Private Finance Projects and off-balance sheet debt - Economic Affairs Committee Contents

Examination of Witnesses (Question Numbers 77-99)

Councillor Richard Kemp and Mr Richard Buxton

Councillor Kemp: We are quite happy to answer questions, my Lord.

20 OCTOBER 2009

  Q77  Chairman:

Welcome to the Economic Affairs Committee. This is the second public hearing of our inquiry into private finance projects. Copies of the Members interests or their entries into the Register of Interests showing interests which have been declared are available for the public and witnesses. It is the big tome there on the table if you wish to take a look at that. Councillor Kemp and Mr Buxton, thank you very much for coming. We would be very grateful if you could speak as clearly as you can for the benefit of the webcast and the shorthand writer. Do either of you want to make any opening statements or would you prefer it if we went straight into questions?

  Q78  Chairman: On the questions side, you do not both need to answer.

  Councillor Kemp: I think we have decided that if it is technical the officer will answer.

  Q79  Chairman: Perhaps I can make a start by asking you what are the main areas where local authorities engage in private finance projects? How important are they compared to other areas of local authority activity?

  Mr Buxton: I think by far and away the largest area of activity for local authority PFI projects is in relation to education where there has been a major programme specifically to build or refurbish schools. Other areas include housing, transport, social care. An important point is that actually the local authority PFI expenditure amounts to a relatively small proportion of total local authority capital investment. Over the course of the last five years we are looking at figures of in the range of 10-15% of local authority capital investment. I think it is important to see PFI very much in the context of an overall approach to local authority capital investment and not to regard it as, in a sense, the most burning and critical issue relating to local authority investment.

  Q80  Chairman: You said then that PFIs are a minority sport, as it were, but how do local authorities decide whether to use the private finance route or some other route?

  Councillor Kemp: This is one of our concerns, that there is not necessarily flexibility to enable us to choose PFI or prudential borrowing or standard routes, we are more or less guided into a particular project by the government finance being made available for PFI. One of the things that we do think we need is more flexibility so that we can choose the appropriate financing route for the appropriate project.

  Q81  Chairman: So you have a budget, as it were, for PFI?

  Mr Buxton: What happens is that the government makes available PFI credits for certain types of projects. For example, there are PFI credits specifically set aside for an investment in building new schools. If a local authority wants to build a school and to receive a subsidy for building the school, then in a sense it does not have a choice, it can only use the PFI route because there is no conventional capital subsidy available for building a school. The only route is through the PFI credits and that means that the local authority is forced to use those credits if it wants to take advantage of the capital subsidy. I think what we are suggesting is that if there were a level playing field the capital subsidy element would potentially be available for a range of alternative funding mechanisms and not just for a PFI mechanism.

  Q82  Lord Eatwell: That is intriguing because I was about to ask you about the main contribution that private finance has made to local authority delivery and it sounds to me as if the main contribution is that it gives you the chance of capturing a subsidy. Is that fair or is there some other wider contribution than the fact that you can capture a subsidy in this particular way?

  Mr Buxton: Let us assume that there was capital subsidy available, or no capital subsidy available equally for conventional procurement and for a private finance initiative. If we start with that assumption and then we say given the level playing ground does PFI offer certain advantages, I think the answer to that question would be, yes, it offers certain advantages but it also has certain drawbacks and, therefore, you actually need to look at each project on a case by case basis. The main advantage of a PFI project is that it gives you a higher degree of certainty over build costs and subsequent maintenance costs on a classic PFI scheme and that is where the concept of risk transfer comes in. We are not talking about a transfer of the whole risk. We are not talking, for example, about the contractor taking on the risk that all the children will or will not all get five GCSEs. What we are talking about is the construction cost risk and the subsequent maintenance cost risk because those are priced in at the beginning of the contract on a relatively fixed and determined basis.

  Q83  Lord Eatwell: That is the biggest advantage and you said that we have to balance this against the disadvantages. What is the biggest disadvantage?

  Mr Buxton: The disadvantage is that obviously you are tied into a commitment over that period of time. For example, if we take something like school maintenance, historically a local authority would have been able to take a decision about whether or not to spend money on school maintenance. At any particular year it could have decided not to invest in school maintenance but actually to spend some money on some other form of service provision. The disadvantage of that is that might lead to under maintained schools which over a long period of time would require further investment. So there is a slight loss of flexibility but, as I say, there are benefits. The other factor is that in the pricing mechanism for PFI contracts at the moment a private contractor who is borrowing to finance will probably be paying slightly more than a typical local authority for borrowing. Therefore, you need to weigh up the benefits and the disadvantages on an individual project basis.

  Q84  Lord Eatwell: So in capital terms the project is more expensive?

  Mr Buxton: Not necessarily.

  Q85  Lord Eatwell: From your point of view it is less flexible.

  Mr Buxton: It may not be more expensive, that depends on the potential cost overrun issue. Historically public sector projects have had large cost overruns. The information collected by the National Audit Office suggests that private finance projects are actually more disciplined in terms of the financial angle and, therefore, there is a trade-off.

  Q86  Chairman: Would it be possible to set aside the source of funds issue and have exactly the same contractual arrangement, possibly with the same company, for the whole life contract which might have been a PFI or might be an ordinary public sector one?

  Councillor Kemp: I think it is important that we recognise, particularly as it is only 10% of the funding, that PFI is a way to create a particular relationship between the public and private sectors. There has always been that relationship. For example, we have never built our own schools, we have always contracted to buy a school. What we need to be more imaginative about is how to create those relationships and, if I can put it further, how to create the partnerships within which the public and private sectors can work to the best advantage. If we can create effective partnerships in a long-term relationship then some of those problems with rigidity and lack of flexibility might disappear. We are very keen on partnerships and have the contract second. One of the problems is that PFI methodology leads you straight to the contract before you develop the relationship.

  Q87  Lord Levene of Portsoken: I am sorry to labour this point, but having been involved in one of the early iterations of this whole programme, which was called Competing for Quality, which Lord MacGregor may remember, the whole object of the exercise was to have this element of competition. In other words, you had the in-house team who could do this and you would have outside providers, PFI or PPP, to do so. Are you saying that there are projects now where that choice is lost to you, that you do not have the ability to choose between the public sector doing the job itself and the private sector doing it as an alternative and you are just dictated to as to which way you have to go?

  Mr Buxton: I think some of those decisions have actually been taken at a programme level. For example, if you take the schools programme that has been subject to a very thorough value for money review at the whole of the programme level and, therefore, individual projects are financed within the context of that programme. Individual projects still have to demonstrate that they meet the value for money criteria, but at the moment if you are seeking to build a new school then if you want the capital subsidy that goes with that effectively that requires a PFI approach.

  Q88  Lord Levene of Portsoken: Can I ask you a different question, if I may? Is there sufficient understanding within local authorities and a sufficient level of expertise to be able to manage the project of that nature when it is not being carried out in-house but is being carried out by a private sector contractor or consortium?

  Councillor Kemp: In my view there is. In a large authority like my own—I am a Liverpool City Councillor—we are regularly procuring big contracts in a variety of ways and we have in-house knowledge. For smaller councils and very high specialist projects we have traditionally had 4ps, an agency, which is partly paid for by the government and partly paid for by the user and we have now linked up with Partnerships UK to create a new organisation in the Local Partnerships, so that expertise is available across the piece. To follow up partly on your last question, things have moved on in the last 12 to 15 years and very few councils, for example, now have their own architects' department in the way that they used to. It is a question of where we procure the private sector in to help us and in what format rather than we do it in-house or externally.

  Mr Buxton: If I may add to that. I think that if a local authority is going to be building a new school the skills that it requires are going to be very similar regardless of which contractual route it chooses to go down. For example, if you are planning a new school you need to be able to think about long-term time horizons and scenario planning. You need to engage with the service users, the teaching community. You need to think about the different types of things that you want the school to do and its links with the rest of community infrastructure. All of those issues I would argue have to be considered whether you are using a conventional procurement route or a PFI route and, therefore, actually the issue for me is not so much do local authorities have the skills to do PFI but do local authorities have the skills to do large-scale procurement, which is a slightly broader question. I would entirely endorse what Councillor Kemp has said. I think the major authorities will have that expertise in-house and some of the smaller local authorities will need to rely on some external expertise, which is where an organisation such as Local Partnerships, which is partly owned by the Local Government Association, has been deliberately set up to provide that support to those authorities who do not have that expertise in-house.

  Q89  Lord Paul: In your experience have the private finance projects delivered value for money?

  Mr Buxton: I think in general that the answer has to be yes. I think the National Audit Office have themselves done a number of studies of the delivery of private financial projects. They have, for example, shown that private finance projects do deliver to time slightly better than conventional procurement. They have also found that private finance projects deliver on budget slightly better than conventional procurement. I would, however, have to stress that the differences between private finance projects and conventionally procured projects is not enormous, so we are not saying that this is an absolutely one-sided argument, that private finance projects always deliver on time and on budget because there are a percentage that do not, but it is a slightly higher percentage than we find with conventionally procured projects. I think on balance, looking at the trends over the last few years, we can say that private finance projects have delivered what they were expected to deliver. Clearly the critical issue, and this again applies as much to conventional procurement as to PFI procurement, is if the local authority does not really understand and have a clear vision for what it is seeking to procure, the limitations are going to be in that initial conceptualisation. Do you want a school that simply sits there and is used by students during school hours or do you want a school that is part of the community infrastructure? That is the critical issue from my perspective. Again, when you are thinking about a school and we are building something that has to be there for 25, 30 years or longer, do we understand what we are going to require out of the school in 25 or 30 years' time? I think those are some of the complex issues, but I would argue that they are the same issues for conventional procurement as for PFI procurement.

  Q90  Chairman: Can I push that slightly further back to my earlier question and that is in principle at any rate the nature of the contract, whether it is a PFI contract or a conventional public contract, could be precisely the same and the only difference would be the sources of funds, so wherein lies the benefit from a different source of funds if both sources were unconstrained? Obviously if one is constrained and the other is not—

  Councillor Kemp: It is not necessarily a different source of funds, it is a different route to funds possibly from the same source. If we went for a prudential borrowing route it would cut out one element of that process. Not a very large part of the process because, as Richard says, the importance for the local authority is to understand what it wants to procure, so a lot of the checks that go into a PFI route would be done by a local authority choosing any route. It would make things a little easier. For example, we can borrow money more cheaply than a private sector organisation can, but so can other partners. For example, I chair a housing association and we can also borrow more cheaply than the standard private sector. We have a £100 million fund to invest and in one part of the northwest we are building a health centre. There is no reason why we could not build a school taking advantage of the lower rates in a community which we understand because we control the housing there to which we could add on our housing association head office for the area, to which we could add on other facilities which we know the local community wants, but those are very difficult to do because if you go through the health route you have a LIFT scheme; if you go through the education route they have bulk bought from a series of providers. It does take out to some extent that local originality and our ability to find savings by being small because the assumption is that you find savings by being big.

  Mr Buxton: If I could add, Chairman, typically with a private finance scheme the local authority is only paying when the scheme is delivered, so there is that element of risk transfer. Arguably you could set up forms of slightly different procurement which would rely more on local authority borrowing which could actually come up with a mechanism which would transfer, but essentially the essence of the private finance project is that it is payment on delivery and it is that extra security that the local authority is given that is the key advantage of the private finance contract.

  Q91  Lord Paul: Out of the two, if you had to choose in the first reference, which one would you choose?

  Mr Buxton: I would not. I see that conventional procurement and PFI have advantages and disadvantages and it depends what your priority is as a local authority. If you want slightly more flexibility then you do not want to tie yourself to a longer contract. On the other hand, if you want greater price certainty then you may well wish to enter into a PFI contract. It really depends on the nature of what you are trying to deliver. It also depends on the risks that you are trying to avoid. For example, if you are building a leisure centre then actually the private sector is very capable of taking on the whole risk of the occupancy or use of the leisure centre. On the other hand, if you are building a prison what private sector contractor is going to take an occupancy risk on a prison? Clearly they are not. Therefore, this issue of risk transfer, yes there is always an element of risk transfer but it is not the whole risk associated with the entire life of the project. I think sometimes the public perception is that PFI transfers the whole risk. No, most PFI projects concentrate on transferring the construction cost risk and the operational maintenance risk. Some projects can transfer more than that but actually the core risk transfer is around the capital construction cost and the maintenance cost risk. It is not a case of better or worse and I think that is why what we would be arguing for is as neutral and level a playing field as possible so that local authorities can make their own decisions as to the appropriate nature and use of PFI projects. For certain types of projects that is absolutely not the right thing to do.

  Q92  Baroness Hamwee: To extend that slightly, as well as asking us, as I assume you are, to back your call for the level playing field, presumably you would like us to say that the greatest flexibility in the type of project would be helpful when government is issuing credits, putting it in rather straightforward terms.

  Councillor Kemp: Any local authority has a variety of needs. We deal with things on a themed basis because that is the way ministries do it. We need, in capital as well as revenue projects, to be able to assemble what our communities need and there is often in that context more conflict between local government and Central government delivering mechanisms than there is about our particular route for financing any particular set of circumstances.

  Q93  Baroness Hamwee: Can I ask about the longer term impacts using PFI, whether there is any difference between PFI and conventional projects. We have had some evidence from I think it was Sheffield where they say that an emerging issue is that PFI contracts with fixed price or inflation-linked contracts in the public sector funding environment where standstills or even cuts are going to be possible, non-PFI arrangements may be easier to manage down in such an environment.

  Mr Buxton: If we take the schools example. Let us say that you go through conventional procurement and you build a school, you expect to maintain it. A school has costs that you have to pay. The issue with conventional procurement is that you can in a bad year choose not to do the same degree of maintenance on the school and, therefore, you have a slightly greater degree of flexibility. Whether it is a good thing not to do the maintenance on the school I would have to put a question mark there. On one level you can say that the local authority should have the flexibility not to maintain its schools; on the other hand, as a parent I might be saying, "Actually I would prefer a situation where the local authority was really committed to maintaining the school during the life of it because arguably a poorly maintained school is not a conducive environment for learning". We are not arguing PFI is wonderful or PFI is awful, there is a balanced approach to be taken to this and there are arguments for and against. I would accept that one of the challenges, if you have a long term contract, is that your payments are fixed.

  Q94  Lord Tugendhat: You have made some very interesting points in answer to a lot of questions within other questions, as it were, but coming back to the point that you have just made, do you believe that some private finance projects are more successful in some public services than others? In other words, are some projects more suitable for PFI than others?

  Councillor Kemp: Quite clearly those that are best are ones that you know are going to be there for a long time. You build a road; you build a school, things like that. They are solid, they are going to exist. There might be some questions around the edges about what a school will be doing precisely in 25 years, but those are good long-term things on which we can see the effects. It should not be used for things like IT which change so rapidly. By the time you have actually gone through the process the specification will have moved on. That is where you go for a more flexible partnership. For example, a lot of councils now have set up Joint Venture Companies with their IT provider and that is another way of bringing in finance, of bringing in appropriate private sector expertise in a way that is very readily adaptable to meet continually changing circumstances.

  Q95  Lord Tugendhat: I realise that this is not your direct responsibility, but would you feel, therefore, that hospitals are perhaps a less appropriate kind of project because of the very high IT involvement?

  Councillor Kemp: It comes back to your view on whether we have hospitals in their current form. In my own city the Health Service is dispensing with its big hospital that was going to last 100 years and creating community facilities around. It is a question of how you would evaluate the risk because you could well have a contract for building and then a different set of contracts in relation to what goes in it. So you have to make a decision on what you think the Health Service is going to be doing in 25 years and say, "Do I want to procure a hospital through that route?"

  Q96  Lord Tugendhat: The distinction you have just made is one that could also be made for schools.

  Councillor Kemp: Absolutely.

  Mr Buxton: That is absolutely the critical point, that PFI for a hospital could be everything from simply doing the building and maintaining the building, all the way ultimately through to actually running all the medical staff. The issue is where do you draw the line if you are going down that route? Do you include all the medical equipment; do you include ancillary staff; do you include medical staff? What is the limit? There is scope. This is an area where it is possible to make different decisions and it is not a case of there has to be one answer. Clearly there will be some government programmes where they will choose a particular strategic direction, but PFI does not force you to choose, within that spectrum you can actually make choices.

  Q97  Lord Tugendhat: One final question. Within your association is it your experience that different local authorities have made a range of very different choices on the same issue or is there, broadly speaking, a mainstream view?

  Councillor Kemp: I would rather turn that slightly on its head. I would find it difficult to discern whether Lib-Dem, Labour or Tory authorities went one way, or urban or rural authorities. By and large most local authorities are extremely pragmatic and that is why we are looking for the level playing field. We have to have a relationship with the private sector for a lot of these activities. As I said before, we have never built a school. Although we have said it is a council property we have never built it. So the question is how do we enter that relationship. I think we would find it very difficult to come up with an authoritative answer to your question because I have never seen such differences as I go around the country.

  Q98  Baroness Kingsmill: I am stuck with the boring question, actually! That is, could you elaborate on the accounting treatment of private finance projects?

  Mr Buxton: I think from a local authority perspective the critical issue for a local authority is the impact on the council tax. That is the real issue. The reality is that it does not make a great deal of difference whether you go down a PFI route or a conventional procurement route. If you have built a school the school is going to need to be paid for. You are either going to be borrowing money to build the school and be paying that money back, or you are going to be paying a private contractor a unitary charge for the use of that school. The impact on the council tax is broadly neutral, and I think that is the issue from the local authority perspective: is there going to be a significance difference in impact on the council tax and the answer is broadly speaking it does not make a great deal of difference which route you go down in terms of the impact on the council tax because the council tax is about what you are actually spending rather than a set of relatively arcane accounting rules about whether something is or is not on balance sheet. The question for local authorities is what is the impact on the council tax and not what does the balance sheet look like.

  Q99  Baroness Kingsmill: I am delighted to hear that! So how prepared do you think local authorities are for IFRS?

  Mr Buxton: I think the National Audit Office is actually doing a piece of work on this at the moment and it is proposing to come out in the New Year with a statement. My understanding talking to colleagues in local government is that no major problems at this stage are anticipated. That is my broad indication, although I have to say that that is based on a relatively limited sample of discussions with colleagues at the Local Government Association. As I say, I think the National Audit Office will be coming out with more definitive guidance on this topic either at the end of this year or early next year.

  Councillor Kemp: It is interesting for me to compare what I do as a Housing Association Chair, which is in my view a public sector body, where I am acutely aware of the balance sheet because I use the balance sheet as a tool to borrow more money and do more things, and the concept of a balance sheet in local government. I do not have a clue what the net assets of Liverpool City Council are because I only look at the revenue consequences. If we moved further into the field of prudential borrowing then that would have to change. Perhaps that is one of the things that the changes will make us more aware of. If I have got assets how can I best use them to use more money in the way that the private sector does? So I think those changes are useful. How or where councillors are aware of these issues I am not sure, but we have always had officers to guide us.

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