Written evidence submitted by Professor
David Heald |
My memorandum concentrates on those issues raised
by the Committee's request for evidence on which I have specialist
expertise. I make some brief comments about other matters within
the remit of this Inquiry.
Committee Question 2A: If PFI debt had been on-balance
sheet rather than off-balance sheet would PFI projects have been
used as much?
The answer is categorically "No".
I refer the Committee to the table showing the October
2007 classification of UK Private Finance Initiative (PFI) projects
as on- or off-balance sheet for financial reporting. This was
included in the memorandum of evidence I submitted to the Committee
in the previous Parliament, in relation to the 2008 Budget Report
(Heald, 2008, p Ev67).
At the request of the then Chairman, I submitted
supplementary evidence on accounting for PFI after the oral evidence
session on 14 December 2009 (Heald, 2010). That memorandum provides
a concise summary of the conclusions of my academic research on
PFI accounting (Heald and Georgiou, 2010, 2011).
It is inconceivable that such a pattern across functional
departments could have emerged as a result of the objective characteristics
of particular projects. Education (0% on-balance sheet) and Health
(2%) contrasted markedly with Justice (93%) and Transport (88%)
(Heald, 2008). This pattern arose because of (a) public expenditure
control arrangements, and (b) auditor appointments. The then Comptroller
and Auditor General (Sir John Bourn) drew Parliament's attention
to departments indicating on their websites that PFI projects
had to be off-balance sheet, notwithstanding the Treasury's declared
policy that accounting treatment would not influence project choice.
The National Audit Office (NAO) took a more restrictive line than
the appointed auditors of the Audit Commission. The fact that
this could happen resulted from the availability of arbitrage
between the Accounting Standards Board's FRS 5A (ASB, 1998) and
the Treasury Technical Note 1 (Revised) (TTN1R, Treasury Taskforce,
1999). It is also noticeable that the Northern Ireland Audit Office
followed the NAO approach whereas Audit Scotland and the Wales
Audit Office did not (Heald and Georgiou, 2011).
The consequences were (a) inconsistent treatment
across sectors and countries, and (b) probable loss of Value-for-Money
(VFM) because accounting treatment became a dominant consideration
in project choice (Heald, 2003).
It is important to note that this accounting arbitrage
ended with the adoption of International Financial Reporting Standards
(IFRS) from 2009-10. The adoption of the mirror image of IFRIC
12 (IASB, 2006), changing the criterion from risks and rewards
to control, brought almost all PFI projects on-balance sheet for
financial reporting. However, the Treasury (2009b) announced in
June 2009 that Spending Review 2010 would be conducted on a national
accounts basis, exploiting the lax criteria in the Eurostat (2004)
rules. All that is required to keep PFI projects off the national
accounts public sector balance sheet is the transfer of construction
risk and availability risk to the private sector consortium (Heald
and Georgiou, 2011).
Committee Question 2B: How should PFI deals be
I have written extensively on this topic (Heald,
2010; Heald and Georgiou, 2010, 2011), so I will here concentrate
on the major issues without providing full justification for my
The crucial point to note is that there are two separate
types of accounting for government activity: that for financial
reporting (now IFRS, as modified by the Treasury's Financial Reporting
Manual and approved by the Financial Reporting Advisory Board)
and national accounts (ESA 95 being the governing regulation).
My view is that the PFI financial reporting problemarbitrage
being rifehas now been resolved in the United Kingdom.
This took 10 years, and alertness is required to ensure that PFI
schemes are not modified to escape from the remit of the mirror
image of IFRIC 12 (IASB, 2006; Heald and Georgiou, 2011). The
bringing of PFI on balance sheet to the public sector client has
been attributed by the Treasury to the move from risks and rewards
as the criterion under UK GAAP to that of control under IFRS.
I am not convinced by this argument as most projects would have
been On-balance sheet under UK GAAP if FRS 5A had been properly
applied and not arbitraged by TTN1R. The switch to IFRS provided
a convenient cover for a change that had long been necessary.
The new UK arbitrage is between IFRS-derived financial
reporting (almost all PFI is on the client balance sheet) and
budgetary treatment following national accounts. The June 2009
announcement that Spending Review 2010 would treat PFI on a national
accounts basis (Treasury, 2009b) also ran counter to the objectives
of the "Clear Line of Sight project" (Treasury, 2009a).
Misleadingly, the Treasury has claimed that it must follow national
accounts treatment for budgeting purposes: the United Kingdom
has long used control aggregates which, though national accounts
based, deviated from them in various ways (Heald, 1995). The important
issue now is to ensure that there are clear reconciliations between
In summary, my answer to the direct question is as
the existing financial reporting treatment.
that the budgeting treatment will create a new phase of project
distortions, with (a) PFI being preferred to conventional procurement
for "accounting" rather than VFM reasons, and (b) PFI
schemes that satisfy the Eurostat rules for off-balance sheet
treatment being preferred to those which do not.
Committee Question 3: How far can risk really
be transferred from the public to the private sector?
Committee Question 4: Are there particular kinds
of risk which are particularly appropriate for transfer through
PFI deals, or particular projects which are suited for PFI?
Questions 3 and 4 should be taken together. A standard
decomposition of risk in relation to PFI projects is as follows:
changes in relevant costs;
Under PFI, construction risk can be transferred to
the private sector and, in most UK PFIs, this has been done. This
was not relevant to financial reporting treatment under FRS 5A
because it is extinguished prior to accounting recognition by
the public sector client. However, it is relevant to VFM calculations
(Heald, 2003) if such risk transfer cannot be achieved under conventional
procurement. Importantly, this opens up a wider question of why
the UK public sector finds it difficult to transfer construction
risk on conventionally-financed projects. This emphasises the
importance of considering PFI, not in isolation, but within the
context of overall public procurement policy.
In international discussions, terminology poses a
serious obstacle to understanding. The United Kingdom regards
PFI as a sub-set of a broader set of public-private interactions,
labelled as "Public-Private Partnerships" (PPP). In
most other countries the term PPP is used either for all asset-based
long-term contractual service delegations (PFI in the United Kingdom)
or only for those service concessions (such as motorways and tunnels)
where there are third-party payers.
The critical issue is whether the public sector client
can actually transfer risk to the private sector which operates
through a Special Purpose Vehicle (SPV). Attempts to transfer
risk inappropriately to the SPV will (a) be expensive, and (b)
increase the probability that the SPV might default. Australian
States have made extensive use of PPPs for tolled infrastructure,
transferring some or all demand risk. Experience has shown that
what is really important is that there are mechanisms through
which a PPP project can be smoothly passed from a failing operator
to a new operator, without cost to the public sector or inconvenience
to users. In New South Wales, these transitions have been accomplished
in relation to three transport infrastructure PPPs, showing that
(some) demand risk had been transferred.
In the above cases, the credibility of demand risk
transfer was clearly related to (a) the existence of third-party
payers, (b) features of contractual design, and (c) the facility
being sufficiently free-standing. Without such features, demand
risk transfer is likely to be (i) extremely expensive (transfer
is not VFM), and (ii) ineffectual (the SPV lacks the capacity
to sustain the risk when it materialises).
Those risks associated with the operational phase
of the PPP are more conducive to transfer, subject always to the
condition that the SPV must be able to withstand the materialisation
of such risks, either from its own resources or through insurance
or parental guarantees. In this category are to be found: penalties
for under-performance; penalties for non-availability; and potential
changes in relevant costs.
Typically, the physical asset may have an expected
economic life of 60 years, in comparison with the PFI duration
of 30 years, after which that asset reverts in good condition
to the public sector client. It is for this reason that residual
value risk is regarded as so important in relation to balance
sheet treatment for financial reporting. Issues of design risk
(the facility is not well-designed for purpose) or obsolescence
risk (the facility becomes less functionally suitable because
of changes in service delivery patterns) will also manifest themselves
in effects on residual value at reversion date. Whether residual
value risk can be transferred to the SPV will depend, inter
alia, on whether the public sector client would have access
to alternative facilities at the reversion date.
Residual value does not figure in the Eurostat (2004)
rules regarding national accounts treatment. However, it figures
importantly in financial reporting treatment under the "mirror-image
of IFRIC 12" treatment required by the Treasury and which
is proposed in the International Public Sector Accounting Standards
Board's Exposure Draft 43 (IPSASB, 2010). Tightening financial
reporting treatment may lead to some reconfiguration of PFI projects
so that they fail on the control tests of the mirror-image of
IFRIC 12 (ie fall outside its scope) (Heald and Georgiou, 2011).
If so, this would repeat the earlier experience of PFI projects
being designed, possibly in ways damaging to VFM, to fail the
risk and rewards test of FRS 5A.
An overriding point is 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,
either in terms of managerial action that reduces the amount of
risk or of being able to bear that risk in less costly ways. 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.
Committee Question 5: If PFI debt had been on-balance
sheet rather than off-balance sheet would PFI projects have been
used as much?
I have answered this Question at 2A and 2B above.
Committee Question 6: In what circumstances are
PFI deals suitable for delivery of services?
The PFI should be regarded as one option in the armoury
of public procurement. It should be neither ruled out ex ante,
nor imposed through the operation of budgeting and authorisation
rules, as was widely understood to have occurred with NHS and
schools projects in much of the 2000s. The VFM of PFI schemes
can only be effectively assessed if there is a mixed procurement
model, when the Public Sector Comparator (PSC) is credible because
it is fundable. Where it is known in advance that no public funding
is available, whatever the numerical results of a Green Book (Treasury,
2003) project appraisal, it is predictable that the PFI project
will almost always be pronounced best VFM. Moreover, in such circumstances,
the lack of recent experience with conventional procurement means
that the PSC is not credible, either to advocates or critics of
During an extended period of fiscal austerity, the
"shortage of public capital" argument will again have
influential advocates, such as PricewaterhouseCoopers (2011).
In most circumstances this argument is invalid.
Although VFM judgements are difficult to make, depending on forecast
events over long time horizons, decisions on the role of PFI should
be driven by VFM considerations, not by the desire to evade budgetary
restrictions. Governments learn how to present narratives: the
official rationale for the policy being VFM while it is widely
known that the driving factor is budgetary and accounting treatment.
Not only is this damaging to transparency but it is also likely
to damage achieved VFM.
Whereas it is now clear how accounting treatmentboth
financial reporting and national accountsdoes treat PFI
projects, the satisfactory resolution in relation to financial
reporting (almost all UK projects are rightly on-balance sheet)
will not be matched by national accounts treatment. The international
context of changes in national accounts means that the present
lax arrangements will remain in place indefinitely. However, that
does not prevent the United Kingdom from being fully transparent
in its own budgetary presentations, including the publication
of clear reconciliations.
Assessing VFM from PFI remains problematic, both
at the ex ante project appraisal stage (for the reasons
discussed above) and ex post. The long duration of PFI
projects means that a definitive assessment is necessarily long-term,
after which much else will have changed and there will be inevitable
disputes about the relevance of findings about projects executed
many years previously. Nevertheless, given the scale of UK PFI,
it is imperative that there are systematic empirical studies of
cohorts of projects across functional areas of government at key
stages in their life: e.g. commissioning; early operation; mature
operation; and reversion. Restrictions on resources and access
to information mean that academics are unable to undertake such
studies. This puts an enormous responsibility on public audit
offices across the United Kingdom to undertake such studies and
on the Parliaments and Assemblies to demonstrate interest in dispassionate
work. It would be expecting too much for such studies to eliminate
political disagreement about the desirability of the PFI but such
work can aspire to provide a sounder factual basis for policy
ASB (1998) Amendment to FRS 5: Reporting the Substance
of TransactionsPrivate Finance Initiative and Similar Contracts,
London, Accounting Standards Board.
Eurostat (2004) Long Term Contracts between Government
Units and Non-government Partners (Public-Private Partnerships),
Heald, D A (1995) "Steering public expenditure
with defective maps", Public Administration, Vol 73(2),
Heald, D A (2003) "Value for money tests and
accounting treatment in PFI schemes", Accounting, Auditing
& Accountability Journal, Vol 16(3), pp 342-71.
Heald, D A (2008) "The implications of the delayed
switch to IFRS", in Treasury Committee, Budget Report
2008, Ninth Report of Session 2007-08, HC 430, London, Stationery
Office pp Ev65-71.
Heald, D A (2010) "The accounting treatment
of Private Finance Initiative projects", in Treasury Committee,
Pre-Budget Report 2009, Fourth Report of Session 2009-10,
HC 120, London, Stationery Office, pp Ev50-52.
Heald, D A and G Georgiou (2010) "Accounting
for PPPs in a converging world", in G Hodge, C Greve and
A Boardman (eds) International Handbook on Public-Private Partnerships,
Cheltenham, Edward Elgar, pp 237-61.
Heald, D A and Georgiou, G (2011) "The substance
of accounting for Public-Private Partnerships", Financial
Accountability & Management, Vol 27(2), pp 217-247.
IASB (2006) IFRIC 12: Service Concession Arrangements,
London, International Accounting Standards Board.
IPSASB (2010) Accounting and Financial Reporting
for Service Concession Arrangements, Exposure Draft 43, New
York, International Federation of Accountants.
PricewaterhouseCoopers (2011) Infrastructure Investment
in the Wake of Crisis: Impact of the Global Economy on PPPs in
OECD Countries, PricewaterhouseCoopers.
Treasury (2003) The Green Book: Appraisal and
Evaluation in Central Government, London, Stationery Office.
Treasury (2009a) Alignment (Clear Line of Sight)
Project, Cm 7567, London, Stationery Office.
Treasury (2009b) Consolidated Budgeting Guidance
from 2009-10 (IFRS updated), London, HM Treasury.
Treasury Taskforce (1999) How to Account for PFI
Transactions: Technical Note No. 1 (Revised), London, Office
of Government Commerce.
102 Three New South Wales Government PPPs have run
into financial difficulty. In each case the operator went into
receivership (due to patronage not meeting initial expectations)
and the receiver subsequently sold the business to a new operator:
- The Cross City Tunnel is a 2.1 km road tunnel under the City
of Sydney. It opened in August 2005. The operator went into receivership
in 2006 after the traffic volumes failed to meet initial expectations.
The receiver sold the operation to a new operator in December
2006. The tunnel will transfer to the State at the end of the
30-year term of the PPP.
- The Lane Cove Tunnel is a 3.6 km road tunnel at Lane Cove, a
Sydney suburb. It opened in March 2007. The operator went into
receivership in January 2010 after traffic volumes failed to meet
initial expectations. The receiver sold the operation to a new
operator in May 2010. The tunnel will transfer to the State at
the end of the 30-year term of the PPP.
- Four privately-operated railway stations opened on the new (State-operated)
railway to Sydney Airport in May 2000. The operator went into
receivership later that year due to passenger volumes failing
to meet initial expectations. The receiver eventually sold the
stations to a new operator in March 2007. The stations will transfer
to the State at the end of the 30-year term of the PPP.
This information has been provided to the author by the New South
Wales Treasury. Back
It is not possible to be conclusive on this point. Alternatively,
it could be argued that it was so easy to arbitrage FRS 5A by
reference to TTN1R that project redesign was unnecessary. Back
Some countries, particularly in the developing world, may not
have access to capital markets. In the case of non-tolled PFIs,
the "shortage of public capital" argument is frequently
used without regard to the fact that the PFI unitary charges will
have to be met from future budgets. Back