Private Finance Initiative - Treasury Contents


Written evidence submitted by T Martin Blaiklock, Consultant, Infrastructure & Energy Project Finance

INTRODUCTION

The Treasury Committee has requested comments with respect to issues relating to the use of PFI. This paper represents my response to that Inquiry.

I have been a consultant, banker and practitioner in infrastructure and energy project finance,—PFI, PPP and the like,—for the last 35 years or more, with both UK and wide overseas experience. I also regularly give seminars on these topics internationally, eg World Bank/IFC, EBRD, etc.

1.  What are the strengths and weaknesses of different public procurement methods?

PFI V. CONVENTIONAL GOVERNMENT PROCUREMENT
[OF CAPITAL ASSETS FOR PUBLIC SERVICE DELIVERY]
PFI Advantages
PFI Disadvantages
1.  Embraces private capital (equity) resources for public investment

2.  Can be structured as "off balance sheet" for Government (see below)

3.  Facilitates technological and operational innovation by PFI concessionaire

4.  Ensures cost control of investment (public sector projects historically have cost over-runs).

5.  Locks-in asset maintenance regime over project life-cycle

1.  Complex structure & documents for PFI

2.  PFIs take twice as long to arrange

3.  High up-front costs for PFI: twice as much as conventional procurement. Hence, PFI only suitable for investment projects exceeding, eg £40 million.

(NB some up-front costs can, on occasion, be capitalised into the funds raised)

4.  Reduces competition: high costs and complexity means only major companies can afford to bid for such concessions

5.  Not suitable for PFI concessions when the underlying output specification may change over time, eg IT

6.  Demands significant senior staff attention

7.  Difficult to resolve in the event of default or failure

2.  If PFI debt had been on-balance sheet rather than off-balance sheet, would PFI projects have been used so much? How should PFI deals be accounted for?

SUMMARY

—  The underlying accounting rules as to what is "on" and "off" balance sheet are unclear, but the problem is not UK-specific. International initiative is required.

—  The UK Government has employed a flawed methodology for determining whether to support PFI-type deals or not. This has led to PFI deals being undertaken, when conventional analysis would not have supported PFI.

2.1  There are two main types of PFI (or, now generically termed, "PPP"s):

(a)  the delivery of a public service by a private (PFI) concessionaire, when the Government or its agents purchases the service, often in the form of an "availability" payment, eg an NHS hospital or a school; and

(b)  the delivery of a public service by a private concessionaire, when the user or consumer pays for the service delivered, eg a cash toll-road.

In both cases, lenders will typically contribute 70-90% of the funding for such deals. Further, lenders, under conventional project financing techniques, will take a lien over the project assets, for as long, at least, as their loan is outstanding.

Hence, if the concessionaire fails to perform, the lenders technically can take over ownership of the assets. Alternatively, they will demand repayment of their loans, if the Government wishes to take the assets back into public ownership. For international PFI/PPP-type deals, lenders will insist on international arbitration provisions to bolster their security.

2.2  Overall, therefore, PFI deals can create:

—  a contingent liability for Government under structure (a) above. In other words, PFI is being used like a credit card for Government. It removes the financial obligations for the purchase of an asset from Capital to Current Account (…………………and we all know how easy it is to overspend on one's credit card!!); and

—  a contingent liability under both (a) and (b) above, if the underlying project is an essential service, which Government cannot fail to deliver to the public, funded either as a PFI or conventionally.

2.3  The question arises as to whether such contingent liabilities should be recorded in National Accounts. Unfortunately, the accounting rules are a mess! It is also ironic that the architects of PFI/PPP have been the international accountants, who have made fortunes from creating such obfuscation in the first place, failing to adjust the accounting rules to meet modern corporate and financial structures, and then advising proponents of such structures how to avoid tax!!

An anecdote: in 1995-96 I applied for a post in the PFI Executive and subsequently was interviewed by HM Treasury officials in Whitehall. At the end of the interview I was asked if I had any questions for them. I responded: "who is to count up the contingent liabilities of all the PFI deals (being promoted at that time)"? Embarrassed smiles all round. Silence! End of interview. No job offer!

2.4  In February 2004, Eurostat published a Decision, which stated that:

If a PPP Concessionaire carries both the construction/completion and demand or "availability" risk, then the transaction can be considered "off" balance sheet for the host government. If not, then the transaction will be deemed "on" balance sheet for the host government.

2.5  In the above, it is clear that the determinant for this on/off decision is the interpretation of what "represents "risk" in any situation. Unfortunately, risk,—uncertainty,—is a subjective, not objective, value!!

2.6  Secondly, the determination depends on a judgement,—not an objective measure,—as to how much risk is transferred from the public to the private concessionaire. As a result, the basis for this Decision is flawed, notwithstanding that many non-EU, as well as EU, countries now use this definition for PFI!!! [It is a convenient definition for governments!].

2.7  As to whether a transaction should be deemed "on" or "off" balance sheet is in essence a financial decision, so should be based on financial, not physical or commercial, criteria. It comes as no surprise, therefore, that many governments (including the UK!) by using the current Eurostat definition have hidden many transactions "off" balance sheet, whereas they surely should be "on"!!

The classic case has been Network Rail, which receives 80% public subsidy for its operations, yet whose £20 billion—odd of debt is considered "off-balance sheet" by HM Treasury on the grounds that its debt is a contingent liability for Government, which only becomes a direct liability, if Network Rail defaults.

2.8  Many commentators have recognised the problems, but no agreed answer has emerged, not even to at least publicly record the data. Just as banks have been asked to clean up their balance sheets in recent times, so one might claim governments should do so too.

2.9  However, if this is to include the contingent liabilities arising from PFI/PPP, so it also should cover government participation in para-statal organisations and their debt, eg Manchester Airport; Electricité de France, Schipol Airport, etc., which represent contingent liabilities for national/regional governments.

2.10  Whatever is decided, it certainly would be prudent for all Governments and their agencies, which they control financially or corporately, to publish such contingent liability data as a start.

2.11  Finally, it should be noted that Greece, Spain, Portugal and Ireland have all in recent years been very active in PFI/PPP. Germany have not!.

2.12  The Inquiry asks whether UK Government has been influenced by balance sheet issues in promoting PFI/PPP. Possibly. Only Whitehall can confirm this.

However, what has influenced the decision in the past has been the flawed methodology used by HM Treasury to assess whether to pursue conventional or PFI-type procurement for a particular public service investment.

2.13  When undertaking investment analysis of a range of project opportunities, the conventional method for determining the value of one opportunity against another is to calculate the Present Value of each option. As PFI opportunities can often span many years, eg 20-30 years, the discount rate chosen to bring future values back into today's terms is key.

2.14  Conventional investment theory dictates that the discount rate to be used is the opportunity cost of capital, eg the interest rate for 30 year government bonds, by way of example. It is, of course, important to choose a discount rate which reflects the overall period of the analyses.

2.15  A second issue is how to treat inflation. Inflation exists in every jurisdiction come what may! If one is undertaking investment analyses of options which include finance, eg PPPs, then the cost of finance (eg interest rate) has to be included. As market interest rates reflect actual, or nominal, rates, the analysis should be undertaken in nominal terms too. This reflects reality, as we all see it.

2.16  The UK Government, when it undertakes analysis of investment options for public service asset projects, uses data in the calculations quoted in "real" terms, ie ignoring inflation and the cost of money. In this respect, the UK is out of step with most, if not all, other countries.

2.17  Via the "Green Book" HM Treasury determines the discount rate to be used to express future values in today's terms. From 1991 to 2003 the discount rate was 6% "real", which, with inflation through that period being, say, 2-3%, gives an approximate equivalent "nominal" rate of 8-9%.

From 1991-2003 the cost of 30 year UK Government bonds ("gilts") varied, but on average was 5.5-6%. This, of course, is a "nominal" value.

Hence, one can see that, by using a 6% "real" discount rate for such analyses, the UK Government was imposing a higher rate of discount than conventional investment analysis would suggest, ie 8-9% versus 5.5-6%; a differential of 3-3.5%.

2.18  The consequence of using a too high discount rate was twofold:-

—  firstly, this choice favoured PFI options against conventionally funded alternatives. In cash-flow terms under a PFI the payments to be made by the purchaser (ie Government), which include the cost of funding the underlying asset, are later in the Concession period than for conventional funding, just like for a credit card.

     If one calculates the value of a 3-3.5% differential in Present Value terms over 30 years, this shows an advantage to the PFI option amounting to 35-37% of the Present Value purely by using such artificially high discount rate. The result was that a number of deals, eg West Middlesex Hospital PFI, were undertaken as PFIs, when in cost terms it would have been cheaper to fund them conventionally; and

—  secondly, if the underlying cash-flows from the analysis are used for budgeting purposes at a later date, they will underestimate the payments to be made to a PFI Concessionaire as they exclude the impact of inflation. This may well be the main reason why many NHS Health Trusts, who undertook PFI projects some years ago, now find they are very expensive, ie the Trusts have under-budgeted.

    Fortunately, inflation has been relatively low in recent times, so this impact has been limited. But when inflation is high, under-budgeting arising from the use of a high discount rate could be very significant.

2.19  In 2003, Government changed the discount rate from 6% to 3.5% "real". Given inflation was low at 2-3%, this discount rate thereafter reflected nominal rates prevailing at the time.

    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. A consultant report on a number of major projects undertaken previously showed various grades of cost over-runs, and so the empirical concept of Optimism Bias was introduced as a multiple to be applied to departmental cost estimates (the Public Sector Comparator) to cover this possibility. The minimum multiple was 1.24, ie a 24% increment for simple projects, whereas for complex projects the multiple could be 1.5-1.6 reflecting 50-60% cost over-runs.

2.20  It is well known universally that Governments often over-spend on projects. However, no other government has formalised the over-runs into a "cross the board" regulation as has the UK through the application of Optimism Bias. Other governments prefer to evaluate these possibilities through conventional sensitivity testing on "base case" cost estimates.

    Arguably, the project data used to develop the UK Optimism Bias multiples was an inconsistent sample. Furthermore, if a multiple of 40% were to apply to any project estimate, could not a strong project manager be employed to control costs for 10% of the cost, plus paid another 10% as a bonus for success, and the sponsor would still be better off by 20%?

    [Another flaw in the methodology was identified in that HM Treasury applied Optimism Bias before risk analysis, whereas some agencies, eg Network Rail, applied Optimism Bias after risk analysis. Mathematically the answers are different. When this anomaly was raised via the Regulator with HM Treasury and Network Rail, they both claimed they were right and that the answers were the same anyway!!]

2.21  The overall net effect of the introduction of Optimism Bias was to largely compensate for the errors which arose through the use of an erroneous discount rate for the years 1991-2003.

    Today, there is greater realism in the UK Government's approach to this topic, but there is, on occasion, a reluctance to use these quantitative tools. Nevertheless, the UK Government remains out of step with other governments on this methodology, which, while not perfect, is probably the best that can be derived. 70-80 countries worldwide now are considering PPPs, but evaluate the opportunities in "nominal" terms.

2.22  Obviously, other factors such as efficiency, innovation, etc., have to be taken into account before arriving at a final figure for "Value for Money".

[NB. when the UK's new Green Book was published in 2003 there was an error in a quoted discount rate. The error remained for a further five years!]

3.  How far can risk really be transferred from the public to the private sector?

3.1  The private sector will be happy to assume the risks they can manage and control, eg design, materials, construction, operations. There will, however, always be some risks which Government has to shoulder, eg land purchase for a PFI road project. Should the private sector be asked to take risks outside their control, the cost to Government is likely to be high.

4.  Are there any particular kind of risk which are particularly appropriate for transfer through PFI deals, or particular projects suited for PFI?

4.1  See above comment in Sec 3.

5.  What state guarantees are explicit in PFI deals?

5.1  See Sec 2 above. Technically, state (financial) guarantees play no part in PFI transactions. Investors and lenders look to the cash-flows for repayment of their capital. However, on occasion, when the creditworthiness or financial sustainability of the Government counterpart in a PFI transaction is in doubt, the PFI concessionaire may require explicit "guarantees" from Central Government underpinning the commercial undertakings of such PFI counterpart.

6.  In what circumstances are PFI deals suitable for delivery of services?

6.1  Certain types of project are more suitable for PFI procurement than others. Much depends on the inherent project risks. Typically, "accommodation"-type projects, where the underlying demand and service output over 30 years does not change, are suitable for PFI treatment, eg hospital accommodation; schools; university accommodation; prisons; Government offices. Interestingly, in the years 1995-2003, more than 50% of UK PFI's were in this sector.

6.2  Other sectors can be characterised as follows:
Metrosnot suitable as PFIs; too many risks
Light railpossibly, as Availability payment PFIs.
Motorwaysyes, as Availability payment PFIs
Estuarial bridges & tunnelssuitable for PFI, either as toll projects or against Availability payment
Urban roadsnot suitable for PFI
Waste treatment plantssuitable as PFIs
Water treatment plantssuitable as PFIs
High-tech buildings [eg NPL]not suitable for PFI
Airports & portspotentially PFI, but high infrastructure costs
[NB. need access infrastructure]
Hospitals including clinical servicesnot suitable for PFI.

April 2011


 
previous page contents next page


© Parliamentary copyright 2011
Prepared 10 August 2011