Select Committee on Health Appendices to the Minutes of Evidence


Memorandum by Professor Allyson Pollock (PS 54B)

  Capital investment in the NHS under the 1990 NHS and Community Care Act: the impact of moving from government grant to debt finance in an under-funded system.


  1.  The founding principles of the NHS are comprehensive care and services free at the point of delivery, delivered on the basis of equity. As a national health service it has neither local tax raising nor income generating powers. Indeed such powers would contravene the spirit of the NHS, returning health services to the inequitable situation which pertained pre-1948—relying on the wealth of local areas and introducing regressive elements to its funding.

  2.  The goal of equity is achieved by using the mechanisms of risk pooling and cross subsidisation. Risk pooling and cross subsidisation were embedded in the structures for the funding and organisation of services. These structures have until 1991 shielded the NHS from the adverse consequences and extra costs of market forces.

  3.  From 1948 until 1991 funding for NHS capital investment was distributed as government grants, and planning structures were evolved to link planning, population needs, and funding. However, as documented by the official NHS historian Charles Webster, the NHS inherited badly run-down estate with enormous inequities in the pattern and distribution of services across the country.[15] From the outset, capital funding was inadequate and the new hospital building programme did not start until 1962 and was never completed.[16] In recent years net expenditure on capital investment has been negative, indicating that the NHS was consuming itself in order to pay for capital investment (fig 1).

  4.  The NHS brought all hospitals and health service facilities apart from GP practice premises under public control and ownership. No charge was made on capital as to do so would have aggravated the inequities in distribution.


  5.  The implementation of the internal market and the purchaser-provider split in 1991 established shadow market mechanisms and structures which allowed NHS services to be priced, bought, and sold. The new pricing mechanisms also involved trusts having to establish the costs of treatment and account for the use and consumption of capital, known as capital charging. No longer funded by block grants administered by health authorities, NHS service providers had to win contracts from NHS purchasers. Hitherto, private sector provision to the NHS had been curtailed by the financial and organisational arrangements that protected services from the market. Now the intention was to put the public sector on the same footing as the private sector, thereby facilitating the entry of private sector providers.

  6.  An important consequence of the internal market was to undermine the principle of cross subsidisation by requiring a costing methodology which would allow each element of the service to be priced for the market place. This includes a cost for capital. However, unlike factories products where the cost of raw materials and plant can be divided by the number of products, accurate costing for complex patients and treatments is impossible. Pricing also introduce new transaction costs and new inefficiencies by requiring the elimination of cross subsidisation and hence risk pooling mechanisms of services.

  7.  The introduction of capital charges ended the era of funding NHS investment using government grant. The government switched to debt finance, requiring NHS services to make a return on capital employed and paying the government as banker and shareholder. From 1991, NHS hospitals were established as trusts with three statutory duties all of which are financial. Trusts were required to (i) make a 6 per cent return on capital employed equivalent to an interest charge and public divided (ii) break even after paying interest (not dividends) and (iii) stay within the external financing limit. There is no logic in requiring NHS services to make a return on capital because the value of NHS estate is a function of historical supply and location and in any case there is little logic behind requiring government, as owner of capital, to pay itself for the use of that capital. However, despite this major change in policy neither the rationale for requiring NHS trusts to make a return on capital, nor the choice of a 6 per cent rate of return on capital employed have ever been challenged or properly evaluated.[17]

  8.  Trusts reflect the additional costs of capital charges in the prices they charge to the purchasers. Health authorities receive capital charges on the basis of the services within their area, not on the basis of the contracts they place. Trusts charge purchasers on the basis of their capital costs and not o the basis of the allocations purchasers receive to cover the cost of capital. The capital charge element of the price is an important lever in establishing different prices referred to as Reference Costs across NHS providers thereby enabling competition for services and the forcing down of prices, as the government funds services on the basis of average prices. The main point to note is that pricing is an arbitrary, unscientific and inexact mechanism as it involves different assumptions and there is no standardised methodology for pricing any of the components which make up the service. More importantly it removes the crucial element of cross subsidisation.

  9.  Capital charges are supposed to be resource neutral. However they are a source of leakage since services formerly supplied by the NHS and provided by the private independent sector also include a charge for capital. It can thus be seen that even at the system level capital charges are not being as resource neutral as they were originally intended to be.

  10.  Moreover at local level capital charges can represent a real cost or a real saving depending on how services have been priced. There is a lack of transparency in the formula and methods of calculating and allocating capital charges to purchasers and from purchasers to providers of health care. There has never been an evaluation of the capital charging regime, with respect to equity and planning.[18]

  11.  Two arguments are commonly made to support the introduction of capital charging. The first, that the introduction of capital charges would increase the efficiency of the NHS's use of assets, has no evidence to support it. On the contrary, the problem stemmed from government failure to inject sufficient capital funds.2 The second claim is that because capital charges are or have been non-cash allocations they are resource neutral and there is no net effect on local services. That being the case one might ask why the government chose to put in this complex system.

  12.  In an under-funded NHS the introduction of capital charges has had catastrophic effects. Their introduction in NHS trusts in the 1990s had strongly negative effects on trust assets and finances. Aggregated financial accounts of NHS acute hospital trusts in England for 1992-98 inclusive show that trusts as a whole failed to make the 6 per cent target rate of return in all years except 1992 and 1994 (table 1). Even then, many trusts were unable to break even after paying interest. The cost of capital charges to the NHS as a whole might have been zero; but their average cost to each NHS acute hospital trust in 1998 (the first year when the government collected the full 6 per cent) was £393,000. In fact, the situation was so parlous that the Department of Health decided not to collect the full 6 per cent until 1998.[19]

  13.  The National Audit Office annual accounts show that in 1999-2000 78 trusts were in serious financial difficulties, failing to meet all their statutory financial duties.[20] The Department of Health's recent departmental report[21] lists as one of the causes of trusts failing in their financial duties "financial problems in Health Authorities leading to Trusts being unable to agree prices sufficient to cover their costs plus the 6 per cent rate of return" (12.24, p 92).

  14.  The second argument—that capital charges have forced NHS trusts to weigh the worth of capital expenditure against the opportunity costs forgone and that that is a good thing—ignores their actual impact. Trusts were reluctant to undertake any new investment because increasing the value of the asset bare increases capital charges. In other words at the local level charges acted as a real cost pressure. Capital charges deterred trusts from undertaking what the DoH regarding as a reasonable amount of expenditure for capital goods. In the first three years of their operation, NHS acute hospital trusts in England underspent on their capital budget by an average of £200,000 per year.[22] Between 1993 and 1997 NHS backlog maintenance costs rose from £2.4 billion to £3.1 billion.[23]

  15.  These shortfalls were a direct consequence of underfunding and the reluctance to take on the debt servicing costs arising from capital charges. Capital charges encouraged NHS trusts to sell NHS assets. As well as contributing to longer waiting lists, the loss of capacity arising from such sales and consequent reductions in bed numbers has been regretted in the report of the National Beds Inquiry[24] and in the NHS Plan.5 Capital charges have had a strongly negative impact on the capital base of the NHS (and especially on planned capital expenditure) and in particular accelerated the decline in service capacity. The volume and scale of land sales and disposals has not properly been recorded or been made subject to parliamentary scrutiny. Nor has the DoH published a proper estimate of the cash released from land sales, nor has it described how land sales and the subsequent use of PFI (see below) affect the capital charging regime.


  16.  Just as the rationale behind the policy which saw a switch fro government grant to debt finance has never been questioned, neither has the switch to private finance the system where the government borrows indirectly by raising funds for capital investment through an intermediary of businesses and banks. In the case of hospitals, a consortium of bankers, builders and service operators known as a special purpose vehicle raise the finance for capital investment, in return for which they design build and operate the buildings and receive an annual fee which covers cost of capital, interest and services.

  17.  In the absence of government grant or public finance for new capital expenditure private finance is the only source of funds for new investment. This means that trusts have had not only to consider capital charges on retained estate but also the effect of diverting revenue budgets to service the real debts of the new owners of capital, ie the PFI consortia.

  18.  The government and its civil servants persistently challenge the notion that PFI is responsible for the reductions in bed numbers and claim either that the clinicians decide the bed numbers or that reductions in bed numbers were simply a function of previous trends. But as we have repeatedly shown using government data, while reductions in bed numbers have been occurring, the DoH bed statistics indicated a flattening out of efficiency savings from increasing the proportion of day case surgery, reducing length of stay and increasing bed occupancy rates as early as 1995.[25] Moreover reductions in acute beds have plateaued since 1995. It was notable that all PFI schemes involved major reductions in acute bed numbers and services and that rehab and longer stay beds are being closed to fund PFI hospitals.26, 27, 28, [26][27][28][29]

  19.  The reductions in bed numbers are also the result in part of the introduction of the capital charging regime which created a pressure locally to decrease the estate (see above). Capital charges were a new claim on scarce revenue budgets and their effect has been compounded by the switch to using private finance which is very expensive. PFI and capital charges, as finance directors acknowledged, created a major affordability gap. This arose between what the purchasers (health authorities and trusts) said they could afford and the requirements of the PFI consortia. The affordability gap arose in part because of the high costs of any new investment. It can be seen (table 2) that the capital value of the new estates is much higher than the asset value of the hospitals they are replacing, even through the new schemes are generally situated on smaller and cheaper land sites and one hospital with a much smaller capacity is replacing up to two or three hospitals. Moreover most if not all of these schemes have seen a rapid escalation in costs from outline business case of more than 200 per cent (table 3).

  20.  The higher capital expenditure necessarily incurs higher capital charges in the form of PFI payments and a capital charges on retained estate and equipment.


  21.  Regardless of the reasons for the higher cost and the cost escalation, the important point to note is the impact on the revenue budget where the annual cost of capital to PFI hospitals has risen from an average of 9 per cent of annual revenue to 20 per cent (table 4). The escalating costs of using PFI and the increased leakage of money from the revenue budget results in reductions in the budget available for care.

  22.  All cost increases resulting from capital investment have to be met from the revenue budgets. Our research into the first 14 PFI hospitals has shown that the affordability gap is bridged in four ways: (i) through subsidies and smoothing mechanisms from the Treasury for the first batch; (ii) the diversion of regional capital budgets which were originally intended for other parts of the NHS; (iii) through diversion of resources from other services and land sales; and (iv) through cuts in the actual services.

  23.  Attempts to keep the costs down have seen dramatic average bed losses of 30 per cent in the first 11 PFI hospital schemes and reductions in clinical budgets of up to 20 per cent, the relocation to cheaper land sites in order to offset the higher costs by land sales, and the removal of equipment from the schemes.

  24.  The source of evidence for the downsizing in bed numbers and staff budgets lies in the planning documentation which underpins the Full Business Cases. Trusts have been given unprecedented control over the planning of new hospitals, employing their own management consultants and advisors. Formerly regions did planning on the basis of population needs. Now health authorities, regions, and clinicians have no active input into determining service capacity. Many of the full business cases do not give detailed caseload and bed planning numbers. There has been a major and unexplained departure from traditional normative and trend based planning. Moreover, much of the planning shows a failure to adhere to standardised DoH definitions of caseload and beds, making interpretation and comparison of previous and current bed numbers and caseload almost impossible. This has led to statistical gerrymandering.[30]

  25.  The planning documentation available reveals that management consultants were either incompetent or simply doing the task they had been asked to do, namely, using unrealistic performance targets for length of stay, occupancy, and day case surgery to justify major reductions in bed numbers. Many of the plans use selective non-evidence-based reviews of admissions to claim that caseload could be deflected to alternative settings, but the location, nature and costs of alternative settings are not provided.

  26.  Civil servants have pointed out that bed numbers are now increasing in PFI schemes since the National Beds Inquiry. But three points should be noted. First, there has been no increase in the baseline of total bed numbers, but rather 13,000 NHS beds have closed since 1997. The reported increase in general and acute beds is simply a reclassification of the beds and not an actual increase in the overall total number of NHS beds. Second, it is not entirely clear in which sector the increased bed provision is to be provided ie whether in public, for-profit, acute, or nursing home beds. The final and most important point concerns how the increase in beds and services are being funded. Where PFI schemes have increased bed numbers from the original plans this must increase costs. It is important to ascertain how service increases are being funded and whether it is at the expense of the system as a whole.

  27.  Although more money has been pledged to the NHS under the Comprehensive Spending Review, it is not known whether it will be enough to cover the increased cost of capital, let alone keep pace with service needs. The review allows for average annual real terms increases of 6.1 per cent in NHS UK funding over the four years to 2003-04. But NHS pay and prices increase faster than inflation and many trusts report annual cost pressures of 6 per cent just to maintain current service levels and eliminate deficits. Moreover much of the new money has been earmarked for modernisation and is not being distributed to the local level.

  28.  Trusts are under a great deal of pressure not to reveal their financial difficulties or the real cuts, which are taking place in services. The new performance framework is tied to performance targets for the NHS which includes a financial requirement to break even. Trust chief executives' and directors' pay and careers are predicated upon gaining a three star rating.[31] The new performance framework which allows three star trusts new earned autonomies includes greater financial decision-making and control over the use of resources from land sales and entering PFI deals and setting up private companies. While providers are in an increasingly powerful position regarding the planning of services they are now also responsible for their own investment and their own revenue to break even. The government has introduced new guidelines and powers which will for the first time in 50 years introduce a time limit to NHS care through the creation of an intermediate care sector. Trusts will have the potential to redefine some NHS care as personal care and to introduce charges for it.[32]

  29.  This has major implications for accountability and transparency. Under these conditions, it will become increasingly difficult for the public to understand what is going, on how care is being paid for and how it is being redefined. This has the potential to increase inequalities in access and will invariably lead to increasing fragmentation and loss of co-ordination in planning and providing care.


  30.  The system of capital charges (public debt finance) makes new investment unaffordable whether public or private. There is no logic in requiring NHS services to make a return on capital because the value of NHS estate is largely a function of historical supply and location. Private finance diverts scarce resources away from services to paying the new owners of capital, and exacerbates under-funding and decreases the volume of services available to the public.

  31.  If the government is committed to an affordable universal national health service and to expanding the range and volume of services which have been lost, it would abandon the system of debt financing, reinstate government grant, and properly resource the revenue requirements. It would also abolish the internal market and pricing and restore planning structures thereby reversing the trend which has seen population needs divorced from service planning.

  32.  The indications are that the retention of market structures, the establishment of trusts, the capital charging regime, the requirement to use private finance, and the new freedoms of trusts to engage in commercial ventures will return the NHS to a pre-1948 situation where trusts become increasingly reliant on the wealth of the local area.[33] Many PFI hospitals, for instance Carlisle and UCLH, are actively seeking charitable funds to help with revenue funding of new capital schemes.

Table 1


No of trusts
Average total income per trust
Average operating surplus
as a % of income
Required capital charges
Actual capital charges

  Figures are for all NHS acute care trusts in England, 1992-98 inclusive.

  Source: Fitzhugh directory of NHS trusts.

  Required capital charges = 6 per cent on capital value plus depreciation.

  Actual capital charges = surplus (to pay interest and dividends) plus depreciation.

Table 2


Net book value
(after depreciation)
£ million
Cost or
£ million
PFI construction
£ million
Carlisle (1999)
Bishop Auckland (1998)
University College London Hospital (2000)
University Hospital Birmingham (2000)
Norfolk and Norwich (1998)
Swindon and Marlborough (2000)
South Bucks (2000)
South Derbyshire (2000)
Greenwich (2000)
Bromley (2000)

  Source: Annual reports and accounts; Department of Health press releases.

Table 3


Post PFI
Capital as % of income
Capital as % of projected income
Norfolk and Norwich
South Tees Acute Hospitals
Dartford and Gravesham
Greenwich Healthcare
Swindon and Marlborough
Bromley Hospitals
Calderdale Healthcare
North Durham Healthcare

  Sources: Fitzhugh Directory 1999; Health Committee, Public Expenditure on Health and Personal Social Services 2000. Memorandum received from the Department of Health containing replies to a written questionnaire from the Committee. London: the Stationery Office 2000; NHS Trusts Annual Accounts, 1998-99, 1999-2000.

Figure 1. Financing of hospital and community health services capital expenditure, 1986-87 to 1998-99

15   Webster C. The National Health Service: a political history. Oxford: Oxford University Press 1998. Back

16   Gaffney D, Pollock A M, Price D, Shaoul J. NHS capital expenditure and the private finance initiative-expansion or contraction? BMJ 1999; 319: 48-51. Back

17   Shaoul J E. Charging for capital in the NHS: to improve efficiency? Management Accounting Research 1998; 9:95-112. Back

18   Pollock A M, Gaffney D. Capital charges-a tax on the NHS. BMJ 1998; 317: 157-8. Back

19   Pollock A M, Shaoul J, Vickers N. Authors' reply to John Appleby. BMJ 2001; 323:281. Back

20   National Audit Office. NHS (England) Summarised Accounts 1999-2000. London: National Audit Office 2001. Back

21   Department of Health. The Government's expenditure plans 2000-01. London: The Stationery Office, 2000. Back

22   Shaoul J. NHS trusts: a capital way of operating. Manchester: Manchester University, 1996. (Working paper.) Back

23   Department of Health. The NHS Plan: a plan for investment, a plan for reform. London: The Stationery Office 2000. Back

24   Department of Health. Shaping the future NHS: long term planning for hospitals and related services, consultant document on the findings of the National Beds Inquiry. London: The Stationery Office 2000. Back

25   URL: Back

26   Pollock A M, Dunnigan M, Gaffney D, Mcfarlane A, Majeed F A. What happens when the private sector plans hospital services for the NHS: three case studies under the private finance initiative. BMJ 1997; 314: 266-71. Back

27   Gaffney D, Pollock A M, Price D, Shaoul J. PFI in the NHS-is there an economic case? BMJ 319; 116-9: 1999. Back

28   Price D, Gaffney D, Pollock A M. "The only game in town?" A report on the Cumberland Infirmary Carlisle PFI London: UNISON 1999. Back

29   Pollock A M, Price D, Dunnigan M. Deficits before patients: a report on the Worcester Royal Infirmary PFI and Worcestershire hospitals reconfiguration. London: 2000. Back

30   Dunnigan MG. The downsized hospital hypothesis: value for money: The results of reducing staffed bed capacity on clinical activity in Lothian Health Board and other Scottish NHS hospitals between 1991 and 2000. Glasgow: NHSCA 2001. Back

31   Department of Health. NHS performance ratings: acute trusts 2000-01. London: Department of Health 2001. URL: Back

32   DoH Health Service Circular/Local Authority Circular. HSC 2001-01: LAC(2001)1 Intermediate care. Back

33   Mohan J, Gorsky M. Don't look back? Voluntary and charitable finance of hospitals in Britain, past and present. London: OHE&ACCE 2001. Back

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