Private Finance Initiative - Treasury Contents

1  Introduction

Overview of PFI

1. In November 1992 the then Chancellor of the Exchequer Norman Lamont made an announcement in the Autumn Statement about "ways to increase the scope for private financing of capital projects."[1] This was the beginning of what was to become known as the Private Finance Initiative (PFI), under which groups of private investors manage the design, build, finance and operation (DBFO) of public infrastructure. PFI was expanded under the Labour government, which came to power in 1997. The current coalition government, formed in May 2010, has confirmed that it remains committed to the Private Finance Initiative as a way of delivering investment in infrastructure.[2] In total, 61 new PFI projects were being procured as of March 2011, with a total estimated investment value of £7 billion.[3] This is additional to over £60 billion of capital investment (at 2010 prices) already committed by private investors under signed PFI contracts.[4]

2. In a typical PFI project, the private sector party is constituted as a Special Purpose Vehicle (SPV), which manages and finances the design, build and operation of a new facility. The financing of the initial capital investment (i.e. the capital required to pay transaction costs, buy land and build the infrastructure) is provided by a combination of share capital and loan stock from the owners of the SPV, together with senior debt from banks or bond-holders. The return on both equity and debt capital is sourced from the periodic "unitary charge", which is paid by the public authority from the point at which the contracted facility is available for use. The unitary charge may be reduced (to a limited degree) in certain circumstances: e.g. if there is a delay in construction, if the contracted facility is not fully operational, or if services fail to meet contracted standards. Thus, the PFI structure is designed to transfer project risks from the public to the private sector.

3. The PFI is one form of procurement for the public sector. There are examples of public sector procurement projects which have performed both poorly and well. For the most part we have not focussed on specific cases as we believe that it can be misleading to focus on high profile and often complex procurements when trying to assess the costs and benefits of different approaches. A large body of reports and research has been completed on PFI and public sector procurement by the National Audit Office and others. As well as drawing on the evidence submitted to the Committee, where appropriate we have drawn on this research. In particular we have considered reports which include samples of projects rather than reports which examine just one high profile project. Where possible we have also looked to work which has compared procurement approaches. We hope that this Report can build on what has already been done by others. The Report is not an exhaustive examination of all the details of PFI and public procurement—we have instead aimed to produce a report in a timely fashion which can inform work already being done by the Treasury in examining the use of PFI.

4. In April 2011 the National Audit Office produced a report[5] which drew on the significant body of work they had done in the past on PFI. This report detailed some of the potential benefits and disadvantages that PFI could bring. A slightly adapted version of a table from the report is reproduced below:

Table 1: Theoretical benefits and disadvantages of PFI
Potential benefits include... Potential disadvantages include...
Encouraging the allocation of risks to those most able to manage them, achieving overall cost efficiencies and greater certainty of success.

The delivery of an asset which might be difficult to finance conventionally.

Potential to do things that would be difficult using conventional routes. For example, encouraging the development of a new private sector industry.

Delivery to time and price. The private sector is not paid until the asset has been delivered which encourages timely delivery. PFI construction contracts are fixed price contracts with financial consequences for contractors if delivered late.

The banks providing finance conduct checking procedures, known as due diligence, before the contract is signed. This reduces the risk of problems post-contract.

Encouraging ongoing maintenance by constructing assets with more efficient and transparent whole-life costs. Many conventionally funded projects fail to consider whole-life costs.

Encouraging innovation and good design through the use of output specifications in design and construction, and increased productivity and quality in delivery.

Incentivising performance by specifying service levels and applying penalties to contractors if they fail to deliver.

Fewer contractual errors through use of standardised contracts.

Higher cost of finance which has increased since the credit crisis.

The prospect of delivering the asset using private finance may discourage a challenging approach to evaluating whether this route is value for money.

Reduced contract flexibility - the bank loans used to finance construction require a long payback period. This results in long service contracts which may be difficult to change.

The public sector pays for the risk transfer inherent in private finance contracts but ultimate risk lies with the public sector.

Private finance is inherently complicated which can add to timescales and reliance on advisers.

High termination costs reflecting long service contracts.

Increased commercial risks due to long contract period and the high monetary values of contracts.

Source: Adapted from NAO, Lessons from PFI and other projects, Figure 1

Other issues with respect to PFI of which the Committee was made aware include: reliance on often poor-quality procurement methods by public sector clients, over-complexity, over-specification, transfer of risk inappropriate to private sector and raised construction costs.

Assessing the Value for Money of PFI

5. The benefits and disadvantages listed in Table 1 will each have differing impacts on the overall value for money of a project and some of them may not materialise. Some of the points listed in Table 1 (both positive and negative) may also apply to other forms of procurement. The key question to consider is whether or not the actual benefits unique to PFI outweigh the disadvantages unique to it.

6. The use of PFI has the effect of increasing the cost of finance for public investments relative to what would be available to the government if it borrowed on its own account. This disadvantage, unique to PFI, is the most easily identifiable and measurable. The additional cost has two main components: a higher transaction cost and a higher return to investors. A principle behind the PFI contractual model is that it allocates risk to the party that is best able to understand, control and minimise the cost of the risk. The cost saving potential of PFI can be seen to be directly linked to benefits derived from improved risk allocation. Where a firm bears a risk, it has an incentive to manage it and take steps to avoid any adverse impact from it. Better management of a risk may result in greater cost efficiency and in certain circumstances this may lead to a lower cost for the public sector. The case for PFI therefore rests on the model's ability to:

  • allocate risks more effectively than conventional procurement; and
  • ensure the public sector gains from the resulting savings (relating, for example, to tasks such as construction, maintenance and service provision).

7. Where such savings offset the model's higher financing costs, PFI may offer greater cost efficiency than conventional procurement (i.e. it will produce the required outputs at a lower cost to the public sector) or as the Office for Budget Responsibility explain in its recent Fiscal sustainability report: "As long as the higher cost of capital is offset by greater efficiencies elsewhere, such projects still offer value for money for the public sector."[6] Insofar as cost efficiency is the key policy objective, the future role of PFI should be determined by its proven capacity to deliver such savings and efficiencies. In gathering evidence we wanted to understand whether the PFI theory, or "theology"[7] as one witness put it, stood up to scrutiny. In particular was PFI being used because it provided better value for money, or were there other incentives at play which led to it being used?

Our inquiry

8. We are grateful to Richard Abadie, Steve Allen, James Barlow, Andy Friend, Dieter Helm, Anthony Rabin, James Wardlaw and Joanna Webber who gave evidence to the Committee. We are also grateful to all those who submitted written evidence.

9. We would like to thank Mark Hellowell, Lecturer at the University of Edinburgh, and John Willman, Editorial Consultant, for their expert advice with the Report.[8]

1   HC Deb, 12 November 1992, col 998 Back

2   HM Treasury, Public Private Partnerships - Technical Update, 2010 Back

3   HM Treasury, PFI projects in procurement, March 2011 Back

4   Committee analysis of HM Treasury, PFI signed projects list, March 2011 Back

5   C&AG's report, Lessons from PFI and other projects, HC 920, 2010-11 Back

6   Office for Budget Responsibility, Fiscal sustainability report, July 2011, p41, para 2.46 Back

7   Q 4 Back

8   Relevant Interests of the Specialist Advisers are as follows: Mark Hellowell - no interests declared (recorded in Committee's formal minutes on 27 April 2011). John Willman has done editorial consultancy work for a number of clients including PwC, HM Treasury & CBI (recorded in Committee's formal minutes on 24 March 2011). The Committee's formal minutes and full details of all declared interests can be found on the Committee's website.  Back

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Prepared 10 August 2011