Conclusions and recommendations
Introduction
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)
| 
