Private Finance Initiative - Treasury Contents

Conclusions and recommendations


1.  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. (Paragraph 6)

Accounting and budgetary incentives

2.  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. (Paragraph 17)

3.  Efforts 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 finance—which 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. (Paragraph 18)

4.  If 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. (Paragraph 22)

5.  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 removed. (Paragraph 23)

6.  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. (Paragraph 24)

7.  International 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. (Paragraph 25)

Value for money

8.  Government 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. (Paragraph 30)

9.  The current higher cost of finance means there may be a significant opportunity cost from using PFI. (Paragraph 31)

10.  Allocating 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 transfer—in some cases inappropriate risks have been given to the private sector to manage. This has resulted in higher prices and has been inefficient. (Paragraph 38)

11.  Some of the claimed risk transfer may also be illusory—the 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. (Paragraph 39)

12.  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. (Paragraph 46)

13.  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. (Paragraph 51)

14.  PFI 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. (Paragraph 56)

15.  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 competitive pressure. (Paragraph 61)

16.  We 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 budgets. (Paragraph 65)

17.  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. (Paragraph 69)

18.  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. (Paragraph 71)

Future investment

19.  Any financial model, such as the current VfM assessment, can be subject to manipulation so it should never be used alone as a pass or fail test for the use of PFI. (Paragraph 72)

20.  Evidence we have seen suggests that the high cost of finance in PFI has not been offset by operational efficiencies. Much more robust criteria governing the use of PFI are needed. These should take precedence over the current VfM assessment. If and only if a project is deemed to pass these criteria should the option of private finance be considered. In our view PFI is only likely to be suitable where the risks associated with future demand and usage of the asset can be efficiently transferred to the private sector. We recognise that this may over time sharply reduce the aggregate value of remaining PFI projects but the higher cost of capital that remains will be easier to justify to the taxpayer. (Paragraph 76)

21.  Owing to the current high cost of project finance and other problems related to PFI we have serious doubts about such widespread use of PFI. There are certain circumstances where PFI is likely to be particularly unsuitable, for example, where the future demand and usage of an asset is very uncertain and where it would be inefficient to transfer the related risks to the private sector. (Paragraph 79)

22.  We believe that a financial model that routinely finds in favour of the PFI route, after the significant increases in finance costs in the wake of the financial crisis, is unlikely to be fundamentally sound. The Treasury should seek to ensure that all assumptions in the VfM assessment that favour PFI are based on objective and high quality evidence. (Paragraph 81)

23.  The Treasury should ensure that guidance regarding Optimism Bias is based on objective, high quality and, as far as possible, contemporary evidence. The Treasury should not approve the PFI projects of departments or public authorities that fail to produce such evidence in support of their Outline Business Cases. We believe that the comparison of procurement routes should take place on the basis of the PFI model and a public procurement model, in which there is a serious attempt to fix prices and therefore transfer risk. (Paragraph 84)

24.  The current 'tax adjustment' is not based on the best available evidence and acts to bias the assessment towards choosing PFI. Private companies entering into contracts with the public sector will quite reasonably seek to minimise their tax liabilities. Governments may also vary tax rates. The assessment exercise which evaluates the value for money of different procurement routes must take this into account. (Paragraph 87)

25.  The National Audit Office should perform an independent analysis of the VfM assessment process and model for PFI. It should audit all of the assumptions within the model, and report on whether or not these are reasonable. This test of the VfM assessment model should, where possible, be based on representative and up to date samples of data. (Paragraph 89)

26.  Sustainable investment in public infrastructure is important for the long term health of the economy. We also recognise the paramount importance at the current time of stabilising the public finances. The Treasury will need to consider using more direct government borrowing to fund new investment. Replacing some PFI with direct public sector investment would not necessarily result in a higher financial liability for the Exchequer. It would mean that the debt was more transparent, as it would be held directly by government rather than through the intermediary of an SPV. An increase in government debt to replace PFI investment should also not necessarily make it any harder to meet the fiscal mandate. Continuing to use an inefficient funding system such as PFI is likely in many cases to increase the overall burden on taxpayers for the provision of public sector capital projects. If, rather than using PFI, the lower financing costs of government are utilised, we have seen evidence that investment can be increased significantly for the same long term funding costs. (Paragraph 94)

27.  PFI is a procurement model where the private sector manages the design, build, finance and operation (DBFO) of public infrastructure. If the public sector funds the investment this changes the financing element of the project but this can still accommodate a high level of private sector involvement. There may be merit in making more use of a design and build (DB) model using a fixed price contract to place risk with the private sector over the construction period. There will be other circumstances where a design, build and operate (DBO) model is most appropriate. Both the DB and DBO model allow government to benefit from its lower cost of funding while transferring significant risk to the private sector. (Paragraph 95)

28.  The most straightforward way of dealing with current PFI contracts is for the government to buy up the debt (and possibly also the equity) once the construction stage is over. This would result in an increase in the headline level of government debt but it would not increase the structural deficit or prejudice the fiscal mandate as this debt would score as government borrowing for investment in the National Accounts. Interest rates on the financing of the deals would fall significantly, releasing savings. Although government debt levels would be higher the public finances would not be any less sustainable. This is because it would become more affordable to service the visible government debt rather than the hidden PFI debt. Every one percentage point reduction in the interest rate paid on the estimated £40 billion of PFI debt would realise annual savings of £400 million. (Paragraph 98)

29.  We welcome the work that the Treasury is doing with the PFI industry on drawing up a code of conduct. We believe that it is in the interest of the PFI industry to cooperate as fully as possible with the government in this regard. In 2002 the government reached a voluntary agreement with industry to share refinancing gains with the taxpayer. Therefore in principle there is no reason why a non-obligatory gain-sharing arrangement could not also be considered in relation to the gains on the sale of equity stakes. (Paragraph 105)

30.  We recommend that HM Treasury collates and compares data to ensure that it gets a good price on any deals already being negotiated. It should benchmark operational costs of PFI projects with market prices outside PFI. It should also compare the equity returns of investors with other investments with a similar risk profile. It should publish as much of this information as is commercially possible. Far more transparency is required. The Treasury should consider whether this should extend to publishing data and costings on existing contracts, where commercially possible, in addition to what is already published. The Treasury should also consider introducing a mechanism for deals in procurement to ensure that any productivity gains are shared with the taxpayer over the life of the contract. Based on the analysis presented in this Report, we ask the Government to give further consideration before proceeding with the procurement in its present form of the Royal Liverpool and Broadgreen Hospital in particular. (Paragraph 107)

31.  The need to improve procurement and project management skills in the public sector is something that all are agreed on. In some ways PFI may have exacerbated problems in this area. Rather than focussing on improving procurement methods and project management, public sector clients' attention has been diverted to financing arrangements and the other requirements unique to PFI. Owing to the complexity of PFI, the public sector has become too reliant on expensive external advisers. We are also concerned that PFI may have resulted in the balance of expertise within the centre of government being tilted too heavily towards financial skills with less input from those with experience in design and construction. (Paragraph 111)

32.  While there is an understandable focus on the current high levels of government debt, the government and the citizens of the country have no proper understanding of the assets which accompany these liabilities—there is no national balance sheet. The audited Whole of Government Accounts will be published for the first time later this year. This will provide further understanding of public sector organisations assets' for financial reporting purposes. (Paragraph 115)

33.  The Treasury should consult on the possibility of using other financing models, including the Regulatory Asset Base (RAB) and Local Asset Backed Vehicles (LABV), as a way of financing capital projects in competition or in preference to PFI. (Paragraph 121)

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© Parliamentary copyright 2011
Prepared 10 August 2011