Memorandum by Professor David Mayston
PRIVATE FINANCE AND OPPORTUNITIES FOREGONE
IN HEALTH CARE CAPITAL
Capital resource management in the UK National
Health Service has a long history of tensions and problematic
development. The introduction of the Private Finance Initiative
(PFI) in recent years has offered managers and ministers the opportunity
to escape from many of the capital constraints of the traditional
governmental funding system. However, it has done so at a potentially
high future opportunity cost. The extent and nature of the risks
which are transferred from the NHS to the private contractors
by the PFI schemes are unlikely to justify a higher cost of capital
for private finance compared to that available to the government.
Instead PFI schemes may introduce potential new risks of their
own. The macroeconomic argument that public investment crowds
out private investment is likely to apply even more strongly to
PFI schemes, which compete more directly for scarce private finance
funds. More efficient ways of raising finance for direct investment
in the NHS could be devised that satisfy also a strong institutional
need for low risk investments to protect future pension incomes.
Greater transparency and value for money could be obtained through
unbundling PFI schemes, and their associated contracts, into their
The management of capital resources in the NHS
has for many years raised interesting and important issues, and
latent tensions [1-2]. This tradition has been continued in no
small measure by the introduction into the UK public sector of
the Private Finance Initiative (PFI) by a Conservative Chancellor
of the Exchequer in 1992, and its continuation under the subsequent
New Labour Government after the partial repackaging of PFI in
the form of Public-Private Partnerships (PPP). Central to the
initiative is the use of private finance to fund capital investment
in hospitals and other capital assets, such as medical equipment,
for which the NHS becomes in effect the lessee over a long contract
period of 30 years or more, typically as part of a package that
may include maintenance and other operating costs being borne
by the private contractor, in return for an overall annual payment.
The ownership of the assets remains with the private contractor
during the contract period, though may revert to the NHS at the
end of the contract if this reversion is included and paid for
within the PFI contract.
Partly because of the complexities which this
new form of financing and contracting raised, the growth of PFI
schemes in the NHS was initially at a low level. However, PFI
projects in the NHS for which contracts have now been signed or
which have reached preferred bidder status are expected to involve
some £1.86 billion in cumulative capital spending by PFI
contractors by the end of the financial year 2002-03 [3-6]. The
capital spending element of many of these contracts will, however,
represent a substantial under-estimate of the present value of
the total costs which the NHS is likely to pay under as a result
of entering into these contracts. Whilst figures are now available
for the total annual spending commitments for existing individual
PFI schemes , separate figures are not in general available
for the different service elements, including future maintenance
and operating costs, that these contracts involve, separated out
from each other and from the cost of capital.
The issues which the growth of PFI raises are
multi-dimensional. The first dimension which we will examine is
that of time, and the associated issues of inter-temporal efficiency
One of the primary immediate benefits of PFI
for the Government, NHS management, and patients is the upfront
benefit of new capital facilities becoming available to the NHS
under PFI sooner than they would have done under the traditional
NHS system of funding capital investment directly out of public
capital expenditure. With access to PFI funding, the Secretary
of State for Health, Alan Milburn, has been able to announce another
"29 new hospital schemes with a capital value of £3.1
billion"  shortly before the 2001 General Election, with
obvious electoral appeal. This forms part of an overall NHS capital
investment programme totalling £12.9 billion between April
2000 and March 2004 [9, p.31]. Even allowing for the fact that
direct capital expenditure in the NHS was cut substantially over
the period 1994-95 to 1997-98 as PFI funding was increased, paying
for new hospitals and medical equipment through annual lease payments
will typically enable several times more new assets to be available
to the NHS in the early years, out of any given level of total
NHS funding inclusive of upfront capital expenditure, than would
direct capital expenditure by the NHS on these assets.
However, it is important to appreciate the full
force of the logic of compound interest in this context, particularly
as the cost of capital that is implicit in many PFI deals is widely
believed to be significantly in excess of the Government's own
borrowing rate of interest. The annual "availability fees"
for making PFI hospitals available to the NHS have been estimated
by Gaffney et al  to range from 11.6 per cent to 18.5 per
cent of the initial construction costs of the facilities, including
an element of maintenance charges that makes the underlying cost
of capital not directly specified. The cost of capital, r, that
is implicit in a series of constant annual payments, Y, for the
capital facilities, rather than for any service and maintenance
elements, is given by:
where n is the length of the contract in years, Ko
is the capital value that is make available now, and Arn is the
relevant annuity factor .
From (1), we can calculate the total capital
value that can be made available now for a given stream of annual
payments, Y, for different values of the annual costs of capital,
r. One stream of annual values of Y that it is of interest is
the case where Y is set equal to the construction cost of a new
hospital, which we will initially assume to be the same for all
new hospitals. This enables us to consider the trade-offs and
opportunity costs that are involved in making total capital of
Ko available now to the NHS through PFI schemes, rather than spending
the associated annual payments on the direct construction costs
of a whole series of one additional new hospital a year for the
next n years.
The second column of Table 1 considers the case
of n = 30. When the cost of capital is three per cent, 19.6 new
hospitals could be financed now by PFI out of the same stream
of annual payments that would have paid for the direct construction
costs of a whole series of one new hospital a year for the next
30 years. When the cost of capital rises to 15 per cent, only
6.57 new hospitals could be financed now out of the same stream
of annual payments that would have paid for the direct construction
costs of a whole series of one new hospital a year for the next
30 years. The third column of Table 1 considers the case of n=60.
When the cost of capital is three per cent, 27.68 new hospitals
could be financed now by PFI out of the same stream of annual
payments that would have paid for the direct construction costs
of a whole series of one new hospital a year for the next 60 years.
However, when the cost of capital rises to 15 per cent, only 6.67
new hospitals could be financed now by PFI out of the same stream
of annual payments that would have paid for the direct construction
costs of a whole series of one new hospital a year for the next
The rate of time preference, and associated
willingness to give up the prospect of 30 additional new hospitals
for the NHS over the next 30 years in return for substantially
less now, may then differ across the community. Current politicians
and NHS managers, under immediate pressure for more capital facilities
to meet current needs, may take a shorter term view than the longer
term interests of many sections of the population at large whose
health care needs may extend over future decades. The extent to
which this is true is compounded by both demographic and technological
change. The major increases in the size of the UK population over
the age of 75 in the decades after 2010, from 3.4 million in 2001
to nearly 7.6 million in 2035 , are likely to place significantly
increased demands on NHS funding. Even if the needs of this expanding
age group are better met outside of hospitals, the foregone freedom
to switch funds out of future potential hospital building programmes
into other forms of health care implies similar long-term opportunity
costs to current PFI schemes.
|Cost of Capital
||Number of Hospitals now 30 year
PFI contract60 year
|3 per cent||19.60
|6 per cent||13.76
|10 per cent||9.43
|15 per cent||6.57
|20 per cent||4.98
The existence of technological change would also lead one
to expect that a more steady process of investment in new hospitals,
that are able to incorporate recent technical developments as
they become available, would result over time in a more efficient
and effective capital stock in coming years. This will be particularly
the case if there is a need for a long-term re-configuration in
the pattern of acute hospital provision in the NHS , and there
is a risk of PFI schemes being too hastily pursued by their sponsoring
Trusts with an inadequate consideration of the long-term needs
of the NHS . The establishment of the Capital Prioritisation
Advisory Group (CPAG)  in the NHS may help to ensure a greater
degree of rationality in the choice of current PFI schemes, although
will not change the basic inter-temporal trade-offs that a high
PFI cost of capital implies.
A fully rational system of investment planning over the current
and the next n years would be one that seeks to maximise some
valuation function V subject to an inter-temporal budget constraint,
such as that given by
where I, is annual capital investment at time t, Ct is current
expenditure (excluding PFI annual cost of capital payments) at
time t, Ft is the total funding available to the NHS at time t
from central government, net of any user charges, with F = (Fo,
.., Fn) and a = (ao, .., an) is a vector of demographic and other
relevant parameters, including the rate of technological change.
Kt, is here the level of the effective capital stock available
to the NHS at a time t, and is some function:
of the capital stock, Ko, at the start of period 0, and of subsequent
investment levels and rates of technological change.
In this context, PFI involves an initial level, Io, of capital
investment in the NHS at time t = 0 plus current expenditure,
Co, in excess of the direct funding for the NHS, Fo, from central
government. Satisfying the inter-temporal budget constraint involved
in (2) requires that total funding in at least some later period
must then exceed the level of capital investment plus current
expenditure in those later periods, to pay for the future PFI
annual payments. If there is a tendency to defer the day of reckoning
until later in the n year time horizon, this will imply that
ie increases in the cost of capital reduce the overall benefits
that the NHS can achieve out of its future stream of funding.
Assessing the relative health care needs of present and future
NHS patients within the valuation function V in (2) raises issues
of both inter-temporal efficiency and inter-generational equity,
not only with respect to the levels of health care investment,
It and current expenditures, Ct, in each future year, but also
to how these should be funded over time through the time stream
of tax-based governmental contributions Ft. Once PFI schemes and
borrowing are permitted, Ft may diverge from the sum of It and
Rt through the shifting of annual payments over time. The projected
demographic changes over the next 35 years include not only an
increased total population in older age groups, but also a declining
tax base of younger age groups of working age , albeit with
higher per capital real incomes, and consumption expectations,
through economic growth. The time pattern of tax-based governmental
contributions to the NHS is therefore unlikely to be a matter
of indifference, but instead enter into the valuation function
V in (2). It is then questionable whether an optimal policy of
public finance does involve the accumulation of additional long-term
obligations for annual PFI payments which must be met partly out
of tax revenue in later years when these demographic trends become
particularly acute. In contrast, there may be a strong case for
the current generation of 40-60 year olds to pay more in tax in
the next 10 years to fund direct NHS investment in a capital stock
that will benefit them in future years, rather than shift forward
these tax liabilities at a high rate of interest to a time when
there will be greater pressures on the tax base, and when this
generation may be less able to fund such additional liabilities.
Nevertheless, even if present health care needs are given
considerably more weight than future needs within the valuation
function, Table 1 illustrates that significantly more new hospitals,
or other capital facilities, could be made available now for the
same annual cost of a 30 year PFI contract at a 15 per cent cost
of capital, if the NHS had access to capital at a borrowing cost
of six per cent or three per cent. Indeed such lower borrowing
costs would enable, respectively, 2.1 and 3.0 times as many new
hospitals of a given size to be made available now as the PFI
contract does. Seeking to accommodate such an increased cost of
capital within any given total annual level of funding may result
in pressure to reduce the specification of the PFI schemes proposed.
Reductions averaging between 26 per cent and 31 per cent have
been found [15-16] in the beds to be made available by the first
wave of PFI schemes compared to those currently available. These
reductions are in addition to any resulting from the pressure
that has already been exerted on NHS Trusts to reduce their bed
stock through the internal NHS capital charging system (which
includes a six per cent interest charge) since 1994, when the
system became "non-neutral" in its incentives for such
a reduction . The planned reductions in bed numbers are also
despite the findings of the National Beds Inquiry  that "the
long term trend in reductions in general and acute beds is not
compatible with the requirement to improve access to care and
cannot be sustained" [17, p.42].
A second dimension which we need to examine is that of risk and
uncertainty. These will interact with our above discussion involving
time through the adjustment which must be made to the relevant
cost of capital, r, to include an allowance for any systematic
risk which the investment projects involve. Such systematic risk
arises from any correlation between the costs and/or demand for
the project and general economy-wide uncertainties. It remains
even after all project specific risks that are uncorrelated with
such economy-wide uncertainties have been diversified away by
being spread over the entire government sector , in the case
of direct NHS investment, or over the capital market , in
the case of PFI investment. Under the standard Capital Asset Pricing
Model (CAPM) of finance theory, the existence of systematic risk
implies a competitive cost of capital, and risk-adjusted discount
factor, to be applied to the net cash flow of project j at time
If the project is run as a PFI scheme, a cost of capital
above the risk-free rate is justified if the contract does transfer
significant positive systematic risks to the PFI contractor. However,
demand risk will remain with the NHS (see ) unless the PFI
payments vary with the level of demand for the facility. Similarly
if the PFI contract index-links payments to general construction
and energy cost movements, the systematic risk will remain with
The net present value of the expected stream of payments,
P;tt for t = 1...., n, for the jth PFI scheme, minus the expected
construction costs and operating costs, using the risk-adjusted
discount factors in (4), is given by:
If there is competition in the supply of PFI contractors,
we would expect the contract to involve a zero NPVj of excess
profits and yield rates of return equal to the cost of capital.
If the PFI contractors are bearing no significant systematic risks,
this implies a competitive rate of return close to the risk-free
rate of interest. An actual rate of return on the PFI contract,
and implicit cost of capital charged to the NHS, in excess of
this competitive rate would reflect a lack of strong competition
in the bidding for PFI contracts. The relative effect of a higher
cost of capital on the number of hospitals which could be made
available now in return for a given future stream of constant
annual payments is again illustrated by Table 1.
The National Audit Office has stressed that "appropriate
risk transfer is crucial to obtaining value for money in privately
financed projects" . However, the NAO does not distinguish
between systematic and more specific risks which can reduced in
total down towards zero through diversification. In stating that
"the aim of a PFI procurement is to achieve an allocation
of the individual risks to those best able to manage them"
[21, p. 27], the NAO appears to move beyond the transfer of risk
as the justification for the PFI route to one of managing a change
also in the expected value of construction and other costs. If
private sector contractors do have greater management skills than
the public sector in controlling construction cost escalation,
NHS options appraisals should include any such differences in
expected values, net of management costs, in their evaluations
of the Net Present Value (NPV) of the respective costs of publicly
managed schemes compared to privately managed schemes, using the
appropriate competitive cost of capital. A difference in the expected
value of construction costs does not, however, justify the use
of a higher long-term cost of capital for PFI schemes. If there
is competition between private contractors, the gain from any
generally higher sector management efficiency should be passed
on to the NHS through lower PFI contract prices. Similarly, any
superior ability of the private sector in general to reduce the
variance of construction costs should be passed on to the NHS
through competition in the PFI contract terms offered to the NHS,
rather than through a higher cost of capital. If there remains
some construction cost risk around a lower expected value, this
would still only justify a higher cost of capital than the risk-free
rate for the initial period in which such risk occurred, and only
to the extent that such risk does involve systematic risk [11,
Construction and design cost risks can themselves be addressed
more directly through the alternative format of a fixed-price
Design and Build contract. This can enable the risks of construction
cost escalation, building completion delay, design faults and
latent defects to be transferred from the NHS to private sector
contractors in a potentially more efficient way than through a
more complex long-term PFI contract, including scope for separate
latent defects insurance  where appropriate. Such an approach
would enable the different elements of the Design, Build, Finance
and Operate (DBFO) requirements that make up a typical PFI contract
(see eg ) to be unbundled and awarded to the most suitable
contractors under the most suitable contract terms. This can include
scope for the Facilities Management (FM) element of operating
NHS capital assets to be contracted separately if this proves
desirable because of genuinely lower operating costs, and for
finance for the initial capital investment to be obtained from
the most cost-effective source, independently of any bundling
It should be noted the risk may not simply be transferred
through the involvement of private contractors, but also increased.
If contracts cannot fully determine the activities of the contractor,
including the quality of the final product delivered, or fully
anticipate changes in the environment, there is a risk of high
agency costs, through increased monitoring and bonding costs,
and high residual losses [24-27]. Problems in securing adequate
hospital cleaning by private contractors, with potentially high
costs , and problems in securing the adequate maintenance
of railway track in the UK by private agencies suggest that tying
the NHS into 30-year contracts with individual PFI contractors
would not be a risk-free strategy. This may be particularly so
if there is a financial incentive for the contractor to seek to
increase the profitability of the contract by hiring inexperienced
or unmotivated labour at the lowest possible cost. The inclusion
within PFI contracts of explicit performance criteria may mitigate
this problem to some degree. However, unanticipated changes, such
as improved environmental and health and safety requirements,
may lead to expensive disputes and costly litigation, as the experience
of contractual disputes between EuroTunnel and its contractor
Trans Manche Link, following stricter health and safety requirements
for the Channel Tunnel after King's Cross Underground disaster,
In the case of health care, the need for future flexibility
is underlined by both the multi-dimensional nature of demand across
different forms of treatment and the technological uncertainty
that currently exists over the nature and extent of future cost-effective
forms of health care treatment that it might be desirable for
the NHS to provide in future decades. As stressed in [19, 29],
it is unclear that the NHS should want to assume additional risks
from tying itself into 30-year contracts with specific PFI providers
that may constrain the flexibility of the NHS to later respond
efficiently to these future changes, and again risk expensive
disputes and litigation if the PFI contract does not easily accommodate
such future changes.
The extent to which risk transfer is actually effective may
also be reduced by the existence of a risk of insolvency of the
PFI contractor, when it encounters higher construction costs,
maintenance costs or operating costs, or lower revenue than it
anticipated. In the case of Leeds Armouries, the risk of insolvency
of the PFI contractor, when demand at the prices charged to the
public under the PFI contract proved lower than anticipated, resulted
in the sponsoring government department deciding to bail out the
PFI contractor through additional funding for the costs, and losses,
of much of the scheme . The public sector may then be paying
a risk premium for a risk which is not actually fully borne by
the PFI contractor when the circumstances of the risk materialise.
Despite the intended transfer of risk through a PFI contract,
many of the costs which arose from delays in the implementation
of a new computer system for the UK Passport Office fell on the
public sector and general public, rather than the PFI contractor
. There is also some incentive for the Special Purpose Vehicles,
that are often created to act as the private PFI contractors,
to minimise their own exposure to risk by not leaving surplus
fund in their financial structures. Brealey and Myers  emphasise
the scope for risk-shifting games to be played in the private
sector in order to shift unwanted risks on to unwary parties.
This may result in a moral hazard risk that imposes additional
agency costs on the NHS when it takes the PFI route, both in the
ex ante monitoring of such risk and in bearing additional ex post
insolvency costs if they are not adequately controlled.
Given that some of the major PFI contractors have multi-million
pound obligations not just to the NHS, but also to major other
parts of the public sector and to privatised public utilities,
such as Railtrack, fully assessing their insolvency risk may be
a difficult task. The share price of at least one major PFI contractor
has fluctuated dramatically in recent years. The need for public
sector clients, such as the NHS, to ensure clarity within PFI
deals over their liabilities and rights to take possession of
key assets in the event of insolvency of the private contractor
has recently been emphasised by the NAO .
It should be noted that HM Treasury's  own prescribed
discount rate of six per cent in real terms, for evaluating investment
projects in the NHS and other parts of the public sector, appears
to be based chiefly upon the approximate pre-tax rate of return
to equity across the economy as a whole [33, p. 83]. This will
include elements of risk to private sector equity, both from systematic
risks and from the accentuating influence of debt leverage on
equity risk, making six per cent above inflation is itself an
excessive estimate of the relevant risk-free rate of interest.
The sensitivity of the computed economic advantage of PFI schemes
in the NHS to the choice of discount rate is demonstrated in .
An increased cost of capital also brings with it an increased
supply and affordability risk for the NHS, as a result of the
reduced ability of the NHS to meet future PFI payments as well
as many other future demands on its available funds. Such affordability
risk may be compounded by a moral hazard risk if politicians face
short-term pressures and local NHS managers seek to solve their
immediate capital problems by agreeing to PFI schemes that impose
onerous longer-term financial obligations on the NHS . The
willingness of PFI contractors to agree to such deals is increased
by the introduction of the NHS (Residual Liabilities) Act 1996,
under which the Secretary of State must take over the liabilities
of any NHS Trust or Health Authority that becomes insolvent as
a result of such obligations or is otherwise disbanded.
The affordability and sustainability risk associated with
the growth of PFI in the NHS is also complicated by the unclear
nature of the future funding position of the NHS to cover the
future annual payments that result from the capital costs of current
PFI schemes beyond those which the NHS would otherwise incurred.
There are a number of sources of such additional funding for PFI
schemes. One is from reducing current expenditure on other health
care activities in the NHS, which is a generally unattractive
course of action. Another is from any operating cost savings that
are generated by the PFI projects themselves, such as from the
more efficient management of energy and maintenance costs. However,
the magnitude of these savings is unclear, under a situation where
both capital costs and operating costs are typically bundled together
in an overall annual PFI payment. This makes difficult an external
assessment of whether PFI schemes do offer value for money. It
also makes difficult the prediction of the future public expenditure
needs of the NHS compared to what they would have been under traditional
ways of financing NHS capital expenditure.
A third way is through viring monies which would have instead
been used in future years to fund direct capital expenditure by
the NHS into payments for current PFI schemes. It might be objected
that this represents a form of "mortgaging the future"
and of "eating the seed corn" of funds that would otherwise
provide the new hospitals and capital equipment of the future.
The traditional NHS separation between capital and revenue funds
has been for the purpose of preventing such capital funds being
raided to solve immediate current revenue expenditure pressures,
a sentiment which would also seem in part to lie behind HM Treasury's
 claimed desire for a "a clear distinction between current
and capital spending". However, this separation appears to
be breached by the new virement which HM Treasury itself appears
to permit when it states [35, p. 26] that: "Departments will
be able to channel funds earmarked for capital expenditure into
current expenditure....to finance private-public partnerships".
The willingness to divert capital funds to help finance PFI payments
appears to be confirmed in several cases in the NHS .
A fourth way in which current PFI schemes may be financed
is through additional new money into the NHS over the life of
the PFI assets. However, there is at present no indication or
guarantee that this will be forthcoming. If it is not, there arises
a potential risk of instability in NHS finances due to the circular
nature of the present NHS capital charging system. This involves
a positive feedback loop (see ) in which the total capital
charges levied on the NHS's own capital stock are re-circulated
to all NHS health authorities through the NHS's weighted capitation
system  to form part of the "resource" income of
individual health authorities. Under this system, each individual
health authority, i, receives as its annual income, Mi, a proportion,
ai<1, of the total income, M, that is circulated to health
authorities, where ai reflects its age-weighted population and
local need factors, and where:
M = R + c. KN with Mi = ai . M
R is the extent of the total NHS non-capital Exchequer funding,
KN is the value of the directly-owned NHS capital stock, and c
is the total capital charging rate, of a six per cent real interest
rate plus an annual rate of depreciation on the capital stock,
where for the sake of simplicity we now omit time subscripts.
The annual expenditure, Xi, of health authority i will equal:
Xi = REi + c.KNi + Pi
|where REi is annual current expenditure, on items such as nurses' salaries, on health authority i's patients by the NHS Trusts with whom health authority i has contracts, KNi is the corresponding value of their own directly-owned capital stock, and Pi is their annual PFI payments. In order for the expenditure and available income to balance, we require:|
Pi + c.KNi = ai . RREi + ai . c.KN
The ability of each individual NHS Trust and its health authority
to finance any given level of annual PFI payments depends in part
on the level of directly-owned capital stock, KN, which all NHS
Trusts maintain. There is a risk here that individual NHS Trusts
and health authorities may themselves over-estimate the affordability
of their own PFI schemes because they may base their calculations
(see eg ) upon the current levels of their income, Mi, and
the associated current level of the directly-owned NHS capital
stock KN. If PFI is used in place of direct NHS capital investment,
the annual depreciation of NHS assets, together with any NHS land
sales to partially finance PFI schemes, will cause the value of
the directly-owned NHS capital stock, and hence (other things
being equal) the incomes of individual health authorities, to
There is also a risk here of individual NHS Trusts free-riding
on the capital charges income generated by other NHS Trusts. Holding
constant the directly-owned capital stock used by the many other
health authorities, the annual budget constraint (7) permits an
almost a one-to-one switch from capital charges, c.KNi, on the
directly owned assets used by health authority i into PFI payments,
Pi, by the NHS Trusts with whom it has contracts. However, other
things being equal, health authority i making this switch will
cause the total NHS directly-owned capital stock, KN, and hence
all other health authorities' incomes, to fall. PFI payments are
here acting as a leakage from the circular flow of income in the
NHS capital charging system. In a parallel way to the circular
flow of income in macro-economics , there is a consequent
potential multiplier effect of this leakage of PFI schemes and
other expenditure items.
Other health authorities will respond to their fall in income
in general in part by reducing their own directly-owned capital
stock and associated capital charges, through ward closures and
other measures, and in part by cutting back on their own current
expenditure and potential new PFI payments. The capital charges
on the directly-owned NHS capital stock will then equal:
where KoN is a baseline level of the directly owned capital
stock that does not vary with the health authorities' incomes,
and 0 is the marginal propensity of health authorities in total
to vary their directly-owned capital stock as their total resource
income varies. From the budget constraint (8), Q will equal unity
if each health authority refuses to cut back on its own current
expenditure and annual PFI charges in the face of such income
variation, but will be less than one if it is willing to make
such cutbacks. The value of Q will depend upon the annual net
price c.(1 ai) each health authority i faces for additional
capital stock in (8) under the now "non-neutral" system
of NHS capital charges (see ).
Inserting (9) into (8) yields the value of the multiplier
effect of any reduction in the baseline value of the directly-owned
NHS capital stock, due to a switch into PFI assets, to be:
Recent years have indeed seen a decline in the value
of the directly-owned NHS capital stock in real terms, after adjusting
for annual depreciation and indexation, from £25.7 billion
in March 1997 to £23.7 billion in March 1999 prices [41-43].
Fortunately, the next few years should see an increase, with direct
capital investment, net of asset sales, under the new NHS Investment
Strategy  projected to increase from £1.6 billion in 2000-01
to £2.6 billion in 2003-04.
The sensitivity of the real cost of PFI in Table 1 to the
cost of capital highlights the desirability of the NHS making
use of cheaper sources of finance, whenever the additional risk
premium associated with use of private finance is not justified
by the risks which are actually transferred to the private sector.
Even if some systematic risk remains with the public sector, NHS
investment projects have a high capacity to utilise risk-free
government borrowing as a source of finance. The recent reductions
in direct public sector investment and government borrowing, that
have accompanied the growth of PFI, have been associated with
a substantial fall in long-term interest rates on government bonds/gilts
to around 2.2 per cent for index-linked returns. These in turn
have been associated with very low annuity rates now on offer
to many thousands of pensioners currently retiring with "money
purchase" pension funds to be converted into future annual
income in their retirement. The result of such low annuity low
rates will be substantially smaller future pensions for these
The changing demographic structure of the UK is itself associated
with increasing numbers of individuals retiring with capital sums
to invest in annuities. As the stock market looks a more uncertain
prospect after the recent collapse of the long bull market and
the Internet share bubble, current investors in pension funds
may also increasingly seek safer havens for their money. The problems
in recent years at both Maxwell Communications and the more highly
respected Equitable Life Assurance Society in the UK illustrate
the potential financial difficulties which can be encountered
in the running of private pension schemes. Investors in the diversified
"with profits" investment fund of Equitable Life have
found themselves faced with unexpected undiversified risks when
the future guaranteed annuity rates promised to investors by the
Assurance Society before 1990 proved impossible to honour, illustrating
the difficulty which even well-established private sector institutions
have in offering risk-free rates of return.
The mechanism which has been in place under the 1995 Pensions
Act for ensuring the ability of private pension schemes to pay
guaranteed levels of pension, once an annuity is purchased, has
been the Minimum Funding Requirement (MFR), which encourages such
schemes to invest a high proportion of their associated funds
in government bonds. However, following the declining availability
of government bonds, the Myners Report  has recommended the
abolition of the MFR to permit other securities, such as corporate
bonds, to replace pension fund holdings of government bonds, a
recommendation which the UK Government has now accepted.
The increased risk to private pension funds which may result
from such a substitution of government bonds by corporate bonds
is illustrated by the case of British Telecommunications (BT),
whose debt level has increased dramatically in recent years to
a peak of £30bn, following its multi-billion pound bids for
third-generation mobile phone licences. The subsequent downgrading
of the credit rating of BT's corporate bonds by both Moody's and
Standard and Poor's, and the recent substantial decline in new
mobile phone sales, underline the extent to which existing corporate
bondholders are exposed to significant risks of loss of value
as a result of both management and market behaviour. That the
proposals to relax the MFR may have adverse effects on efficient
risk-bearing is underlined in a recent report by a major firm
of actuaries . These effects include the discouragement of
risk-taking by firms, an increased risk of insolvency of companies,
the winding-up of company pension schemes, and the declining availability
of defined benefit schemes for individuals investing in private
pension funds. Financing direct NHS investment by issuing more
government bonds would therefore have advantages not just for
the NHS. Rather it would provide an efficient risk-free form of
investment for pension funds, on whom increasing numbers of pensioners
will be dependent, for their future ability to maintain a healthy
standard of living into their old age.
One major economic reason for limiting the size of direct
public borrowing is that public borrowing crowds out private finance
for investment in manufacturing industry and other parts of the
private sector. However, the use of private finance to fund capital
assets for the NHS via PFI itself directly crowds out private
finance which might have otherwise been available for investment
in manufacturing or elsewhere in the private sector. Moreover,
such PFI finance competes directly for scarce risk-bearing capital
funds that are likely to be more appropriate for financing private
sector investment. In contrast, financing NHS direct investment
through government-backed borrowing makes use of a different sector
of the capital market, serving institutions requiring risk-free
forms of investment, that is less suitable for financing many
private sector investments. The substitution of direct borrowing
by PFI finance therefore involves a double inefficiency in financial
risk-bearing. It displaces private finance which might otherwise
be used to finance genuinely private sector projects, whilst at
the same time pushing pension funds that have a strong need for
risk-free assets into riskier corporate bonds that are less suited
to their financial needs.
The use of public borrowing to finance investment in the
NHS would be perfectly consistent with the Chancellor of the Exchequer's
own Golden Rule , that "Over the economic cycle the Government
will borrow only to invest and not to fund current spending".
His second rule in the Code for Fiscal Stability , namely
the Sustainable Investment Rule, states that "Borrowing to
finance investment will be set so as to ensure that net public
debt, as a proportion of Gross Domestic Product (GDP), will be
held over the economic cycle at a stable and prudent level".
UK general government net borrowing has now dropped from 2.0 per
cent of GDP in 1997 to minus 2.1 per cent in 2000, whilst general
government gross debt has dropped from 51.1 per cent of GDP in
1997 to 42.9 per cent in 2000 . Even if Britain's entry into
the Euro and Economic and Monetary Union within the EU is the
dominant concern, these figures are well within the relevant Maastricht
Treaty's Convergence Criterion for EMU entry, namely that total
outstanding government debt must not exceed 60 percent of GDP,
with general government debt not to exceed 3.0 per cent of GDP.
The net borrowing figures are, moreover, expressed conservatively
by not anticipating the receipt of £22.5 billion from the
sale of third-generation mobile phone licences in the year of
the sale . Instead their receipt over the next 20 years will
reduce the net borrowing figures well into the future. Overall,
public sector net debt is expected to fall from 44 per cent of
GDP in 1997 to under 30 per cent in 2002-03 . The need to reduce
public borrowing is therefore not a binding constraint in the
context of the £500 million capital spending that is now
involved in PFI schemes in the NHS.
However, even if reducing formal government borrowing were
a primary consideration, there are alternative mechanisms which
could be devised to fund the expansion of direct NHS investment
in place of PFI. One such mechanism might be the establishment
of a supplementary pensions fund  in which prospective pensioners
could invest and in which retired pensioners could deposit their
accumulated capital sums in return for annuities. The available
capital funds would be made available for direct NHS investment
in new capital assets, in return for annual payments that represent
a cost of capital lying between the current long-term index-linked
yield of around 2 per cent on government bonds and the 6 per cent
real cost of capital which HM Treasury currently impose as the
cost of capital to the public sector. The need for adequate supplementary
pensions provision is underlined by the falling adequacy of the
basic state pension to meet the future retirement needs of many
individuals, who otherwise risk imposing a large financial burden
on future social security funding (see ). The value of the
pensions coverage provided by the existing complex State Earnings
Related Pensions Scheme (SERPS) has also declined in recent years
(see ). A simpler supplementary pensions scheme might involve
increasing current National Insurance contributions in return
for increased future pension payments embodying a guaranteed rate
of return on the increased payments, together with a right of
individuals to opt out of these additional contributions and associated
supplementary pension. Such a scheme would have similar characteristics
to unfunded pension scheme contributions, even though the funds
generated would be available to invest in NHS capital assets,
and would not count as part of government net borrowing .
Investment in the NHS assets would be matched by a corresponding
long-term future commitment, but a less onerous one than is involved
in PFI schemes, whenever the latter involve a high cost of capital
to the NHS.
Providing an attractive risk-free form of long-term investment
with reasonable rates of return through such a scheme may encourage
increased saving for retirement, and add to the large potential
market for the NHS to tap in order to finance its direct investment
in capital facilities. The growth of PFI not only has the effect
of causing the NHS to fail to tap this market in an efficient
way. It also pushes the NHS towards raising finance from the private
sector via an inherently more costly route, involving substantial
additional costs in contracting, negotiation, consultancy and
potential litigation costs if contract terms become difficult
later to honour. Short-circuiting this route through financing
direct NHS investment would eliminate many of these costs.
HM Treasury's claimed motivation for the growth of PFI in
the NHS and elsewhere is the pursuit of value for money .
However, an alternative explanation is the desire to satisfy the
convergence/ Maastricht criteria  on public sector indebtedness,
as a pre-condition for Britain's entry into Economic and Monetary
Union (EMU) and the Euro zone. PFI offers the political attraction
in this context that it can be used as a form of "off-balance-sheet
finance" to reduce apparent public sector indebtedness. This
is true under the Treasury's  revised guidelines on How to
Account for PFI Transactions, provided that the different elements
of the PFI scheme, such as capital construction and financing,
cannot be separately identified within an overall service payment,
and that "sufficient" risk is intended to be transferred
to the private sector. As noted above, there must be doubt over
whether these two features of PFI schemes help to promote value
for money for the NHS. However, the role of accounting considerations
in determining the details of PFI schemes is illustrated by the
recommendations of HM Treasury's Taskforce on Private Finance
[53, p 15] that:
where the accounting analysis requires a PFI transaction to
be treated in substance as borrowing . . . the public body should
examine the scope for reworking the deal so that it is clearly
for the provision of services.
The use of off-balance-sheet finance, to avoid greater transparency
in the long-term obligations that are being incurred, has in the
past resulted in substantial financial difficulties for many private
and public sector organisations . The importance of achieving
transparency in the presentation of public financial statements
has itself been stressed by HM Treasury [35, 46] as "an indispensable
hallmark of good policy" and to avoid "poor policies
and bad decision-making" in its own pursuit of the goal of
fiscal stability. The economic assessment of the suitability of
the UK for entry into the Euro is of some national importance,
with the experience of the UK's participation into the earlier
Exchange Rate Mechanisms (ERM) illustrating the substantial risks
which may arise if economic realities are ignored. The ability
of PFI schemes to remain off-balance-sheet may itself prove to
be short-lived if the UK Accounting Standards Board soon adopts
suggested proposals [29, 54] for requiring the on-balance-sheet
treatment of operating leases and similar arrangements that bundle
together services, such as maintenance, with the availability
of capital assets, in the same way that many PFI contacts do.
A major consideration in whether or not a PFI scheme can
be left off the balance sheet of the NHS Trust that makes use
of the resultant hospital or other capital asset, both under HM
Treasury's own guidelines  and under the ASB's regulations
, is the extent of the risk transferred to the private PFI
contractor. A strong desire to keep the assets and liabilities
created by PFI schemes off-balance-sheet may well then lead to
some risks being transferred to the private PFI contractor at
an excessively high cost to the NHS. This is particularly the
case as the risks which are relevant to the accounting regulations
are not simply the systematic risks which finance theory [11,
31] suggests should be priced.
The doubtful value for money that the desire to keep the
arrangements off-balance-sheet may produce is compounded by a
further factor. This is the significant weakening [56, p 13] that
has occurred in recent years in the earlier Treasury-imposed Ryrie
rules that privately financed schemes pass a value for money test
against a public sector comparator. Without a readily available
alternative source of public funding for direct NHS investment,
such a test becomes unrealistic, with pressure on NHS managers
in recent years to pursue PFI even at high future cost as the
only option that was likely to be available to them to secure
new capital facilities [10, 29].
The traditional form of financing the NHS is reflected in
the physical condition of many existing NHS sites, as an assortment
of often poorly maintained buildings, with many smaller extensions
and outbuildings when small amounts of capital became available
. Whilst PFI schemes provide some opportunity to rationalise
current facilities and to inject more capital investment into
NHS sites, its potential problems still reflect the underlying
financial management framework of the NHS. This has fortunately
now moved beyond the dominant annuality and cash accounting principles
of the past that generated many inefficiencies in managing NHS
capital resources . The new Comprehensive Spending Review and
Resource Budgeting  financial framework, within which the
Department of Health now operates, involves a three-year planning
and budgeting horizon. It also involves a separate Departmental
Capital Budget for direct capital expenditure which may, or may
not, be set an optimal level consistent with the overall optimal
use of resources in (2). PFI has the attraction to current managers
and politicians of having its main impact outside the three year
budgets for which they have immediate concern, and avoiding the
constraint on direct investment that is imposed by the Departmental
Failing to record adequately the assets and liabilities to
which PFI schemes give rise on the public sector balance sheet
can encourage the passing on of hidden liabilities to future generations
of taxpayers. Under an inter-generational "Ponzi game"
[58, p 97], the present generation gain an immediate benefit,
here from securing new hospitals, but pass most of the cost on
to future generations of taxpayers, at a cost which increases
over time if they all play the same game. This danger will be
mitigated to some extent under PFI by the fact that its costs
are spread out over future generations who will also benefit in
some degree from the PFI schemes, and who will be under some financial
pressure not to allow additional PFI payments to escalate out
of control within their own tax-paying lives. However, the precise
extent to which future generations will benefit from current PFI
schemes depends upon key details of the schemes, such as the implicit
cost of capital, the future availability of beds and their flexibility
to adapt to new medical needs and technology at reasonable cost.
A higher cost of capital for the NHS under PFI schemes is unlikely
to be justified by the extent and nature of the risk transfer
that the schemes involve. Instead, securing capital via the PFI
route is itself likely to impose significant new risks upon the
NHS. More efficient ways of raising finance for investment in
the NHS could be devised that would benefit also increasing numbers
of pensioners in maintaining a healthy standard of living. Unbundling
PFI schemes, and their associated contracts, into their constituent
elements of design, build, finance, maintain and operate, could
provide much greater transparency of the extent of the value for
money obtained in each direction. Such transparency is necessary
to overcome the suspicion that the PFI is driven mainly by short-term
accounting considerations aimed at paving the way for British
entry into the Euro, or by other political factors that are extraneous
to the long-term needs of the NHS. Unbundling PFI schemes would
also provide the opportunity to purchase the constituent elements
from the most efficient sources, with a much closer association
between risk and reward than PFI schemes at present provide. Thus
if it is genuinely the case that private contractors can provide
more efficient design, build and facilities management services
for the NHS than the public sector can, these can be identified
and priced separately. Such a separation would not imply a need
to forego lower cost sources of public finance and would avoid
the need for potentially inflexible long-term contracts that the
NHS may prove to be very costly for the NHS.
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