Private Finance Initiative - Treasury Contents

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 accounted for?

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 conclusions.

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 problem—arbitrage being rife—has 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 various presentations.

In summary, my answer to the direct question is as follows:

—  I support the existing financial reporting treatment.

—  I believe 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:

—  construction risk;

—  design risk;

—  demand risk;

—  third-party revenue risk;

—  penalties for under-performance;

—  penalties for non-availability;

—  potential changes in relevant costs;

—  obsolescence; and

—  residual value risk.

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.[102]

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.[103]

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 responsibility—legal and reputational—remains 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 PFI.

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.[104] 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 treatment—both financial reporting and national accounts—does 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 discussions.


ASB (1998) Amendment to FRS 5: Reporting the Substance of Transactions—Private Finance Initiative and Similar Contracts, London, Accounting Standards Board.

Eurostat (2004) Long Term Contracts between Government Units and Non-government Partners (Public-Private Partnerships), Luxembourg, Eurostat.

Heald, D A (1995) "Steering public expenditure with defective maps", Public Administration, Vol 73(2), pp 213-40.

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.

June 2011

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. 

103   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

104   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

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Prepared 10 August 2011