3 Value for money
Cost and availability of finance
26. Private finance is invariably more expensive
than direct government borrowing and therefore we explored the
difference in the availability and cost of private and government
debt in our evidence. Balfour Beatty told us in written evidence
that the "financing costs of PFI are typically 3-4% over
that of government debt."
All witnesses agreed that the differential between government
debt and private project finance was significant and that it had
increased since the financial crisis. James Wardlaw of Goldman
Sachs told us "In terms of the cost of that finance, it is
definitely higher [...] the levels were 60 [basis points]
over swaps at the peak, and now we are talking 250 and more."
When we asked him whether or not the upward shift in the cost
of capital was locked in for the foreseeable future Mr Wardlaw
agreed, telling us "Yes, and also that the willingness of
people to finance remains quite short".
Richard Abadie explained that the difference between government
debt and private debt "will never come down [...] to the
levels pre-credit crunch" adding "I do think we are
in a world of more expensive debt".
Steve Allen of Transport to London also told us "there is
a significant premium for the cost of finance through a PFI".
27. A National Audit Office report of 2010 which
examined financing PFI in the credit crisis "found that the
part of the cost relating to loan margins on PFI deals, which
had been 1 per cent or less, widened significantly to around 2.5
per cent on average" and that some "will rise to more
than 3 per cent in stages over the project life". The NAO
explained that this "resulted in substantial increases to
the cost of finance".
As well as loan margins increasing the NAO report also showed
that since the credit crisis arrangement fees, commitment fees
and the 'swap credit spread' had all increased.
These extra fees, which were projected to be more than 3% of the
total value of the debt drawn down, further increase the difference
between the cost of government debt and private finance. The NAO
report also noted that "PFI is less likely to be value for
money unless there are substantial and credible savings to offset
higher financing costs."
28. Some of the reasons for the increased costs and
lack of availability of finance were explained in the International
Handbook on Public-Private Partnerships published in 2010:
The global financial crisis has led to a significant
increase in the cost of private financein particular the
senior debt component. Commercial bond financehitherto
the cheapest form of senior debt for PFI projectshas been
unavailable since mid-2008,when many of the big US 'monoline'
insurers such as Ambac and MBIA lost their 'triple-A' credit rating
in the midst of the 'subprime' mortgage crisis. These institutions
had played a key role in the provision of senior debt for large
projects, by guaranteeing ('wrapping') repayments to bondholders
in return for a fee and thereby reducing overall financing costs.
The withdrawal of the monolines' ability to provide a triple-A
guarantee has removed commercial bond financing as a low-cost
option for the foreseeable future.
At the same time, banking sector liquidity has reduced
dramatically as the financial crisis has developed.
The paper also noted that "the size of the increase
in margins [...] contains a substantial premium that is unrelated
to default risk, and is associated with credit constraints and
the oligopolistic nature of the senior debt market."
As well as the increased cost of debt finance it
is important not to forget that a PFI is also partly funded by
equity. This means that the cost of capital (which includes a
return for equity holders) is higher than just the cost of the
private debt. The Weighted Average Cost of Capital for a conventional
availability-based PFI project in the accommodation sector
is now in excess of 8.5%.
This compares to the current long term government gilt rate of
just over 4%.
Box 1: Private finance comparison with public finance - worked example
Analysis by Mark Hellowell - Specialist Adviser to the Committee
For a PFI to cost less than a conventional procurement,
it must deliver savings in construction, maintenance and/or service
provision that are, relative to the risk-adjusted costs of a conventionally
procured alternative, sufficient to offset the higher financial
Therefore, it is important to consider the scale of the difference
in financial costs between public and private finance. Here, we
examine this by looking at the cost projections relating to the
Royal Liverpool and Broadgreen University Hospital NHS Trust's
PFI project, which is currently in the procurement phase. These
projections are contained in spreadsheets associated with the
Trust's Outline Business Case, which was approved by successive
governments in 2009 and 2010 respectively.
In the version of the spreadsheet used in this
analysis, the project is assumed to involve initial capital expenditure
of £244 million and the contract is expected to run for 34
years, including a four-year construction period and a 30-year
management phase in which the private partner will deliver maintenance
services. During the management phase, the Trust will pay to the
private partner a periodic unitary charge. This provides the private
partner with a revenue stream from which to meet operational costs
(primarily maintenance and lifecycle costs, along with the costs
of running an office and paying insurance), and financial costs
(primarily the costs of making principal and interest payments
to "senior" and "junior" debt providers and
a return to the owners of equity). The cash-flow to all these
investors is called the Project Cash-Flow, and this is the data
source for this analysis.
This cash-flow takes the form of a series of expenditure
cash-flows (relating to the four year construction period) followed
by a series of revenue cash-flows (in which income from the public
sector significantly exceeds the private sector's operational
costs, thereby providing revenue for distribution to investors).
The additional financial cost of PFI can be derived by discounting
the stream of cash-flows at the relevant discount ratewhich
is here taken to be the "gross redemption yield" on
government "gilts" of the approximately the same maturity
as the PFI loans (i.e. 30 year gilts). The current yield is approximately
Discounting the Project Cash-Flow stream at 4.2%
produces an NPV of £175 million. This figure represents the
additional financial cost of using private, rather than public
finance, to deliver that amount of capital expenditure. If
we assume that the outturn costs of construction, maintenance
and services will be the same between the PFI and conventional
procurement options, the government could have spent £175
million less, in NPV terms, by borrowing directly from the capital
markets, rather than through an SPV intermediary.
A different way to examine this is to discount
the expenditure cash-flow and the revenue cash-flow separately
at 4.2%, and then compare the present values of each. On this
basis, the present value of the revenue cash-flow is £421
million and the present value of the expenditure cash-flow is
£246 million, a ratio of 1.7/1. Had the financing been provided
at the gilt rate, rather than at the private finance rate, the
ratio would be 1/1.
There are two different ways of interpreting the
results of this analysis. The first, as noted, is that the public
sector is paying £175 million more than it needs to in order
to secure the amount of capital expenditure required.
This is the NPV of the higher cost of private financethe
cost that the PFI model needs to offset, in terms of efficiencies
in construction, maintenance and/or services compared with conventional
procurement, to represent a cost-efficient solution. An alternative
way to view this is in terms of foregone opportunities for additional
capital investment. Assuming
that PFI does not deliver efficiencies in construction, maintenance
and/or services then,
for the same present value of finance-related payments, the
government could have secured 71% more investment by borrowing
on its own account.
Source data: Royal Liverpool and Broadgreen University
Hospital Outline Business Case, 2010
Table 2: Summary of worked example - Financial cost of capital expenditure
|Cost - Present Value
(@ 4.2% discount rate)
|Savings and benefits PFI needs to deliver in other areas to offset the extra cost of private finance
|Potential increase in investment possible if using government financing, assuming no offsetting efficiencies from PFI (%)
|Potential saving from using government financing, assuming no offsetting efficiencies from PFI (%)
Source: Committee Specialist Adviser analysis
of RLBUH Business Case - see Box 1 for details
29. To understand better the cost difference between
private finance and public finance over the life of a project
we asked our Specialist Adviser to perform an analysis (Box 1
and Table 2). As the differential between the cost of government
gilts and private sector debt has increased notably since the
financial crisis we considered it was important to look at a contemporary
example. The analysis undertaken used figures from a 2010 Outline
Business Case for a new hospital and showed that there was significant
extra cost of using private finance rather than public finance.
The higher cost of capital for the PFI option compared to government
gilts meant that, without any offsetting efficiencies, the cost
of the PFI option would be 70% higher over the life of the project.
One other way of looking at the difference in cost is to consider
how long it takes government to pay off outstanding debt. If government
borrowed directly and followed the same repayment schedule as
the PFI charges the government debt could be fully repaid many
years before the equivalent PFI liability could be paid off.
has always been able to obtain cheaper funding than private providers
of project finance, but the difference between direct government
funding and the cost of this finance has increased significantly
since the financial crisis. The substantial increase in private
finance costs means that the PFI financing method is now extremely
inefficient. Recent data suggests that the Weighted Average Cost
of Capital of a PFI is double that of government gilts. PFI will
only provide value for money if this differential in the cost
of finance, which has significantly increased, is outweighed by
savings and efficiencies during the life of a PFI project.
undertaken by the Committee's Specialist Adviser suggest that,
all else being equal, paying off a PFI debt of £1bn may cost
the same as paying off government debt of £1.7bn. This would
mean that a 70 percent increase in investment could be achieved
for the same long term cost if government funding were used instead
of private finance. An alternative way of expressing this is that
the cost of paying off a PFI debt would be over 40 percent cheaper
if government funding were used.
The current higher cost of finance means there may be a significant
opportunity cost from using PFI.
32. As part of our inquiry we considered if PFI had
resulted in a better risk allocation and whether or not this allocation
had resulted in savings and other benefits for the public sector
which could offset the higher costs of financing. We consider
these points in the following sections.
33. We asked the witnesses if they believed that
PFI had resulted in risk being transferred to the private sector
efficiently. Professor Helm told us: "In terms of inefficiency,
it is quite hard to think of many other aspects of the British
economy that are more inefficient than that risk allocation."
Andy Friend explained that in the past "PFI theology said
you would transfer any risk you could identify". He felt
that this had led to inappropriate risks being transferred such
as energy risk."How a private sector provider of a capital
asset is in a better position to manage energy tariff risk than
a public authority with its potential buying power, I don't know."
He also highlighted some other specific risks such as insurance
and the management of derivatives that he considered could have
been better managed by the public sector.
34. Witnesses did however point out that some risks
such as construction risk had been transferred successfully. Richard
Abadie told us:
One of the clear benefits of contracting out to the
private sector is the transfer of construction risk. Let them
build it, let them give you a fixed price for it [...]
Andy Friend highlighted a number of examples where
construction risk had been transferred, including one which he
had direct experience of:
I was Chief Executive of John Laing Plc when a project
that had been entered into in 1998 went badly wrong, the National
Physical Laboratory. We booked £68 million of losses on that.
Mr Friend considered that other procurement methods
"have involved much greater additional cost in terms of getting
those projects operational" although he did concede that
"there has been improvement in many of the mechanisms".
Mr Friend suggested that once the construction stage had been
completed and the operational stage had started there was a case
for allowing the public sector to refinance the debt.
This would allow the private sector to bear the risk during the
construction phase but transfer the risk back to the public sector
in the operational phase. The benefits of private finance projects
transferring construction risk were made in other submissions
to the Committee:
Construction risk is transferred in PPP [Public Private
Partnership] projects from the public sector to the private sector.
Fixed price, date certain contracts are the norm with no facility
to make new claims on the public sector purse if unforeseen difficulties
Other evidence however noted that PFI and PPP were
not the only ways of ensuring that construction risk was transferred:
The Treasury has acknowledged that on-time and on
budget performance can be secured through conventional procurement,
so long as the design and build services are procured through
a fixed-price, "turn-key" 
35. In its written submission Balfour Beatty discussed
risk transfer, telling us that "clients, often encouraged
by their external advisory teams, are tempted to incrementally
increase the risk transferred to the private sector". However
it considered that often this was inappropriate, explaining that
"these increases in risk transfer are not properly evaluated
in terms of the potential impact on value for money". In
particular, it pointed out that financial penalties that were
used to transfer risk led to higher prices and a deterioration
in value for money.
The payment mechanism is the authorities' main commercial
tool to incentivise performance against the expected standard.
However, our experience is that over time, increasingly aggressive
payment mechanism arrangements result in poor value-for-money
as PFI operators build-in risk to avoid the consequences of disproportionate
The infrastructure company also highlighted four
areas where they considered it better value for money for the
public sector to bear the risk. These were: insurance; energy;
pensions; and demand risk. In terms of energy it believed:
The public sector should resist the temptation to
attempt to transfer risk on tariff which the private sector cannot
manage any better than the public sector. Procurement of energy
must be more effectively managed by the public sector, which can
achieve significant economies of scale compared to the private
It also provided detail about the limited circumstances
where it believed demand risk should be transferred to the private
Except where the private sector is genuinely responsible
for generating customers/users, the transfer of demand risk (eg
traffic counters on highways projects) should be avoided. Demand
risk tends to increase the cost of lending and result in a sub-optimal
project structure which leads to a reduction in value for money
for the public sector.
36. Professor David Heald explained in his submission
that "it should not be an objective of PFI to transfer risk
to the private sector but only to transfer those risks which the
private sector is better equipped to handle". He also told
Attempting to transfer inappropriate types of risk
will instead lead to excess costs and to potential default, with
the materialising costs falling on the public sector. This echoes
an important lesson from outsourcing in the petroleum industry:
if the responsibilitylegal and reputationalremains
with the 'principal', the loss of operational knowledge and control
may offset the apparent cost savings. Especially in an institutionally
fragmented public sector, it is difficult to be an intelligent
client and to sustain that through a 30-year PFI.
37. Transport for London had some insights regarding
risk transfer. It explained that "risk can be fully transferred
only if the procuring authority could abandon a failing PFI concession,
which is unlikely ever to be the case", adding that "TfL's
experience is that the general public have little appetite for
a blame gameclearly to the extent TfL can control its own
assets, it can control its performance." It added:
TfL's view is that the private sector is willing
to bear significant risk but only if it is paid enough. The question
should be which party is best placed to manage each risk [...]
where the private sector can manage risk better than the public
sector, it should do so. However, this decision does not necessarily
lead to using PFIturnkey construction or maintenance contracts
can be effective in risk transfer.
risk to the private sector is only worthwhile if it is better
able to manage the risk and can pass on any subsequent savings
to the client. The main benefit highlighted to us by PFI providers
was the transfer of construction risk. However a PFI contract
which lasts for 30 years is not necessary to transfer this risk.
There are also other methods such as turnkey contracts which can
be used for the same ends. We have seen evidence that PFI has
not provided good value from risk transferin some cases
inappropriate risks have been given to the private sector to manage.
This has resulted in higher prices and has been inefficient.
39. Some of
the claimed risk transfer may also be illusorythe government
is ultimately accountable for the delivery of public services.
Therefore it would not be able to allow a number of services provided
under a PFI contract to cease for any length of time.
Whole life cost and innovation
40. In PFI, the SPV is responsible for both the construction
and operation of the asset, and the cost of both (along with the
cost of finance) is included in a single price provided to the
public authority. Supporters of PFI say that bundling in this
way encourages up-front investments that will contribute to cost
reduction over the asset's life cyclei.e. spending more
on construction might make sense if this will result in lower
maintenance spending in the long term. The Treasury points out
that this aspect of PFI distinguishes it from other forms of procurement:
Unlike other forms of procurement, PFI projects benefit
from whole-life costing over 30 years, involving both construction
and service delivery [...]
However the NAO noted in a paper published in 2009
that there are other methods that can be used to ensure that whole-life
costs are considered:
Private finance is not, however, the only way to
ring-fence maintenance funding or consider whole-life costs. The
London Borough of Lewisham, for example, has established a sinking
fund to ensure its non-PFI schools are maintained to the same
standard as its PFI schools.
The Treasury believes that, owing to the benefit
of whole life costing, operating costs of PFI projects cannot
be bettered by the services tendered as part of a non-PFI procurement
or provided in-house. If they do cost less this will be done by
"compromising the quality of service" with "sub-optimal
They advise public bodies to adjust the PFI cost according to
sector experience. This has resulted in the Department of Health
recommending an assumption that annual 'life cycle costs' will
be 15% cheaper for PFI deals for Trusts considering the different
procurement options for a new build hospital.
41. Many of the PFI contractors, investors and advisers
that submitted evidence to the committee highlighted the consideration
of 'whole life cost' as a major benefit of PFI. PricewaterhouseCoopers
told us PFI resulted in "Focusing procurers on the whole-life
cost and performance of infrastructure rather than making short
term decisions based on short term budgets".
Canmore Partnership Ltd explained that "one of the main benefits
of the PPP-type provision of public use infrastructure has been
the whole-life integration of design, building, maintenance and
life cycle costs." It went on to explain:
This correctly incentivises developers to invest
in quality facilities at the outset, thus also increasing the
availability of those facilities. At the end of a typical PPP
concession the public sector will inherit assets which have been
Barclays Infrastructure also pointed out that "PFI
procurement encourages whole life costing, whereas traditional
procurement focuses mainly on the initial construction costs."
42. If bidders know they can achieve lower whole-life
costs and the procurement process is sufficiently competitive,
then this should result in lower prices for the public sector.
If the benefits of whole life costing are working it would be
reasonable to expect that building design would make use of innovations
in order to provide higher quality buildings that will last longer
in good condition. A previous Treasury Committee's report on PFI
in 2000 made this very point and recommended that PFI projects
should be monitored for "innovative approaches" that
could be "transferred effectively to publicly-funded projects".
Professor James Barlow has done research on innovative design
in the health sector and we explored the issue of innovation with
him. He was clear that PFI had hindered rather than encouraged
design innovations: "I think the way risk was devolved and
transferred has meant that it has made very difficult to stimulate
any kind of innovative thinking about the design of the buildings".
We asked him how this compared to hospital building programmes
of the past and he told us: "there was more design innovation
in the 1960s and 1970s."
However he had not done research on the quality of the buildings
and considered that PFI "should drive up quality".
43. Although PFI theory states that the process should
drive up building quality to keep long term costs down we received
evidence which directly contradicted this. The Royal Institute
of Architects told us that "the quality of the buildings
delivered through PFI schemes remained poor in many cases".
It explained that: "The poor quality of the buildings' design
lead to a number of issues, such as rising maintenance costs over
the lifetime of the building". One of the reasons it pointed
to was "value-engineering by contractors", telling us
that there was strong anecdotal evidence that contractors were
withholding information from clients. This resulted in "essentially
reducing the intended quality and cost of the project compared
to that specified by the architect, to the detriment of the finished
building, without the knowledge of an unaware client." The
reason this was done was to "maintain the contractor's preferred
levels of profitability".
44. Where possible it is useful to compare PFI buildings
to non-PFI buildings to see if benefits are being realised. The
Audit Commission did a report on PFI schools in 2003. Although
it found no difference between the construction costs of PFI and
non-PFI schools it
did find that the quality of PFI schools was significantly worse
than that of the traditionally funded schools. The average score
given by the Building Research Establishment (BRE) for the PFI
schools was lower than the non-PFI schools in all of the areas
tested such as architectural design, user productivity and ownership
costs. The report also noted: "The best examples of the type
of innovation that can improve fitness for purpose and minimise
running costs over a school's lifetime came in traditional schools".
In its inquiry on PFI of 2009-10, the Lords Committee on Economic
Affairs received a written submission on design quality from academics
at the University of Edinburgh:
The NAO commissioned the Building Research Establishment
to compare design quality between a group of PFI and a group of
non-PFI hospitals. It found that there were "no meaningful
differences" in build quality between the two groups. However,
it also noted that the average age of the non-PFI hospitals was
There are also other comparisons that have been done
between PFI and non-PFI hospitals. A recent Committee of Public
Accounts report said that:
One of the stated benefits of PFI is that it should
ensure buildings are maintained to a high standard through the
contracts' lives, yet 20% of Trusts were not satisfied with the
maintenance service provided within their PFI contracts. In addition,
unlike support services, the costs of maintenance cannot be revisited
and are not subject to regular benchmarking.
45. The National Audit Office's report The performance
and management of hospital PFI contracts gave some examples
of problems regarding the maintenance element of PFI contracts:
King's College Hospital was dissatisfied with lift
maintenance. Broken lifts meant patients often share lifts with
visitors to get to operating theatre. This is an ongoing issue
yet to be resolved.
Hull and East Yorkshire experienced poor performance
on some maintenance work. A high level of involvement from matrons
has since ensured that clinical and maintenance services run smoothly
The NAO report found when comparing PFI and non-PFI
hospitals that there was no significant difference in the assessment
of the environment and little difference in costs charged for
46. It is difficult
to establish clear cut evidence in the area of whole life costing.
In theory whole life costing should encourage the use of innovative
designs in PFI to deliver buildings of better quality. These should
in turn provide cost savings over the life of the building that
can, to some extent, offset the higher financing costs inherent
in a privately financed deal. The long term nature of a PFI contract
should also incentivise providers to maintain buildings to a high
quality thus reducing costs in later life. However we have not
been provided with clear evidence to suggest that PFI performs
better in this area. Indeed in the area of design innovation and
building quality we have seen some evidence to suggest that PFI
performs less well than traditionally procured buildings.
To 'time and budget'
47. We received a number of written submissions which
presented one of the key benefits of PFI as being the method more
likely to deliver to time and budget than conventional procurement
methods. The CBI made this point in its written submission:
[...] transferring financial risk to the private
sector partner has contributed to improved performance during
the construction phase, with a larger proportion of projects being
delivered on time and within budget.
So did PricewaterhouseCoopers:
At the outset financiers perform detailed due diligence
on assets, costs and contracts using technical advisors to ensure
the project will be delivered on time and to budget.
The NAO, in a report for the Lords Economic Affairs
Committee, noted that: "Most private finance projects are
built close to the agreed time, price and specification."
However they noted that of their sample of PFI projects over 31%
had been completed late and 35% had not been delivered for the
contracted price. They explained that "using PFI is not a
panacea for solving construction problems."
48. Any improved performance in terms of time and
budget is only an achievement if the benefit outweighs any extra
cost involved. The BMA considered that there was a 'risk premium'
which meant overall the benefit of being on time and budget was
not good value:
[...] research which found that hospital trusts were
paying a 'risk premium'conservatively estimated at 30%
of the total construction coststo ensure projects are running
to time and budget. So while it is true that the private sector
absorbs the cost of overruns etc, additional charges are written
into the contracts to account for this.
A report published by the European Investment Bank
estimated that the contracted price was 24% higher for PPP roads
than conventionally procured roads. The authors considered that
the difference was largely due to cost overruns in traditional
procurement meaning that there was little difference in the overall
out-turn cost of both methods.
49. If the budget is already 20% higher in a PFI
procurement then a budget overrun of less than 20% in a conventional
procurement would mean it was still cheaper. It is therefore important
to consider how much projects which do not meet their budget exceed
it. A National Audit Office report which considered a group of
public sector projects that went over budget in 2003 and 2004,
reported that the average level of overspend was 4.1%.
Any improvement in delivery to time also needs to be seen in the
context of the procurement process. Submissions to the Committee
recognised that for PFI this process was complex and lengthy.
The UK Contractors group told us that "even now the procurement
process for a new hospital project in the UK can take over two
years before any construction work is undertaken."
The NAO reported in 2007 that on average the overall tendering
process took over two years for schools and over three years for
hospitals. HM Treasury
in its document Meeting the Investment Challenge recognised
this as an issue: "Procuring through PFI can be complex and
can involve lengthy negotiations before contracts are signed."
It added "Long lead times are a result of a number of factors,
some common to all procurement, and some associated with PFI".
50. There are also other reasons why to focus on
the baseline of 'time and budget' may be misleading. The
price of construction in conventional procurement is agreed at
a stage of project development that is equivalent to a much less
advanced stage than in a PFI. The risk control mechanisms built
into the PFI model are factored into the price before contracts
are signed. It is known that contract costs can increase during
the preferred bidder stage of procurement, an exclusive stage
of bidding in which competitive tension is absent and the public
authority is in a weak negotiating position.
51. The fixed
nature of PFI contracts means they are likely to provide more
certainty regarding price and time. However there is no convincing
evidence to suggest that PFI projects are delivered more quickly
and at a lower out-turn cost than projects using conventional
procurement methods. On the contrary, the lengthy procurement
process makes it likely that a PFI building will take longer to
deliver, if the length of the whole process is considered. Proposing
that post-contractual price certainty can be taken as a good measure
of overall cost efficiency is to use a comparison already likely
to favour PFI. This is because the PFI contract price is set at
a much more advanced stage in the process. It is evident that
a project delivered "to time and to budget" (in post-contractual
terms) may nonetheless represent poor value for money if the price
paid for the risk transfer was too high.
52. One issue that was prominent in both the written
evidence we read and from our witnesses was the inherent inflexibility
of PFI. Transport for London were clear that its "experience
is that PFIs are the least flexible form of contract". It
told us that PFI bound "both client and contractor to a series
of outputs that have diminishing desirability and/or affordability,
with much less scope to negotiate change than under other forms
of contract". However this inflexibility did have both pros
and cons: "This can be a strengthas client changes
are often a significant cause of cost overrunsbut is also
a major constraint."
Steve Allen, the Managing DirectorFinance at TfL told us
that PFI was "therefore only suitable for procurements where
you don't need to change what it is you require over the life
of the contract". Mr Allen explained that the financing of
a PFI made any changes much more difficult:
The involvement of the finance in the PFI makes it
more inflexible, because it is not just a question of negotiating
with the contract who built the asset. Particularly if the change
is going to require some significant amount of funding, they are
going to negotiate with the equity investors and with the debt
holders as well.
Professor Helm agreed that the structure of a PFI
made it more inflexible. He told us that a PFI acted to "bundle
the finance and fossilise the contract and put in the inflexibility
that costs us so much both in terms of the efficiency of the project
and in terms of the cost of capital".
Barclays Infrastructure also noted that the financial structure
was a reason for inflexibility:
These problems are accentuated by the capital structure
used in most PFI transactions, where leverage is = 90% and hence
all variations require multi-party involvement and consent. Such
leverage results in a low cost of capital but is restrictive to
future change as there is little incentive on lenders (who are
the dominant capital providers) to facilitate change.
53. Anthony Rabin, the Deputy Chief Executive of
Balfour Beatty, told us that the best way to allow for future
changes in requirements "would be to have that discussion
at the start of the contract to allow the public sector sufficient
However Mr Allen told us that although some flexibility could
be built into a contract there would always be limitations particularly
as some issues would only emerge once the work had started:
You can build certain amounts of flexibility into
the contract that you let if you can foresee what flexibilities
you need, but there will always be limits around that, and it
will affect the appetite of people to bid and the price that they
will bid for that.
He explained that in some cases the only way to resolve
problems was to bring a PFI back in house:
[...] if I go back to the Croydon [Tramlink] example,
essentially what we had to do was buy the SPV from the shareholders
because there wasn't the flexibility to renegotiate the terms
of the contract.
He emphasised that it was the ability of TfL to borrow
directly that gave them the flexibility to opt out of the inflexible
[...] having the ability to borrow ourselves [...]
gives us some flexibility in renegotiating existing contracts
in that we can buy the debt back and refinance it on our own terms,
and we have had examples of that.
54. We explored the effect of the inflexibility in
PFI projects in some detail particularly with regard to the health
sector. Professor James Barlow told us "I think one problem
is that we have large, highly-specified buildings that are inflexible".
He went onto explain that "my concern really is about the
inflexibility of these buildings and the impossibility of, over
a 30 or 40-year period, predicting what the demand is going to
be like for the bed spaces in those buildings". He believed
that the "way risk was devolved and transferred" in
a PFI meant it was "very difficult to stimulate [...] any
real sort of attempt to think about future flexibility".
Jo Webber of the NHS Confederation expressed similar concerns
about being fixed into long term contracts:
[...] the most recent sort of direction of travel
for care is to have it much closer to home, much more around people
in their own communities. It is very difficult to change a very
high-value environment like a ward environment into something
that is affordable.
55. The British Medical Association considered that
the fixed nature of the unitary payments agreed in PFI contracts
would mean that efficiency savings would be more difficult to
achieve. "The NHS is being tasked to find efficiency savings
of £20 billion by 2014-15". It went onto explain:
[...] at the same time (during the next spending
review period from 2011 to 2014) repayments for NHS PFI projects
will reach £4.18 billion, an increase of almost £1 billion
from current levels. As a legal contract PFI removes discretion
in capital spending and it is likely that hospitals will be forced
to make cuts to health care services to make their ongoing PFI
Jo Webber told us that meeting PFI payments in the
light of other pressures meant that "there will be a big
affordability challenge over a long period"
adding that it "will become more of a challenge for people
over the next few years".
contracts are inherently inflexible. Specifications for a 30 year
contract must be agreed in detail at the start of a project. The
PFI financing structure also requires negotiation with the equity
and debt holders before any substantial changes are made during
the life of a contract. Debt and equity holders have little to
gain from changing profitable contracts so will be unlikely to
agree to changes unless they significantly enhance profitability.
We have received little evidence of the benefits of these arrangements,
but much evidence about the drawbacks, especially for NHS projects.
The inflexibility of PFI means that any emergent problems or new
demands on an asset cannot be efficiently resolved. In the case
of Transport for London its only option was to buy out the SPV,
but most PFI procurers cannot afford to do this.
PFI and competition
57. If there is healthy competition in the PFI market
this should drive down costs and result in better value for taxpayers.
We received written submissions that pointed to a lack of competition
in PFI. The Royal Institute of British Architects explained that
competition was reduced as many architects were unable to bid
for work "due to the limited entry routes to the marketthe
lack of design frameworks, or open competitions". It also
pointed out that "the fact that contractors are required
to have a design team on-board before bidding for the work, meaning
they frequently use their own in-house design teams and a small
number of practices that they have worked with previously."
Martin Blaiklock considered that one of the disadvantages of PFI
was that it "reduces competition: high costs and complexity
means only major companies can afford to bid for such concessions".
However Dr James Robertson noted that one of the potential benefits
of PFI was that it "may open up domestic markets to overseas
58. One of the issues we explored with witnesses
was the procurement process and cost and whether or not this affected
competition. Mr Rabin agreed that "relative to other forms
of procurement it probably is expensive. It is more complex; there
is a whole machinery about PFI that you need to get right, otherwise
it doesn't work".
Regarding the competitiveness of the market he added "I would
perceive from our side of the table that there is a reasonable
amount of competition".
When we asked Mr Rabin about how many new school PFIs Balfour
Beatty had bid for he replied: "I would guess that one in
three possibly we would have bid for, something like that."
When we challenged him about the fact that in some areas his company
had been the only serious bidder, he told us: "That is not
something we were aware of at the time".
59. If costs are too high to bid this will act as
a barrier to entry in the PFI market. Mr Friend concurred with
the view expressed in a written submission that failed bids cost
approximately £2m per school and £12m per hospital.
Mr Friend told us "We at Laing thought we were doing well
if we won 40% of what we were shortlisted for. So, you are writing
60. In 2007 the National Audit Office noted that
"there is evidence that PFI projects are receiving fewer
developed bids than previously". A third of the PFI projects
they surveyed (between April 2004 and May 2006) had attracted
only two detailed bids. In the same period only 20% of the PFI
projects received four or more bidsthis compared unfavourably
to an earlier survey (2003 and before) which showed that 50% of
the projects received four or more bids.
It noted that the reason for fewer competing bids was "in
part due to the cumulative impact of lengthy tendering periods
and high bid costs". For example the overall tendering period
lasted on average 34 months.
61. The nature
of PFI means that competition is likely to be less intense compared
to other forms of procurement. We believe the barriers to entry
to be too high, resulting in an uncompetitive market. The long,
complex and costly procurement process limits the appetite for
consortia to bid for projects and also means that only companies
who can afford to lose millions of pounds in failed bids can be
involved. The fact that consortia are formed to bid for projects
also limits choice and competition. For example an architects'
firm may have the best design or there may be one contractor that
has produced the best proposal, but unless these designs and proposals
are part of the chosen consortium's bid they will not be used.
The long term nature and inherent complexity of the contracts
also make comparison more difficult for clients, further undermining
62. All PFI projects have to complete a Value for
Money (VfM) assessment of the PFI option compared to an conventional
procurement option with funding provided by central government
known as the PSC (Public Sector Comparator). The recent decision
to use a PFI to redevelop the Royal Liverpool and Broadgreen University
Hospital is a helpful example by which to consider the value for
money case for PFI. The Outline Business Case shows that the 'VfM
assessment' calculated that PFI could provide a value for money
benefit of 0.03% compared to conventional procurement.
surprised about the supposed precision of this comparison given
the inherent uncertainty in any long term investment decisions,
and we are also concerned about some of the assumptions behind
the VfM assessment. Many of these assumptions act to make the
choice of PFI more likelysee Box 2 for details.
Box 2: Examples of assumptions in the 'VfM assessment'
which made the choice of PFI more likely (Royal Liverpool and
Broadgreen Hospital: Outline Business Case)
|The Internal Rate of Return: The assessment tested the VFM case for investors who needed a IRR of between 13% and 15%. It was assumed that investors would only demand 13%the lowest rate of return, which has rarely been achieved in similar projects. At the 14% and 15% level the PFI route was assessed as poor value for money.
The discount rate: "In accordance with Treasury guidance, a real discount rate of 3.5% has been used for the first 30 years of the project"this is much higher than the real rate on 30 year index linked gilts which is currently less than 1%.
Whole life costs: Life cycle costs were adjusted down by 15% for the PFI option.
Optimism bias: There is an assumption that the costing of the conventional procurement route will always be over optimistic. This resulted in an upward revision of the PSC option of 19% for the capital expenditure and of 15% for the operational expenditure.
Tax: "An adjustment of 6% has been made" to increase the PSC option - to take corporation tax receipts from the PFI option into account. This adjustment suggests that approximately a quarter of all revenues paid to the PFI provider will be profits subject to corporation tax at the full rate.
Risk transfer: "The discounted value of transferred risk is assessed at 9.78%". This adjustment for 'risk transfer' acts to reduce the PFI cost.
Transaction costs: The same value for transaction costs are used for both the PFI and PSC option. This goes against both the evidence we have taken and the Treasury guidance which recognises that a PFI procurement involves "significant transaction costs" which are greater than those of a PSC procurement.
Third party income: The trust estimates that income of £50,000 will be generated under the PFI option but not under the PSC option. If this income had not materialised under the PFI option, the option would not have been assessed as best value.
63. The vast majority of the costs of this PFI project
are related to the capital expenditure and its financing. Analysis
(see Box 1 & Table 2) of the financing costs shows that the
costs of financing the building of the new hospital were significantly
higher (71%) than if the same finance had been raised by the government.
It is therefore clear that the discounting of cash flows and other
adjustments were significant as they resulted in the PFI option
being assessed as better value. Coincidently, around the same
time the go-ahead was given for this PFI hospital, a plan from
the North Tees and Hartlepool Trust for a publicly funded
hospital was cancelled. The publicly funded plan had been originally
chosen as it was judged as providing best value for money. Since
the cancellation the trust have produced another VfM assessment
which indicates that PFI is now best value for money and so it
is now the "preferred option".
64. We received submissions about the VfM assessment
system. Martin Blaiklock noted in his submission that in 2003
government had reduced the discount rate. Reducing the discount
rate meant that PFI projects would be less likely to be assessed
as value for money compared to a public sector comparator. He
To counterbalance this abrupt change, HM Treasury
introduced the concept of 'Optimism Bias' to reflect, as they
thought, the inherent under-estimation of costs that Government
departments had demonstrated over past decades.
He went onto point out "no other government
has formalised the over-runs into an 'across the board' regulation
as has the UK through the application of Optimism Bias".
A written submission
from Greg Dropkin and Sam Semoff also raised similar issues:
"Optimism Bias" is applied to conventional
procurement but not to PFI, giving an inbuilt advantage to PFI
in the comparison. Yet the Treasury has acknowledged that on-time
and on-budget performance can be secured through conventional
procurement, so long as the design and build services are procured
through a fixed-price, "turn-key" contract.
We received a written submission from JP Heawood,
a resident of York, who provided an account of how a York Schools
PFI project had come to be approved:
In the York Schools PFI Project, the executive summary
of the Outline Business Case (OBC) gave the PFI cost as £11.1
million, with the projected Public Sector Comparator (PSC) better
value at £10.3 million. But of course a bid with those figures
wouldn't get public funding [...]
So, as was customary, an "estimated risk"
figure of £1.4 million was added to the PSC, which made PFI
look better value; York's bid was then accepted [...]
This account was consistent with an Audit Commission
report on PFI schools. 9 of the 11 PFI schools that the report
considered had relied on a risk adjustment to show they were better
value for money than the PSC. It also explained that "where
the PSC estimate of construction and running costs was much below
the PFI cost, the cost of risk transfer added on was on average
are concerned that the VfM appraisal system is biased to favour
PFI. Assuming that there will always be significant cost over-runs
within the non-PFI option is one example of this bias. There is
an incentive for both HM Treasury and public bodies to present
PFI as the best value for money option as it is often the only
avenue for investment in the face of limited departmental capital
PFIValue for Money?
66. HM Treasury has consistently said that PFI should
only be used if it is the best value for money route of procurement.
We are concerned however that if public sector organisations do
not have alternatives to PFI to complete capital projects there
is a danger that they will use PFI even if it is not value for
money. The British Medical Association felt that this had been
the case in the NHS:
In theory, projects are value tested against what
the project would cost under public finance. If this process concludes
that private finance does not represent value for money, a public
procurement method is supposed to be chosen. In a context where
PFI is the only funding available and many NHS hospitals are in
need of capital works, managers have faced 'perverse' incentives
to 'manipulate' their assessments and subsequently we have seen
a proliferation of PFI projects.
One of our submissions quoted the leader of Liverpool
City Council being interviewed on BBC radio in November 2010 about
the recently approved Outline Business Case for redevelopment
of the Royal Liverpool and Broadgreen University Hospitals. He
explained in the interview: "I know it doesn't provide Value
for Money now or in the future, but its the only game in town".
Professor Ron Hodges shared a similar concern: "PFI was seen
as the only likely route to obtain funding [...] its result was
to promote a view that managers needed to support the PFI route
if a project was to be completed".
67. The lack of alternatives to PFI was pointed out
in many pieces of evidence. Andy Friend said that his own observations
when involved in the market in the past concurred with a "repeated
phrase in the evidence before you: it was the only game in town,
therefore we went for it".
The Foundation Trust Network told us "there should be other
alternatives" and that "historically there has been
insufficient support for capital investment and maintenance".
The British Medical Association made the point that "governments'
preference for PFI means it has been viewed as 'the only game
in town' for the last decade".
The NHS Confederation also told us in their written evidence that
"it is important the debate acknowledges that without PFI
there would have been few alternative sources of capital funding
for large projects".
Jo Webber from the Confederation told us that "101 of the
135 new NHS hospitals have been through PFI between 1997 and 2009".
A recent Committee of Public Accounts report also noted that "In
many cases local authorities and Trusts chose the PFI route because
the Departments offered no realistic funding alternative."
68. The most straightforward alternative to the use
of PFI is capital spending direct from a capital budget. The annual
budget allocated to every government department and public body
is split out between the current (resource) budget and the capital
budget. If a Department does not have a capital budget to meet
its investment needs the only alternative is to turn to some form
of private financing and use the current budget to meet the annual
payments. This issue is likely to become more acute in the coming
years as the capital budgets of Departments are cut significantly
whereas current budgets are reduced to a lesser extent. The October
2010 Spending Review detailed cuts of 29% in real terms to the
total capital budgets of departments, compared to a 8.3% cut to
their current spending over the same 5 year period.
69. For too
long PFI has been the 'only game in town' in some sectors which
have not been provided with adequate capital budgets for their
investment needs. This problem is likely to get worse in the future
with capital budgets cut significantly at the Spending Review.
If PFI is the only option for necessary capital expenditure then
it will be used even if it is not value for money. A much-needed
reappraisal of PFI needs to be accompanied by a similar reassessment
of its effects on overall capital spending in the public sector.
70. We received evidence from one organisation that
did have access to alternative forms of financeTransport
for London. It explained that this "focuses the decision
on Value for Money (VfM) rather than being skewed by a desire
to access either 'free money' or guarantees of long-term funding
to support the PFI payments". It said regarding the East
London Line Extension "TfL, on inheriting the project from
the Strategic Rail Authority, switched it from being financed
privately to being financed by TfL."
Steve Allen from TfL explained: "most of the PFI contracts
that we have were let, there was no alternative source of finance
for the sort of predecessor entities, so there was no valid comparison".
However now TfL "have the ability to borrow directly, we
do have that comparator, and so you can, in a very real sense,
assess the value for money of the PFI solution."
Mr Allen told us that although TfL's "cost of borrowing is
probably something to the order of between 0.5% and 1% above gilt
rates" it was lower than the additional cost of financing
from PFI. He concluded
"I think it is hard to say that if you look across all the
projects, overall PFI is value for money against that additional
cost of finance."
71. The price
of finance is significantly higher with a PFI. The financial cost
of repaying the capital investment of PFI investors is therefore
considerably greater than the equivalent repayment of direct government
investment. We have not seen evidence to suggest that this inefficient
method of financing has been offset by the perceived benefits
of PFI from increased risk transfer. On the contrary there is
evidence of the opposite. Organisations which have the option
of other funding routes have increasingly opted against using
PFI and have even brought PFIs back in-house. TfL's cost of borrowing
is higher than government's, and yet it still considers this is
overall better value for money than PFI. The incentive for government
departments to use PFI to leverage up their budgets, and to some
extent for the Treasury to use PFI to conceal debt, has resulted
in neglecting the long term value for money implications. We do
not believe that PFI can be relied upon to provide good value
for money without substantial reform.
33 Ev 33 Back
A basis point is 0.01%(1/100th of one percent). For
example 250 basis points is 2.5% Back
Q 9 Back
Q 12 Back
Q 14 Back
Q 122 Back
C&AG report, Financing PFI projects in the credit crisis
and the Treasury's response, HC 287, 2010-11, p9, para 18 Back
C&AG report, HC 287, 2010-11, p31, Appendix 2, Figure 31 Back
C&AG report, HC 287, 2010-11, p12, para 30 Back
International Handbook on Public-Private Partnerships, Chapter
14: The UK's Private Finance Initiative: history, evaluation,
prospects. Mark Hellowell, 2010, p326-328 Back
An availability based project is of lower risk as the SPV only
has to ensure that accommodation is available. If demand risk
is also taken on by the SPV the cost of capital will be higher.
Source: Royal Liverpool and Broadgreen University Hospital Trust
(2010), A New Health Service for Liverpool - World Class Hospitals,
World Class Services, Volume 1 - Outline Business Case Back
Source: Debt Management Office - Long and ultra-long gilt yields
were below 4.2% in May and June 2011. Back
In a PFI, the expected costs of project-specific risks are reflected
in the expected costs of construction and operations projected
by the SPV at the point of financial close (which increases the
price charged for delivering these activities). In addition, an
assessment of risks will add premia to the cost of debt (related
to optimism bias) and the price of equity (related to non-diversifiable
project and systematic risk). This raises the question of whether
a corresponding adjustment should be made to the cost of government
borrowing when considering the cost of finance under conventional
procurement. In fact, an equivalent adjustment to the cost of
public financing would be inappropriate, for two reasons. First,
optimism bias is already accounted for in adjustments to expected
costs of projects (as is discussed later in the report). Second,
economic theory is clear that the public sector bears only a trivial
degree of non-diversifiable or systematic risk, at least in terms
of the costs of a project (as opposed to its expected benefits)
(cf. Grout, P (1997), 'The economics of the private finance initiative.'
Oxford Review of Economic Policy. Vol. 13 (4): 53-66 & Spackman,
M (2001), Risk and the cost of risk in the comparison of public
and private financing of public services. London: National Economic
Research Associates.) Back
The difference is financing cost is also reflected in rates of
return. The gross redemption yield on 30-year government gilts
has fluctuated between 4% and 4.2% over the last two years. In
order to provide a conservative analysis, we use 4.2%. The equivalent
rate of return projected on this PFI project is 8.6%. Back
Q 3 Back
Q 4 Back
Q 14 Back
Q 17 Back
Q 17 Back
Q 3 Back
Ev w75 Back
A turnkey construction contract is where the price is fixed at
the time the contract is signed. As a result, the construction
company is held responsible for exceeding the budget. Turnkey
construction contracts reduce the risk to the buyer of the construction
services and provide an incentive for the company to stay within
Ev w34 Back
Ev 35 Back
Ev 35 Back
Ev w132 Back
Ev 39 Back
HM Treasury, Meeting the Investment Challenge, p66, para 5.32 Back
National Audit Office, Private Finance Projects: A Paper for
the Lords Economic Affairs Committee, October 2009, p26, para
HM Treasury, Quantitative Assessment User Guide, March 2007, p25,
para A90-92 & table A1.5 Back
Treasury's Value for Money Assessment for PFI - Guidance for NHS
build schemes, November 2008, Table B1, p30 Back
Ev 26 Back
Ev w26 Back
Ev w107 Back
Treasury Committee, Fourth Report of Session 1999-2000, The
Private Finance Initiative, HC 147, para 47 Back
Q 93 Back
Q 94 Back
Q 94 Back
Ev w20 Back
Audit Commission, PFI in schools, January 2003, para 22 Back
Audit Commission, PFI in schools, January 2003, para 12&13
& Exhibit 2 Back
Lords Select Committee on Economic Affairs, First report of Session
2009-10, Volume II - Evidence, Ev 135 Back
Committee of Public Accounts, Fourteenth Report of Session 2010-11,
PFI in Housing and Hospitals, HC 631, para 12 Back
C&AG's report, The performance and management of hospital
PFI contracts, HC 68, 2010-11, p23, para 2.12 Back
C&AG's report, HC 68, 2010-11, Figure 7 & Figure 11 Back
Ev w33 Back
Ev 26 Back
National Audit Office, Private Finance Projects: A Paper for
the Lords Economic Affairs Committee, October 2009, p7 &p25,
para 7 & para 2.18 Back
Ev w11 Back
European Investment Bank, Economic and Financial Report 2006/01,
Ex Ante Construction Costs in the European Road Sector: A Comparison
of Public-Private Partnerships and Traditional Public Procurement,
2006, p2 Back
C&AG's report, Improving Public Services through Better
Construction, HC 364, 2004-05, p38, para 2.7 Back
Ev 32, w53, w70, w101 Back
Ev w68 Back
C&AG's report, Improving the PFI tendering process,
HC 149, 2006-07, p4, para 4b Back
HM Treasury, Meeting the Investment Challenge, July 2003,
p 49-50, para 4.18& 4.20 Back
C&AG's report, Improving the PFI tendering process,
HC 149, 2006-07, p16, para 3.4 Back
Ev 37 Back
Q 125 Back
Q 48 Back
Ev w107 Back
Q 100 Back
Q 118 Back
Q 118 Back
Q 78 Back
Q 77 Back
Ev W9 Back
Q 80 Back
Q 81 Back
Ev w21 Back
Ev w16 Back
Ev w101 Back
Q 90 Back
Q 91 Back
Q 95 Back
Q 97 Back
Q 19, Ev w22 Back
Q 19 Back
C&AG's report, Improving the PFI tendering process, HC 149,
2006-07, p12, Figure 4 Back
C&AG's report, HC 149, 2006-07, p5, para 4a& 4b Back
Royal Liverpool and Broadgreen University Hospital Trust (2010),
A New Health Service for Liverpool - World Class Hospitals, World
Class Services, Volume 1 - Outline Business Case, p 202, para
12.3.18 - 12.3.19 Back
RLBUHT (2010), A New Health Service for Liverpool, Volume 1 -
OBC, p 147, para 9.26 Back
UK Debt Management Office: Press notice, Result of the sale by
auction of £1,000 million of 0 5/8% index linked Treasury
Gilt 2040, 7 June 2011. Back
RLBUHT (2010), A New Health Service for Liverpool, Volume 1 -
OBC, p 200, para 12.3.5 Back
RLBUHT (2010), A New Health Service for Liverpool, Volume 2 -
OBC, Appendix K1, Input Summary, p391 Back
RLBUHT (2010), A New Health Service for Liverpool, Volume 1 -
OBC , p 202, para 12.3.15 Back
Q 90 Back
HM Treasury, Value for Money Assessment Guidance, November 2006,
p25, Table 3.1 Back
RLBUHT (2010), A New Health Service for Liverpool, Volume 1 -
OBC , Appendix K1, Input and Assumptions, p390 Back
The debt, which typically is around 90% of the financing, was
due to be financed by government with the equity supplied by the
private sector. Back
Ev w113 Back
Ev w16 Back
Ev w44 Back
Ev w51 Back
Audit Commission, PFI in schools, January 2003, para 57 &
Figure 8 Back
HM Treasury, Value for Money Assessment Guidance, November 2006,
p10, para1.17 Back
Ev w11 Back
Ev w44 Back
Ev w65 Back
Q 4 Back
Ev w86 Back
Ev w11 Back
Ev 30 Back
Q 111 Back
Committee of Public Accounts, PFI in Housing and Hospitals,
HC 631, 2010-11, para 1 Back
HM Treasury, Spending Review 2010, 22 October 2010, p10-11, Table
Ev 37 Back
Q 121 Back
Q 122 Back
Q 123 Back