Private Finance Initiative - Treasury Contents

Written evidence submitted by KPMG LLP, John Laing PLC and Lloyds Banking Group PLC


1.  We are pleased to submit this response to the House of Commons Treasury Committee on the Private Finance Initiative ("PFI"), and welcome the opportunity for further healthy scrutiny of this particular approach to procurement.

2.  Our organisations share a belief that the interests of public value for money, transparency and accountability are best served by comparing and evaluating across the full portfolio of procurement approaches available to the public sector. PFI is one such approach, but only one. A wider scope for this inquiry, covering all public sector procurement, would allow for true comparisons to be made, and highlight the relative strengths and weaknesses of each approach.

3.  The Inquiry will no doubt elicit many submissions outlining the positives and negatives associated with the PFI approach. With the spotlight on one approach only, the danger is that supporters of PFI emphasise examples of its success and detractors emphasise examples of its failure and the true and fair view is obscured.

4.  This joint submission has been prepared with a view to placing PFI in the wider context of public procurement. The intention here is not to "defend" PFI by attacking alternatives. Indeed, each of our organisations are conscious, and to some extent living the financial consequences, of examples of both poorly procured PFI deals, and deals which should never have been PFI in the first place.

(a)  As adviser to public and private sector clients KPMG has frequently advised clients not to pursue PFI within particular project contexts.

(b)  As investors in a wide range of government contracts, not just PFI, John Laing withdrew from the London Underground PPP bid process after concluding that the procurement approach was inappropriate in the context of an unclear specification that would be likely to favour contractors.

(c)  One of the largest investors in and lenders to PFI projects, Lloyds has real insight and practical experience of a small number of PFI projects that have run into difficulties: where risks that are conventionally borne by the public sector have vested with the private sector, and the private sector has borne the consequences. To put this into perspective, Lloyds is involved in around 200+ PFI projects, of which only a few have run into difficulties.

5.  Despite the examples of projects which have failed under PFI, we believe that PFI has brought tangible benefits to the UK taxpayer, and that it should continue to be adapted, amended, and to be considered alongside other procurement approaches. Best value for the taxpayer will be achieved through continually evaluating projects and reconsidering procurement approaches. Indeed, we suggest that the rigour that the National Audit Office has applied to value-for-money reviews of PFI deals should be rolled out across all conventional procurement too. There is much to learn from the failures of conventional public finance procurements such as Eurofighter, Wembley Stadium, the British Library, the Cambridgeshire Guided Busway, and currently the Edinburgh Tram.

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

6.  A fundamental challenge for the debate over public procurement is the lack of good quality data on the historic costs of the public sector procuring and operating its assets and services. This affects the ability of Government to properly compare the value for money of different procurement approaches and the ability of Parliamentary inquiries such as this to properly review those decisions.

7.  We believe government should invest in systematically collecting and analysing evidence on the comparative performance of all procurement approaches. This is not straightforward, as "brick-by-brick" pricing fails to reflect the different commercial terms and long-term maintenance costs. To date the highest quality analysis has been undertaken by the National Audit Office[25], [26], [27], Partnerships UK[28], [29], and University College London[30] and we recommend the Committee to consider those reports.

8.  The single biggest step in this regard would be the institution of a set of national infrastructure accounts, which would show both asset investment and asset depreciation. Such accounts would provide a starting point for inquiries such as this to get under the skin of the infrastructure challenge and to compare like with like, and would force the public sector and its partners to think long-term.

9.  Annex One to HM Treasury's National Infrastructure Plan[31] contains helpful distinctions between approaches to public procurement. It is clear here that different approaches are expected in different arenas, reflecting the respective merits of each. What may in one circumstance be considered a weakness—eg having to take considerable time to negotiate contractual terms on how costs to government for a PFI deal are expected to increase over time (indexation)—may in other circumstances be considered a strength—eg confirming the government's own exposure to various indices.

10.  We consider that there are a series of axes against which procurement approaches should be evaluated: transparency; urgency; accountability; risk transfer; budgetary flexibility; specification flexibility; project complexity; depth of market competition; and cost optimisation. The question of "value-for-money" is much wider than just getting the lowest bid price, or even transferring the most risk, but it is about optimally meeting requirements in the broadest sense. The failure of Jarvis evidences the danger of judging the quality of bids primarily by reference to lowest bid price.

11.  PFI itself has become something of a UK export success story. UK firms and UK professionals have been instrumental in establishing burgeoning PPP markets in the USA, France, Germany, Australia, Canada, and throughout the Middle East. These states have been attracted to the transparency and accountability which comes with the introduction of private finance. Indeed, it is worth reflecting on the point that even oil-and cash-rich nations with large sovereign wealth funds are using PFI, even though they evidently do not need the finance.

12.  We believe the PFI programme will continue to bring much needed innovation to public procurement and that the case for PFI's continued role can be made. PFI today is quite different to the PFI of 15 years ago.

13.  The future role of private finance is subject of a legitimate debate around such questions as: the appropriate discount rate for government to use in evaluating whole-life costing; how decisions are made between procurement approaches; how public sector stop/go decisions are made; how "value for money" can be proven; how barriers to entry can be reduced to encourage further competition; how procurement processes can be streamlined; how the cost of private finance can be reduced through milestone payments or other upfront contributions; when to tender key subcontracts; and how performance data is best displayed. But the scope for continual improvement is no reason to abandon the PFI approach altogether.

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

14.  The challenge for public sector procurement is in determining which approach is the most suitable within a specific project context, and this challenge applies whether the proposed project is infrastructure or services or both.

(a)  PFI deals generally take a long time to procure, down in part to commercial complexity and in part to the need for clear specification at the outset. We would suggest that PFI is not suitable for urgent "quick-fixes".

(b)  PFI deals offer cost and project transparency which is substantially ahead of other procurement approaches. PFI enables the public sector to enter into commitments with its eyes wide open. Building a new school is a financial commitment, and a commitment to a community, and whereas under PFI the costs of the school are defined, conventionally the long term costs of the commitment to the community are unknown. Such transparency also enhances accountability: across much of the world PFI is promoted as a route to tackling corruption.

(c)  PFI relies on clear upfront specification in order to optimise a series of asset management and investment tradeoffs. This means that PFI tends not to be suitable where substantial flexibility is required, such as, for example, in IT procurement.

(d)  One common criticism of the PFI concept is that it is rigid, and prevents governments substantially changing budgets on a regular basis. In some cases such flexibility may be helpful, but in many cases it is perverse to suggest that deviations should be made from an optimally planned maintenance regime. The rationale behind whole life costing is that lower investment on an ongoing basis saves substantial costs down the line. To argue for short term budget flexibility is to saddle future taxpayers with a disproportionately higher backlog of maintenance work.

(e)  Straightforward and commoditised procurements do not necessarily benefit from the rigours of the private finance approach, but where projects get too complex and specifications grow and grow the constraints of private finance can undermine delivery quality. For PFI it is important that both the specification and project risks are clear. The London Underground PPPs failed, in part, because the condition of inherited assets was not well understood.

(f)  The depth of market competition does not necessarily correlate with project complexity, and is always something that should be considered before a procurement approach is adopted. There is no point running a competitive process in which only one bid is received: different procurement approaches offer different solutions to non-competitive situations. PFI isn't best able to manage this kind of situation, and the competitive pressure between bidders is essential to keeping costs low.

(g)  The importance of the discipline that comes with whole life costing, and asking contractors and their lenders to put their money behind their forecasts to the PFI concept cannot be understated. In the right deals the higher cost of capital required on PFI deals[32] compared with public finance can be more than justified on the basis of risk transfer, and enhanced planning, accountability and risk management.

15.  Whilst we do believe that there is potentially a role for private finance in the delivery of frontline services, this would likely require a step away from PFI in its traditional form. Projects risks and opportunities are likely to be different, especially under payment-by-results style regimen.

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

16.  Successful risk transfer is based on understanding not just the project risks, but also which counterparty is best suited to managing those risks. Successful risk transfer is about finding a balanced risk transfer in which risk is optimally located with the party best placed to manage it, and who has the best incentives to do so.

17.  In order to ensure contractual clarity and to properly scope the project, PFI investors undertake rigorous through-life risk analysis, and this forms a substantial part of the PFI procurement process. The intensity of such analysis makes PFI deals stand apart from conventional deals: under conventional procurements the incentive both for the public sector and the delivery partner to undertake risk analysis is diminished.

18.  From the public sector perspective it is about incentivising best delivery. Risk analysis feeds into contractual incentive mechanisms, making the risks less likely to occur. Where risks are transferred to the private sector, and risks do in fact occur, the private sector bears the impact.

19.  Lloyds has practical experience of projects (eg Dudley Hospital and Whittington Hospital) where costs which, were it not for PFI, would sit with the public sector, such as the cost of delayed completion, have been borne by the private sector (contractor, equity provider, investor, banks).

20.  In the early years of PFI when John Laing fulfilled the combined role of investor and contractor, it experienced losses in excess of £130 million across a number of PFI projects on which technical problems gave rise to cost overruns. The most notable being the National Physics Laboratory which has been the subject of an NAO review and Public Accounts Committee review.

21.  True comparison across procurement approaches requires us to understand the parallel risks under conventional procurement. How many conventionally procured projects have faced delayed completion, and what has the cost of this been to the taxpayer (and future taxpayers) when the public sector has had to foot the bill?

22.  In aggregate, across a portfolio of deals, the question has to be whether the premium that the public sector pays for risk transfer is too high. Good public sector procurement should ensure that comparator modelling is undertaken to explore what the cost to government of retaining such risks is. Indeed, the understanding of whole life project risks and their potential impacts is one of the key disciplines which the PFI approach imposes.

Are there particular kinds of risks which are particularly appropriate for transfer through PFI deals or particular projects which are suited for PFI?

23.  Projects must be treated on a case-by-case basis, but as our analysis above suggests, PFI is likely to prove most attractive where transparency, accountability and cost optimisation are required, where a detailed specification can be achieved and extensive flexibility is not required, where there is no immediate urgency, where risks can be evaluated and risk transfer optimised, and where there is a competitive delivery market.

What state guarantees are explicit or implicit in PFI deals?

24.  Under PFI government guarantees to pay if the project requirement is met, and in this regard is no different to any other contract. If the provider fails to deliver the requirement, the government's liability is reduced or eliminated.

25.  If the public sector opts to terminate a deal it is equally costly under PFI or conventional procurement. Whilst under PFI the full return to equity providers and lenders has to be paid out at the time of termination, under conventional procurement the equivalent investment will have already been made through gilt issuance and would be a sunk cost.

26.  Any further guarantees in PFI deals are explicitly written into contracts (such as the SOPC4 standard). As commercial arrangements entered into following rigorous analysis both the private sector and the public sector are expected to face the consequences of the deal—and in some cases this has means that the private sector has lost money.

27.  From the public sector perspective a key difference between PFI and conventional procurement is that whilst under PFI, state guarantees are transparent and can be managed; under conventional procurement such risks tend to be implicit only.

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

28.  The decision as to whether to proceed with a PFI deal should be based on rigorous qualitative and quantitative value for money evaluation of all the procurement options available. Balance sheet treatment should not be a part of this evaluation, and neither should the availability of "credits".

29.  There may have been some cases in the past where too much risk was transferred out of government in an attempt to secure "off-balance sheet" treatment.


30.  We firmly believe there is a continuing role for PFI, but as one of a range of possible means of procurement. In the past, PFI has been the default method and its very existence may have resulted in projects being shaped to fit the PFI model. Any decision to proceed with a capital intensive project should be driven by need and affordability, regardless of balance sheet treatment. The selection of procurement method is a secondary consideration but for the reasons set out above we believe PFI will continue to present the most appropriate method in many instances and will present the best value for money on a risk adjusted basis.

April 2011

25   Improving the PFI tendering process, National Audit Office, 2007. Back

26   Construction performance, National Audit Office, 2003. Back

27   Managing the relationship to secure a successful partnership in PFI projects, National Audit Office, 2001. Back

28   Report on Operational PFI Projects, Partnerships UK, 2006. Back

29   Investigating the performance of operational PFI contracts, Partnerships UK, 2008. Back

30   PFI in school building-does it influence educational outcomes? KPMG, 2009. This report draws on research conducted under the supervision of Graham Ive of the Bartlett School of Graduate Studies. Back

31   National Infrastructure Plan, HM Treasury, 2010. Back

32   Again, there is helpful analysis of this in Annex 1 of the National Infrastructure Plan. Back

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© Parliamentary copyright 2011
Prepared 10 August 2011