Reviewing the UK Private Finance Initiative

[petagny]

For those following the pros and cons of the UK Private Finance Initiative (PFI), there are some interesting activities this week. On Tuesday, the Treasury Committee will hear evidence in its ongoing inquiry into the future of PFI, asking whether it has been value for money for the taxpayer. The following day, the Public Accounts Committee will look at the lessons learned so far from the roll-out of PFI.

BBC on-line news is carrying the story that the Treasury is not keeping track of the selling on of shares in PFIs and the 'excessive' profits being made. From a regulatory perspective, it's probably important to keep track of ownership and excess profits might be a sign of poor deals from which lessons can be learnt, but to try and claw back the 'excess profits' from the deal - as one commentator seems to be suggesting - seems to contradict the rationale for these schemes. Follow the logic through and the state should be compensating 'excess losses' made by private sector companies that sell on shares at a loss (of which there must be some). This doesn't seem fully consistent with the idea of transferring risk to the private sector. Although a case could be made that the risks (and rewards) are never evenly shared: the government is likely to be landed with the ultimate downside risk if the contractor goes bust (e.g. London Underground renovation).

[John Short]

When I was listening to the piece, it struck me that the interest was on the secondary market and the profit made on selling shares in the original deal rather than on the original deal itself in the PFI arrangement: if the secondary market was so profitable then it suggests that the original deal was badly negotiated - a case of locking the stable door after the horse had bolted and had reached Switzerland!

[petagny]

Yes, This is what I had understood as well. As you say, no sense in trying to claw back 'excess profits' from these deals. But they could be an indicator of a poorly designed deals offering low VFM, so I guess there might be some value in monitoring the secondary market so as to learn where mistakes might have been made and design future deals better.

[John Short]

I agree with that!

[harnett]

Or the cynical amongst us could imagine that the deals were deliberately generous (one recalls the selling off of the UK utilities).  Apparently one cabinet minister stated:  ‘the people on the other side must have been laughing all the way to the bank’ (this will be aired on BBC Radio 4 tonight.).  The excessive profit made on these deals is apparently in excess of 50% (according to a report produced by the European Services Strategy Unit) which, as you say, indicates an incredibly poorly negotiated intial deal on behalf of the taxpayer - or a well negotiated deal on behalf of the winning bidders!!  As for the secondary market - surely the fact that there is such a thriving market indicates that the initial tender winner was not, in many cases, best equipped to provide the service offered.

[John Short]

The secondary market is not to supply services but just the "winner" offloading future profit for present cash presumably at a discount that makes it worthwhile for the purchaser!

[petagny]

Deliberately generous or are there information asymmetries that mean that the cards are stacked against the public sector getting a good deal in the first place? The incentives have been all wrong as well: in order to get a good deal, you have to be prepared to walk away from a negotiations, but under the previous government the pressure was to keep on signing PFIs. The performance measures were therefore distortionary.

[harnett]

John - thanks for the clarification - but I don't understand why there should be any criticism of the secondary market - it sounds like it's simply a finacial strategy for raising cash and / or spreading risk.  If the claim is that the secondary market was so profitable then it is the "winner" that is foregoing these profits - not the taxpayer once the original deal is done.

[John Short]

Yes, but it may be an indication that the original contract may have generated too good a deal for the instigator relative to the taxpayer but nothing wrong at all with the secondary placing per se.

[John Short]

Report on PFI published 19th August
http://www.publications.parliament.uk/pa/cm201012/cmselect/cmtreasy/1146/1146.pdf
Chairman of the Treasury Select Committee, Andrew Tyrie MP, said:
"PFI means getting something now and paying later. Any Whitehall department could be excused for becoming addicted to that.
 
"We can’t carry on as we are, expecting the next generation of taxpayers to pick up the tab. PFI should only be used where we can show clear benefits for the taxpayer. We must first acknowledge we’ve got a problem. This will be tough in the short term but it should benefit the economy and public finances in the longer term.

"PFI should be brought on balance sheet. The Treasury should remove any perverse incentives unrelated to value for money by ensuring that PFI is not used to circumvent departmental budget limits. It should also ask the OBR to include PFI liabilities in future assessments of the fiscal rules.
 
"We must also impose much more robust criteria on projects that can be eligible for PFI by ensuring that as much as possible of the risk associated with PFI projects is transferred to the private sector and is seen to have been transferred."
 
Higher borrowing costs since the credit crisis mean that PFI is now an ‘extremely inefficient’ method of financing projects, according to the Committee. Poor investment decisions may continue to be encouraged across the public sector, however, because PFI allows Government departments and public bodies to make big capital investments without committing large sums up front.
 
The Committee has not seen any convincing evidence that savings and efficiencies during the lifetime of PFI projects offset the significantly higher cost of finance. Indeed, the Report raises concerns that the current Value for Money appraisal system is biased to favour PFIs. It identifies a number of problems with the way costs and benefits for such projects are currently calculated.
 
Recommendations
 
Investment could be increased in the long run, the MPs point out, if government capital investment were used instead of PFI. The average cost of capital for a low risk PFI project is over 8%, double that of government gilts. Analysis commissioned by the Committee suggests that paying off a PFI debt of £1bn may cost taxpayers the same as paying off a direct government debt of £1.7bn.

The Committee recommends that:
 
-The Treasury should consider scoring most PFIs in departmental budgets in the same way as direct capital expenditure, adjusting departmental budgets accordingly;
 
-The Treasury should discuss with the OBR the treatment of PFI to ensure that PFI cannot be used to ‘game’ the fiscal rules;

-The Value for Money assessment process should be subjected to scrutiny by the NAO;

-The Treasury should review the way in which risk transfer is identified.

[petagny]

This report should be obligatory reading for 'PPP-pushers' and potential PPP adopters.

The Committee had difficulty in finding benefit from PFI schemes to outweigh the higher financing costs involved. Particularly noteworthy is the difficulty in establishing any advantage from PFI in taking account of the whole-life costs of infrastructure. Because maintenance costs are internalised within a PFI scheme, the contractors were expected to innovate and to deliver higher quality and better maintained infrastructure. As the report says 'If bidders know they can achieve lower whole-life costs and the procurement process is sufficiently competitive, then this should result in lower prices for the public sector' - at least, this is the theory. Instead, it seems that the tendency has been to cut corners and provide infrastructure of lower quality in order to maintain profit margins. The Committee heard evidence to this effect from the Royal Institute of Architects and the Buildings Research Establishment. In conclusion, the Committee found that:

'It is difficult to establish clear cut evidence in the area of whole life costing. In theory whole life costing should encourage the use of innovative designs in PFI to deliver buildings of better quality. These should in turn provide cost savings over the life of the building that can, to some extent, offset the higher financing costs inherent in a privately financed deal. The long term nature of a PFI contract should also incentivise providers to maintain buildings to a high quality thus reducing costs in later life. However we have not been provided with clear evidence to suggest that PFI performs better in this area. Indeed in the area of design innovation and building quality we have seen some evidence to suggest that PFI performs less well than traditionally procured buildings.'

[John Short]

Looks like the PFI in the UK is about to bite the dust at least in its current format.

http://www.ft.com/cms/s/0/0344a800-0edd-11e1-b585-00144feabdc0.html#axzz1dn18HDAO

[petagny]

In the end, it doesn't look as though much is going to change as far as PFIs are concerned. Just some window dressing -  no more 30 year cleaning contracts!

See article in yesterday's FT

http://www.ft.com/cms/s/0/af0a18a6-062f-11e2-a28a-00144feabdc0.html#axzz27OFGJpDt

So much for radical rethinks!