government. ‘Volume is difficult to forecast and in the case of prison provision this risk has been retained by the client’. Further research by Bing et al. (2004) divides risk into three factors: macro, meso and micro. The first of these are risks that are external to the project such as economic conditions, the second are internal to the project such as design and the third are risks derived from the different nature of the private and public sectors and their incentives.
A survey of organisations concerned with PFI carried out by the authors (Bing et al. 2004) found that the risks that should be retained by the public sector include the political decision-making process, political opposition, government stability and site availability. Apart from the latter, all these are seen to be macro risks. Risks that respondents thought should remain with
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the private sector are a combination of macro, meso and micro risks such as industrial regulatory change (although some thought this should be shared), interest rates, weather, environment, ground conditions, financial market and all risks associated with design, construction and operation. Many risk factors are thought better to be shared between the parties or allocated on a case-by-case basis.
Graham Leach (2000) sees risk transfer as ‘the main benefit expected from PFI’ and he points out that if a private sector supplier is asked to carry high levels of risk, VFM will decline. Premium payments will be required by the private sector if it is required ‘to take on risk better managed by the public sector’. Demand can be considered to be the type of risk that a private supplier would find unattractive, but this raises the question of whether the private sector is being asked only to carry those risks that it would normally carry in a conventional project. The NAO takes a similar view to Leach in its examination of deals under the PFI (NAO 1999).
Risks should be allocated ‘to those parties best able to manage them’ and this is seen as a crucial factor in obtaining the best possible deal for the taxpayer. A report by the Kings Fund (reported in The Guardian 9/5/02) emphasises the level of demand risk that will be carried by the public sector as requirements change and technology develops. John Appleby, Director of Health Systems, is quoted as saying ‘continuing change in medical and information technology suggests that hospitals as we know them may not be needed in 10 or 20 years, yet the PFI is locking the government in for 30 years or more’.
Justification of PFI on the grounds of cost and VFM has been challenged by research carried out by Gaffney and Pollock (1999) into PFI hospital schemes. In order to show VFM, PFI projects are tested against a PSC.
Gaffney and Pollock first of all consider the existing capital charging regime in the NHS. NHS trusts are obliged to make an operating surplus of 6%
of relevant assets after inflation and, in addition, a straight line deprecia-tion charge is levied against the lifetime of the assets. The prices charged by the trusts are passed to purchasers who are in turn funded to reflect a component equal to average capital charges. The authors point out that, firstly, the 6% charge for the cost of capital does not reflect the cost of capital to the public sector but has been imposed ‘to ensure that there is no inefficient bias against the private sector supply’ (HM Treasury 1997 quoted in Gaffney and Pollock 1999). Two problems are seen with this system. As the circulating funding must also provide for payments to PFI contractors a leak is created from a formerly closed system and any short-fall must be made up from other budgets available to the public sector procurer.
Gaffney and Pollock also analyse increases in capital costs for the first wave of PFI hospital schemes from the statement of the OBC to the current cost. It was found that cost increases for a total of 14 hospitals averaged 69%
and the authors conclude that the reason for this ‘is largely accounted for by the incorporation of financing costs to the private sector, which amount to
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25% and 15% of the overall cost respectively’ (ibid.); the authors considered the two hospitals where full data were available.
Evidence is also available that the government is at pains to offer PFI schemes that are tailored to be attractive to private sector consortia. For example, the Princess Margaret Hospital scheme in Swindon was originally envisaged as a town centre project and was costed at £48m at OBC stage.
The project has now been relocated to an out-of-town site, thereby releasing valuable town centre land for development by the PFI consortium. The current cost is reported to be £148m ‘which was uniquely determined by the interests of private investors’ (Gaffney and Pollock 1999, p. 59).
Since these relatively early examples of PFI procurement, government has changed the procedure for analysing the risks in comparing a proposed PFI project with a PSC. It is stated that PFI is not suitable for projects of under
£20m capital expenditure and VFM is tested at three different times in the life of the project; at programme level assessment (commencement), at OBC and at procurement level just before financial close (The Treasury 2006). The latest edition of the Green Book confirms that the preferred discount rate is 3.5% (Green Book 5.49) but a range of discount rates are recommended for projects where the concession will last over 30 years.
One early example where PFI was claimed to be an unequivocal success in terms of VFM was in respect of prison contracts. Former Paymaster General, Geoffrey Robinson, sought to justify PFI by citing the ‘20% savings on the most recent prisons constructed and run under PFI contracts’ (Robinson 1999). A former career civil servant at the Home Office, David Wright, confirms this by referring to ‘significant savings on operating costs, in the order of 13–22%’ (Wright 1996, para 22) but the obvious point to make is that these savings may serve merely to increase the profits of the PFI contractor. In terms of capital cost a major problem appears to be that the Treasury, in seeking to control spending, requires accurate costings to be produced at an early stage. If the facility is to be produced using private finance this problem is avoided. This situation can be better understood by considering the way in which publicly funded projects were procured before the adoption of PFI and this is dealt with later in the comparative case study.
In spite of the many early criticisms of PFI, the government continues to argue strongly for its efficacy. In PFI: Strengthening Long-Term Partnerships (HM Treasury 2006) (The Report) the Treasury states the government case for PFI in detail and it is therefore an important milestone document. Partly written in defensive tone, it reports on the success of PFI to date, recommends further improvements to the process and accepts that not all projects are suitable for this type of procurement. The transfer of risk and the importance of ‘value for money’ are both major items in The Report. As a result of ‘the most extensive survey of operational projects to date’ the success of PFI to date is asserted. The argument rests on four main planks:
1. Seventy-nine per cent of the projects report that service standards are delivered always or almost always.
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2. Public authorities report that the overall performance of 96% of projects is at least satisfactory, and that in 89% of projects services are being provided in line with the contract or better.
3. With 83% of projects the contracts always or almost always accu-rately specify the services required with recent contracts showing more improvement.
4. PFI incentives are working with payment deductions being low and when applied the response from the contractor has resulted in good or very good levels of service (The Treasury 2006).
The operational performance of PFI projects is one area where the Report sees the need for further improvement in the following areas:
1. operational performance, flexibility and better long-term VFM;
2. ensuring that contractual incentives align more closely with service provision;
3. handover from procurement to operation;
4. the length of the contract in relation to the nature of the services and assets being provided;
5. the cost of contract termination by the government ‘changing its approach to certain aspects of the financial structure and the calcu-lation of the payment made if the public sector wishes to terminate the contract’ (para 1.21);
6. flexibility in the provision of soft services;
7. length of time from OJEU advertising to financial close. This is stated to be 2 years on average;
8. PFI procurement and monitoring expertise in government;
9. improved competition for senior debt.
It is therefore recognised that in spite of reported satisfaction with the PFI process, there are many areas where improvements are required. Attention is also given to the procurement process itself. ‘The key goal in managing a procurement process is to maintain competitive tension while achieving the requirements laid out in the project preparation stage’ (ibid., para 3.10).
Government here is setting out its belief that VFM is achieved through competition but it tacitly recognises the difficulties of doing this when complex services are being negotiated with a preferred bidder. The VFM drivers are listed as follows:
1. appropriate allocation of risks;
2. optimisation of whole-life costs throughout the life of the project;
3. an output-based specification that allows innovation and solutions that deliver VFM;
4. flexibility to allow changes in service requirements but allowing certainty for the private sector to innovate;
5. private sector incentive structures;
6. risk management expertise (para 3.11).
When these drivers are considered as a package it is difficult to escape the conclusion that government is attempting to reconcile fundamentally opposing incentives and requirements. How can ‘flexibility’ and ‘certainty’
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be achieved at the same time? Who decides on the ‘optimum’ cost (which means costs in relation to performance) throughout the project?
Certain projects are not considered suitable for the PFI route based on past experience. These include front-line service delivery where the terms of employment offered by PFI contractors would be unacceptable. This is called ‘pre-conditions of equity and accountability’ in The Report. Also for projects with fast changing service requirements and for projects of less than
£20m, PFI is thought unsuitable, as the PFI contract cannot cope with the flexibility required, for example, in an information technology (IT) project.
It is also accepted that PFI procurement is too expensive for small projects to be financially viable for contractors.
As stated earlier, certain risks were assumed to be borne by the private sector in the initial stages of PFI promotion by government. Demand risk, for example, is one area that was unacceptable to the private sector and is therefore borne by the public sector. This is rationalised by government as the view that risk should be carried by the party best able to manage it; although, as seen earlier, certain changes to PFI procurement will improve the public sector risk level. The Report sets out those risks ‘typically’ transferred to the private sector, which can be summarised as follows (para 3.39):
1. standards of delivery;
2. cost overrun during construction;
3. timely completion of the facility;
4. underlying and future costs associated with the project;
5. industrial action and physical damage;
6. certain market risks which would be scheme specific.
Figure 4.3 illustrates the risk profile of a typical PFI project.
The risks to be transferred to the private sector come within the all-embracing ‘value for money’ requirement but it is noticeable that there
Public sector
Risk transfer
PFI contractor special purpose vehicle Equity
shareholders
Debt providers or bond holders
Risk transfer
Building contractor
Facilities manager
Insurers Residual risk
Figure 4.3 Risk structure for PFI project.
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is an acceptance that projects that require a high level of flexibility are not thought suitable for PFI. Government also recognises the importance of the
‘people’ factor in projects and procurement. This is defined as ‘partnership working’ (paras 5.48 and 5.49) and will be given advisory weight only by being documented in a ‘shared vision’ document that, although not contractual, ‘sits alongside’ the PFI contract.
Government also believes that the structure of a typical PFI contract inherently protects the public sector by the incentives of the various parties involved in the project. These are listed as follows (para 5.75):
1. Senior lenders will require construction bonds and parent company guarantees and will scrutinise the PFI company closely.
2. As the PFI company will not receive service payments until the facility is running there is a strong incentive to make the facility available, in accordance with the service contract as soon as possible.
3. Investor equity is at risk if the PFI company defaults and will therefore have a strong incentive to manage the PFI company effectively.
4. The ability of lenders to ‘step in’ will be exercised in the case of difficulty and there is a strong incentive for lenders to do that as their debt repayment is at stake.
5. The right of the public sector client company to terminate the PFI contract gives a strong incentive to both equity and debt providers as both will be at risk in the case of default and termination.
Although government appears happy that the PFI structure contains an inherent risk protection, as the penalties for default are great, it is not satisfied with the time taken to procure and complete projects. More emphasis will be placed on defining the project before bidders are involved and schemes will be more closely examined before a preferred bidder is selected. A final approval prior to financial close will be introduced to ensure that the scheme is within the previously approved parameters. These measures are designed to minimise cost increases and time delays when projects come to the market but it is worth recording the financial risk that the public sector accepts with all PFI projects. The risk of inflation is retained by the public sector as a proportion of the unitary charge made by the PFI contractor is indexed to the Retail Price Index (RPI). How much of the contractor’s costs are to be indexed is confirmed in the bid for the project. The retention of this risk is seen as a benefit to the public sector because, if it was not there, the contractor would be obliged to factor the risk into the bid. The risk of interest rate rises is borne by the PFI contractor but government continues to consider whether this offers the best VFM as, in the case of contractor default, the cost of breaking the contractor’s short-term loan commitments becomes a government responsibility.
One of the major criticisms of PFI has been the cost of private finance in comparison with public finance, which is always cheaper. Government is aware that raising public finance through gilt issues tends to push up interest rates as a competitive rate of return must be offered on the gilt issue. Also, if government is in the market as a major debtor, funds will be attracted to a relatively low-risk debtor and this will tend to ‘crowd out’ the private sector
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from the debt markets or make the available debt unnecessarily expensive.
The Report (para 8.2) acknowledges that the cost of government borrowing is lower than that enjoyed by private sector institutions and proposes credit guarantee finance (CGF) to reduce the private sector risk premium. The CGF works very much like the securitised debt described in Chapter 7 when Chase Manhattan Bank was able to lend at a small fraction over London interbank offered rate (LIBOR) as a result of a promissory note provided by the developer. With CGF the government lends to the PFI contractor at the prevailing rate of interest as if the contractor was borrowing in the market.
The government’s loan is guaranteed by one or more financial institutions of undoubted covenant and for this guarantee they are paid a fee. Even after paying the fee, the government is able to show a positive cash flow, which is a net surplus of funds. The Report states that pilot studies of this method have shown cost savings at Leeds Hospital at 8% of financing costs and at Portsmouth Hospital at 16% of total financing costs.