2 Accounting and budgetary incentives
Treatment of PFI debt in the National
10. One possible incentive for the use of PFI that
we explored in our inquiry was the treatment of PFI debt on an
organisation's balance-sheet and in the National Accounts. Evidence
we received was in agreement that PFI should not be used for off-balance
sheet reasons. A joint
submission from KPMG, John Laing and Lloyds Banking Group explained
The decision as to whether to proceed with a PFI
deal should be based on rigorous qualitative and quantitative
value for money evaluation of all the procurement options available.
Balance sheet treatment should not be a part of this evaluation.
The CBI also agreed:
PFIs should be on-balance sheet and the value delivered
by a scheme in terms of certainty and risk reduction should not
be skewed by its accounting treatment.
This is and has been the position of the Treasury
for many years:
The decision to undertake PFI investment, once affordability
has been confirmed, is taken on VfM [Value for Money] grounds
alone. Whether the investment is on or off-balance sheet is a
decision taken by independent auditors and is not relevant to
the VfM of the procurement route.
11. Although the official line has always been that
PFI should not be used for accounting reasons, Andy Friend, who
is the Chairman of InfraMed and was previously the Chief Executive
of John Laing, told us that:
There were clear examples earlier in the decademany
of the written submissions to you refer to thatwhere there
was distortion in the structuring of deals in order to achieve
a particular accounting treatment.
Although he added that "Hopefully, we are moving
beyond the world in which the off balance sheet tail was wagging
the value-for-money dog".
Richard Abadie of PricewaterhouseCoopers agreed that the classification
of debt had driven behaviour.
12. Professor Dieter Helm of Oxford University was
more explicit. He said that PFI had succeeded as "an exercise
to get investment off the public balance sheet so that the debt
numbers look better than they otherwise would have done".
As part of our request for evidence we asked whether PFI would
have been used as frequently had all PFI debt been on-balance
sheet. Professor David Heald told us "The answer is categorically
13. Professor David Heald explained in his evidence
that the "accounting arbitrage ended with the adoption of
International Financial Reporting Standards (IFRS) from 2009-10"
with the "bringing of PFI on balance sheet to the public
sector client" but there were still other issues which had
not been resolved:
The crucial point to note is that there are two separate
types of accounting for government activity: that for financial
reporting (now IFRS, as modified by the Treasury's Financial Reporting
Manual and approved by the Financial Reporting Advisory Board)
and National Accounts (ESA 95 being the governing regulation).
He explained that the "PFI financial reporting
problemarbitrage being rifehas now been resolved
in the United Kingdom" although he did add that "alertness
is required to ensure that PFI schemes are not modified to escape
from the remit" of financial reporting standards. However
in the terms of the National Accounts Professor Heald explained
there was still a problem:
[...] the satisfactory resolution in relation to
financial reporting (almost all UK projects are rightly on-balance
sheet) will not be matched by National Accounts treatment.
He pointed out that
[...] the Treasury announced in June 2009 that Spending
Review 2010 would be conducted on a National Accounts basis, exploiting
the lax criteria in the Eurostat (2004) rules. All that is required
to keep PFI projects off the National Accounts public sector balance
sheet is the transfer of construction risk and availability risk
to the private sector consortium.
He considered that this would create a new phase
of project distortions with:
(a) PFI being preferred to conventional procurement
for 'accounting' rather than VFM reasons, and
(b) PFI schemes that satisfy the Eurostat rules for
off-balance sheet treatment being preferred to those which do
Professor Ron Hodges also noted that the current
fiscal environment would be likely to add to the allure of PFI:
In periods of austerity off-balance accounting may
be particularly attractive to governments as a means of accessing
finance without having to record the underlying obligations.
The NAO also noted that the favourable treatment
of PFI debt may encourage its use:
There remains an incentive to use private finance
over other procurement options, however, as the rules still exclude
PFI from statistical calculations of Public Sector Net Debt.
14. In 1997 the Labour government stated it would
have two fiscal rules. These were summarised by the Institute
for Fiscal Studies as:
The golden rule:
over the economic cycle, the government will borrow only to invest
and not to fund current spending [...]
The sustainable investment rule:
over the economic cycle, the ratio of net public sector debt to
GDP will be set at a 'stable and prudent' level, defined by the
Chancellor as no more than 40% of GDP.
The current coalition government also has fiscal
rules, referred to by the Office for Budget Responsibility as
the fiscal mandate and the supplementary target. The OBR explain
them as follows:
"total public sector receipts need to exceed total public
sector spending (minus spending on net investment) after adjusting
for the temporary effect of any spare capacity in the economy."
"public sector net debt as a percentage of GDP to be falling
at a fixed date of 2015-16" 
The current fiscal mandate should not incentivise
the use of PFI or other additional or off-balance sheet financing
methods instead of direct capital spending and similarly the golden
rule of the previous government should not have encouraged the
use of PFI. This is because both fiscal rules allow borrowing
for investment. However the current supplementary target could
provide an incentive to favour PFI or similar schemes rather than
spending funded directly from government borrowing and the sustainable
investment rule could have also had this effect in the past. This
is because in the short term a PFI scheme would result in less
government borrowing and therefore a lower level of Public Sector
Net Debt. PFI projects which replace direct capital investment
could be used in 2015-16 to ensure that the headline level of
debt reduces so that the supplementary target is met. Similarly
in the case of the previous sustainable investment rule if the
net public debt level was approaching 40% of GDP one way of reducing
it in the short term would have been to transfer more direct capital
investment towards PFI schemes.
15. As well as fiscal rules at a national level there
are also rules at the European level. The Maastricht Treaty obliges
member states to avoid excessive budgetary deficits. In particular
it set out that governments' annual deficit and debt should not
exceed certain reference values.
These values were defined in the Protocol on the Excessive
Deficit Procedure as:
(a) 3% for the ratio of the planned or actual government
deficit to gross domestic product at market prices;
(b) 60% for the ratio of government debt to gross
domestic product at market prices.
These European fiscal rules make no distinction between
borrowing for investment and borrowing for current spending. They
therefore both incentivise the use of PFI or other methods of
off balance sheet financing rather than direct capital spending
funded through government borrowing. One of the written submissions
to the Committee noted that "Greece, Spain, Portugal and
Ireland have all in recent years been very active in PFI/PPP."
In 2005 for example Greece introduced a new 'PPP law' and two
new government bodies were set up to encourage and expand the
use of Public Private Partnerships.
The use of other off balance sheet financing methods deployed
by governments to circumvent fiscal rules have been noted. The
Financial Times reported that in 2002 Goldman Sachs had helped
Greece raise off balance sheet finance "by arranging a massive
swaps transaction aimed at reducing the cost of financing".
The press report explained:
Because it was treated as a currency trade rather
than a loan, it helped Greece to meet European Union deficit limits
while pushing repayments far into the future.
The article added that other European Countries had
used derivatives and methods such as securitisations to flatter
their national accounts.
16. A recent report by the Office for Budget Responsibility
notes that many PFI deals are not recognised in the National Accounts.
They note that:
As well as lacking transparency, this has fuelled
a perception that PFI has been used as a way to hold down official
estimates of public sector indebtedness for a given amount of
overall capital spending, rather than to achieve value for money.
The report details the scale of the problem noting
that "at March 2010, PSND [Public Sector Net Debt] included
about £5.1 billion (0.4 percent of GDP) in respect of PFI
deals that were recorded as on balance sheet in the National Accounts."
However the OBR considered that "the total capital liability
of on and off balance sheet PFI contracts was closer to £40
billion (2.9 per cent of GDP)."
They estimate therefore that if PFI contracts were all recognised
as debt in the National Accounts this would increase the level
of debt by around 2.5% of GDP.
17. The introduction
of IFRS (International Financial Reporting Standards) in 2009-10
has resulted in nearly all PFI debt being included in the financial
accounts of government departments for financial reporting purposes.
However so long as certain risks are deemed to be passed to the
private sector on a PFI project then the project is, by contrast,
recorded off balance sheet for National Accounts and statistical
purposes. As a result, most PFI debt is invisible to the calculation
of Public Sector Net Debt (PSND) and is therefore not included
in the headline debt and deficit statistics. If all current PFI
liabilities were included in the National Accounts then the OBR
estimates that national debt would increase by £35 billion
(2.5% of GDP). Therefore there has been, and continues to be,
at least a small incentive to use PFI in preference to other procurement
options, as it results in lower headline government borrowing
and debt figures in comparison to other forms of capital investment.
to meet fiscal rules at a national and European level may have
contributed to the misuse of PFI. Rules designed to promote fiscal
sustainability have had the paradoxical effect of incentivising
the use of off-balance sheet financewhich is likely to
prove less sustainable. Given the salience of the public debt
statistics in the current political climate, the attractiveness
of the PFI method for any government has been evident whether
it provides value for money or not.
Treatment of PFI capital expenditure
in a Departmental budget
19. Just as the capital values of most PFIs are invisible
to the national debt statistics, the capital expenditure that
PFI delivers will similarly not impact on Departmental capital
budgets. Depreciation charges to Departmental current budgets
will also be avoided in such cases. The benefit of using PFI for
capital investment which does not score in capital budgets is
clear to organisations who use PFI. Kent Police noted that "capital
sums do not have to be identified along with financing arrangements"
as the first point in their list of PFI strengths in a written
submission to the Committee. A PFI deal will have a smaller (but
much longer lasting) impact on the current budget of an organisation
whereas a conventionally procured capital project will result
in a significant one-off hit to the capital budget. In the short
term the use of less of an organisation's budget will provide
an incentive to use PFI rather than other forms of procurement.
20. As with the calculation of debt and deficit,
the level of capital expenditure continues to be measured according
to the ESA (European Standard Accounts) definition, and in most
cases this means the capital expenditure incurred due to a PFI
will not be included in capital budgets.
There is therefore a fundamental difference between the way many
PFIs are scored in Departmental budgets or DELs (Departmental
Expenditure Limits), compared to how they are measured in the
financial accounts. For conventionally procured projects, the
full investment cost of the project needs to be met from the budget
when the asset is created. For projects which are off balance
sheet (in National Accounts terms), unitary charges are met from
the budget for the year in which they arise, and commitments against
future budgetsoften well beyond the period for which budgets
have been setare created, effectively constraining organisations'
budgetary flexibility for many years, sometimes decades, to come.
These long term commitments are not however recorded in budgets
as liabilities to government.
21. Government departments and other public bodies
will only plan their budgets a few years in advancegenerally
no longer than the period covered by the latest spending review
so will not be considering PFI payments 20 or 30 years in the
future. For example, the latest Spending Review of October 2010
set Departmental budgets for the period up to and including 2014-15.
From a budgetary perspective, over this period, a PFI will often
seem more affordable than the alternative, although in the long
term it could be much more costly. The lack of budgetary and financial
control in PFI may lead to poor investment decisions being made.
Andy Friend considered that this had happened in the past:
At the programme level, I believe in certain situations
it encouraged over-consumption and decisions to be too lightly
taken in terms of procuring very substantial capital assets, perhaps
without due consideration of either the alternativesof
which there are many, much less developed in the UK market than
elsewhereor the long term obligations.
Departments or public bodies do not have a capital budget large
enough to allow for desired capital investment, there is currently
a substantial incentive to use PFIs which are not included within
Departmental budgets (Departmental Expenditure Limits). A PFI
deal will have a smaller (but much longer lasting) impact on the
current budget of an organisation whereas a conventionally procured
capital project will result in a significant one-off hit to the
capital budget. In the long term, the PFI arrangement will build
up big commitments against future years' current budgets that
have not even yet been allocated or agreed. We are concerned that
this may have encouraged, and may continue to encourage, poor
investment decisions. PFI continues to allow organisations and
government the possibility of procuring capital assets without
due consideration for their long-term budgetary obligations.
Removing the accounting and budgetary
incentives of PFI
23. As detailed above there are incentives in play
which could act to encourage the use of PFI for reasons other
than value for money. If
PFI is to be pursued only if it provides value for money it is
essential that any incentives unrelated to value for money are
24. We welcome
the Office for Budget Responsibility's decision to include, in
their Fiscal sustainability report, an assessment
of the impact of the PFI liabilities which are currently not included
in the National Accounts. We believe that the Office for Budget
Responsibility should also include an assessment of such liabilities
in its Economic and fiscal outlook, which assesses the
Government's performance against the fiscal mandate and the supplementary
target. We recommend that the Treasury clarify its view of the
remit of the OBR to ensure that the OBR include PFI liabilities
in all future assessments of the fiscal rules. This would help
prevent the use of PFI to 'game' fiscal rules.
Financial Reporting Standards (IFRS) require that most PFI projects
be scored in an organisation's financial accounts. Capital investment
related to PFI projects rarely, however, scores in individual
government Departments' budgets (Departmental Expenditure Limits).
This is because Departmental budgets follow the definitions used
in the European Standards of Accounts (ESA), rather than those
set out in IFRS. This is not only confusing, but also creates
incentives to use PFIs, rather than direct capital investment
by departments. We recommend that the Treasury should consider
aligning the treatment of PFIs in Departmental budgets with the
treatment in financial accounts. This should mean that most PFIs
score within those budgets in the same way as direct capital expenditure.
If this change were made it may also require an adjustment to
Departmental capital budgets.
9 Off balance sheet debt is debt that does not appear
as a liability on the balance sheet of an organisation's financial
Ev w30 [Note: references to 'Ev wXX' are references to written
evidence published in the volume of additional written evidence
published on the Committee's website] Back
Ev w33 Back
HM Treasury, Value for Money Assessment Guidance, November 2006,
p10, para1.17 Back
Q 1 Back
Ev w130 Back
Ev w130 Back
Ev w64 Back
C&AG's report, Lessons from PFI and other projects,
HC 920 2010-11, p20, para 2.17 Back
Institute for Fiscal Studies, The Government's Fiscal Rules,
April 2001 (updated November 2006), p2 Back
Office for Budget Responsibility, Economic and Fiscal Outlook,
March 2011, p154, para 5.5&5.6 Back
Office for National Statistics, Statistical Bulletin: Government
deficit and debt under the Maastricht Treaty, 31 March 2010, p4,
para 1 Back
Official Journal of the European Union, Protocol on the Excessive
Deficit Procedure, Article 1,16 December 2004 Back
Ev w18 Back
DLA Piper, European PPP Report 2009, Country Section - Greece,
Financial Times, Athenian arrangers, 17 February 2010,
OBR, Fiscal sustainability report, July 2011, p41, para
OBR, Fiscal sustainability report, July 2011, p42, para
OBR, Fiscal sustainability report, July 2011, p79, Box
Ev w57 Back
This is because Treasury has determined that Departmental budgets
will follow the ESA and National Accounts definitions of balance
sheet rather than those used by IFRS and in Resource Accounts. Back
Q 4 Back