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

Examination of Witnesses (Question Numbers 119-139)

MS JIL MATHESON, National Statistician and MR JOE GRICE, Chief Economist, Office for National Statistics, and PROFESSOR GEOFFREY WHITTINGTON, University of Cambridge, examined.

20 OCTOBER 2009

  Q119  Chairman: Ms Matheson, Mr Grice and Professor Whittington, welcome. If I can please ask you to speak reasonably slowly and clearly that will be helpful both for the webcast and for the shorthand writer. I do not know whether any of you would like to make an opening statement or whether you would like to move straight into questions.

  Ms Matheson: Maybe I can just say a few words, thank you. I just wanted to say thank you for the opportunity to explain and discuss the statistical treatment of PFI projects both in the national accounts and in other official statistics. A key part of what we do is to follow international standards governing statistical accounts—the UN system of national accounts and the European system of accounts—and we have got a legal basis for compliance with those. Statistical guidance and accounting guidance has, up until now, been similar in the relevant respects, so we have been able to use the audited accounts of public bodies to use in the national accounts. The introduction of the new International Financial Reporting Standards this year may have some impact but public bodies are still being required to produce accounts on the old basis as well, so we can continue to fulfil our legal obligations. Finally, of course, our obligations go beyond that, and we are conscious of the need to meet public needs for transparency of statistical information. So we have work under way looking at the presentation of additional information—for example, on public sector liabilities. It is a complex area but we are publishing and have already published a series of articles to help us and our users understand the issues, and we would be very happy to try and explain that today.

  Q120  Chairman: Just before we move on to the accounting and statistics side, can I ask you one general question, which is to ask you what you see as the defining characteristics of private finance projects?

  Ms Matheson: Can I start, just from the statistical point of view, because that is what I can talk about? Following the international standards that I referred to, it is about risk, and the assessment of where the risk lies. Is it with the public sector or the private sector partner in the arrangement? The European system of accounts and the international standards are quite clear about that. So, as far as we are concerned, we take the audited accounts which themselves have assessed where risk lies. Where the bulk of the risk is judged by the professional accountants to be in the public sector then they are on the public sector balance sheet; where it is in the private sector then they are not. So that is the defining characteristic in terms of how we, as statisticians, interpret the accounting rules.

  Q121  Lord Eatwell: I would just like to follow up from that. What I did not understand from the memorandum you sent us, also indeed from what you have just said, is the relationship between what you think would be an appropriate accounting standard and the accounting standard which is being imposed upon you by others. Your memorandum consisted entirely of referring to other accounting institutions—to the IFRS standards, and so on and so forth—it did not say at all whether you thought they were satisfactory (if you like, fit for purpose) for the UK assessment of risk in PFI projects. I wonder if you could comment on that.

  Ms Matheson: I will start and then perhaps I can ask my colleague to add on to that. I think it depends on what is the purpose. If you think about our purpose with national accounts, then we are looking at the economy as a whole, and the important (and, I mentioned that we have a legal obligation) obligation as well is to make sure that what we do is consistent with the treatment of other countries. So the international standards are important in that they are the ones that we stick by, but they are important because they are an important way of looking at the economy across countries.

  Q122  Lord Eatwell: I can see that if everybody wants to get their national income accounting straight then they will get the national income accounting straight, but we are trying to understand the value to the public purse of these procedures. We all know, for example, in the national accounts, if you employ a housekeeper it is part of the GDP and if you marry her and do not pay her it is not part of the GDP. We all know that. So if we are looking at social welfare, the national accounts are not representing social welfare in those terms. If you are interested in social welfare we would not look to the national accounts. So I think that this international comparison is a complete red herring; the issue is: are these accounting procedures appropriate for us to understand the welfare contribution to the UK of these particular projects?

  Ms Matheson: Let me, in one sentence, reply, and then I will hand it on. As I said, it depends on what the purpose is, and the assessment of value for money or any of those other considerations are not considerations for me or for the Statistics Office; that is not what we are here to do; that is a matter for the NAO or for others. What we do have a responsibility to do is be transparent about what we are measuring and how we are measuring it.

  Professor Whittington: Could I make an observation, please? I did not want to make an initial statement but the initial statement did actually say something that I believe to be incorrect (I am sure it was a mistake, not deliberate), namely, that this balancing of risks that is done by the internationally accepted methods of national accounting is not the same as the current UK standard FRS 5 and the application note to that or even the Treasury's guidance to that, which has widely been interpreted as allowing everything to go off balance sheet but was not intended, I hope, for that purpose. The big thing that gets missed out of the assessment of risks under FRS 5, and is included by the national accounts and was alluded to by the local authority representative just now, is construction risk. Obviously, we all know—anybody who has dealt with builders knows—that construction is a horrible process to go through. Construction contracts carry enormous risk, but that risk occurs irrespective of whether I buy an asset or whether I lease it or whether I get it under a PFI contract. That is something that happens before the asset is created. Once the asset is created, as an accountant within current accounting standards, I have to ask myself: "Should that asset which has now been created be on the balance sheet?" In other words, who do all the subsequent risks and rewards (or however I care to evaluate it) lie with? Do I sit in this position that an owner of the asset sits in, or am I really just renting it from a provider of services? That has to be done once the construction is over. I think the potential conflict with national accounts (the ECOFIN system) lies in the fact that they only identify three areas of risk, much narrower than FRS 5, and one of those areas is construction risk. That means that most PFI contracts will say: "Well, the construction risk lies with the constructor because the price is usually fixed under contract"; hence it is off balance-sheet. Under FRS 5 that would not happen. That is a serious problem now because we have a new international interpretation, IFRIC 12, which has been adopted by the Treasury and is going to be used in resource accounting. IFRIC 12 is based on control but I think we can bypass that—control of risk and rewards are not so different as you might think, but I do not want to get into technicalities—and IFRIC 12 will bring on to the balance sheet a lot of things, it is widely believed. However, these things will not be brought on to the balance sheet by the internationally accepted method of doing national accounts. Not only does that apply to the national accounts but I understand the Treasury is applying this same standard to budgetary procedures by departments, so that for budgetary purposes they will be leaving things off balance sheet and for ex-post accounting they will bring them on balance sheet, which I find quite extraordinary. So there is a conflict between the way national accounts are done, and the way business accounts are done and the way they are being interpreted by the Treasury for the accounts of departments. This is not the fault of the national statistical office but it is a matter of government policy; I guess it has to do with international agreements on borrowing requirements, and so on. It is, nevertheless, a practical problem.

  Q123  Chairman: Is this a conflict which can or has to be resolved, or is it a paradox you just have to live with?

  Professor Whittington: We get back to the issue Lord Eatwell was discussing before, of what all this is for. I believe, because I like to think accounting is useful, that accounting is telling us what our obligations are when it is recording liabilities. I was very struck by the discussion you have just had with the local authorities which indicated that a PFI contract binds future generations. In fact, because of the fact that it suppresses what economists call "real options" it actually, in some way, is more burdensome than a conventional purchase of an asset. The fact that future generations, or future taxpayers, are bound—hence the scope for allocating revenue in the future is constrained—is a very important thing that people should know; they should know how much they have borrowed, how much the Government is in debt—in the economic sense as well as in the legal or technical sense. I do think that is very important information from a policy point of view and an ex-post appraisal point of view. It gets suppressed if we do not put these things on balance sheet.

  Q124  Lord Levene of Portsoken: Just on the basis of what Professor Whittington said, if I heard you correctly, you said the same risk was there whether the building was bought or leased. Surely, it depends on who is doing the buying and leasing, because if the Government or a local authority buys a building they are at risk throughout the process, but if they are leasing it it is the owner/contractor who is going to do the leasing who is at risk, and the local authority or the Government only has a problem once they have taken it on. Is that not right?

  Professor Whittington: I was thinking of a long-term lease. I was thinking in terms of finance leases; in short-term leases or rental, clearly, the landlord is responsible. The longer the lease, usually, as you know, the more responsibility the tenant takes on. If I have a 999-year lease, then it is pretty well mine. I understand that one of the Cambridge colleges is actually owned by an Oxford college (or, at least, the ground is) but it is 999 years so nobody talks about that and they repair their premises as if they own it.

  Q125  Lord MacGregor of Pulham Market: I think, like others, I may be having some difficulty in getting back on track! Can I ask the question which I hope will help do that. Could you elaborate more to justify having liabilities treated differently in the departmental resource funds and the Treasury national balance sheets, and indicate more of the consequences of that?

  Mr Grice: I think a lot of this comes back to what are the purposes for which these accounts are used. I can imagine it would be safest, I suppose, if there was one set of accounts which will give you the answer to everything. So far as we are concerned, we have at least three objectives, as Jil mentioned at the outset. One is we do have international obligations to compile national accounts according to international conventions. The overriding convention existing on national accounts is voluntary, the United Nations System of National Accounts, but the European System of Accounts, which is essentially derived from that, is a statutory obligation; it is an obligation in European regulation and those procedures we have to abide by in order to produce gross domestic product figures and other national accounting information according to the European standard. For that purpose, the information provided by, essentially, as I understand it, UK generally accepted accounting practice (which is largely on which the resource accounts are based) is appropriate for making those calculations. We believe it is appropriate and so, too, do the European authorities. A second purpose is actually to produce the public finance figures where, again, we have legal requirements under European regulation in connection with the Stability and Growth Pact and the Excessive Deficit procedures. Again, for that purpose the resource estimates that the Treasury produces and uses in its budgeting, we have access to and, essentially, take on board, is appropriate. We believe that and, again, so do the European authorities. Then again, this is not the only purpose; this is not the only information one would want to look at in analysing these kinds of situations, and while it is certainly not our job as the statistics office to make assessments of value for money in PFI deals, or anything of this kind, it is our job, we see, to produce a range of information about public finances in general which will indicate the transparency and enable such judgments to be made. In that connection, it may be the IFRS, the new accounting standard, is something we need to look at, and indeed we have started to do that. I am not sure that is a direct answer to your question but that is the position we are at, at the moment.

  Q126  Chairman: We are talking about IFRIC 12 or IFRS thing, which is what we are about. Would it be a practical problem for the ONS to, as it were, sum what is on the various local authorities and other government departments IFRIC 12 data to produce a separate national figure? Not to supplant the European approach but as a supplement to see it from a different view. Would that be a problem?

  Ms Matheson: I do not think it would be a problem. What we would need to do is be very clear about what it was that it was measuring and what part of the overall picture is that about. Again, our role, as you say, is to aggregate and we do that based on audited accounts; we are not responsible for the standards against which those are audited. So if there was some great user demand for us to do that and if those data were available and audited, then adding them up—

  Q127  Chairman:—would be a fairly simple thing. I am sorry to be simplistic but let me push it a bit further. If it was analogous to a business and that business had a whole string of subsidiary companies, which may be local authorities or government departments or whatever it is, then in summing the consolidated accounts of that business you take all the subsidiaries and you add them all up and you would know what you had got, at the end of the day, because the two would be the same. Here we have an anomaly whereby, at the moment, the sum, which we do not know, of the equivalent of the subsidiaries in the public sector does not match what should be the consolidated accounts at national level. All right, you are caught by different standards—and we understand why that has happened—but I would have thought that it might shed a little bit more light if, in addition to the European approach, you actually summed what we have got in our various national subsidiaries. Am I being too simple? Perhaps I should ask an accountant. Professor Whittington, does that make any sense?

  Professor Whittington: It makes sense to me but I am not a national accountant. I was over-awed by being here with two of them.

  Ms Matheson: It would not be a national account is the point.

  Q128  Chairman: Absolutely, but it might shed some light on national liabilities.

  Mr Grice: We are very open to the idea that national accounts are not the only information that is useful in this area. Indeed we did, over the summer, publish a series of papers on ways in which more transparency and wider information about the public finances might be produced. In that light, I would certainly regard the proposal as being one which merits further examination, but we would have to look at the feasibility, exactly what it measured, and so on.

  Q129  Lord MacGregor of Pulham Market: That is actually what I meant by the consequences in my question. You described the situation from your point of view, which I think most of the general public do not understand at all, but there is a widespread concern, for example, in terms of national liabilities and national debt, that some of the PFI projects and other things are not appearing in the national debt figures and that this is, somehow or other, because of the way in which the statistics are drawn up. I wonder if you could comment on that.

  Professor Whittington: I will comment on it, if you like, because they are reluctant. Can I just briefly comment because I think what you said is exactly correct? I can understand the international standards for national accounts but I think they are behind the times, as it were. Accounting has moved on a lot in the last 30 years and the way people do business has; complex contracts with PFIs have emerged and they are a bit behind the game, if you like, and that is why they have not thought it out and they have got construction risk in there and missing lots of others out. It also, of course, suits, no doubt, many national governments that they do their national income accounts that way because they are under a bit of pressure from borrowing. People use these very naive numbers—Public Sector Borrowing Requirements and things. So, naturally, I imagine, there is a reluctance by many governments to change this system. Then, of course, we have the question: should the UK change and then be blamed for borrowing more than anybody else, when it is purely an illusion? I think there is a serious problem. That is as an outside observer.

  Q130  Lord MacGregor of Pulham Market: You mean an illusion that we are borrowing more than anybody or an illusion that if we changed the system our figures would look larger than they actually are compared to others?

  Professor Whittington: The illusion is not in absolute terms. If you mean: "Are they telling the truth?" I would say they are telling the truth if they did proper accounting, as I put it. They are not telling the relative truth, and countries and currencies are often measured in relative terms. If they have all got this little bit of buffer called the PFI there and we make ours hang out as if it is borrowing and the others do not, it makes the UK look worse than it ought, and is not doing the country a favour—I can see that. That is a problem of the emerging practice on national accounting. In the future, I think, there is a great deal of hope because international standards are developing very rapidly; IFRIC 12 comes from the private sector International Standards Board, there is a Public Sector International Standards Board as well which has been working on IFRIC 12-type interpretations for government, and I am sure that these bodies, eventually, will persuade international organisations like the World Bank and the IMF, that are backing them. I think practice will improve in the future. At the moment we have an anomaly because they are catching up.

  Ms Matheson: There is a dialogue between the two anyway; so these things do take time to evolve—that is certainly true. On your first point about transparency, of course, as we have said, the national accounts are the national accounts, and we are interested in improving transparency outside the national accounts framework to help public understanding of the nature of public debt or other aspects. So that is absolutely consistent with the direction that we are going. It is just not easy to do, and I am never sure that we are quite going to be in a position very quickly to get to the point where the public do understand all the complexities of this. That is the challenge.

  Q131  Lord Best: Improving public understanding—and mine too, I think—does get pretty difficult. I guess that governments of all persuasions are going to want to try to find ways in the future of spending money that does not show up in the national debt. If the basis really comes down to where the risk lies, my question is about how you determine the risk transfer between the public body and a private company, or a special purpose vehicle. Let us try this from a kind of public perception and understanding of these things. At one level we now know from the collapse of the banks that the government has to pick up the bill at the end of the day; the risk, ultimately, with these organisations that are too large to fail, and so on, rests with government. We have not transferred risk even in the banking system out of the hands of government, at the end of the day. If things go bust, government picks up the bill. In the world of PFI, of course, the school, if it is half-built, if the PFI company goes out of business and this whole thing falls apart, the public sector has to pick up the bill. It falls back on the taxpayer—local or national taxpayer—because we need the public services. To say that the risk is transferred to a private sector body, at one level, must be a bit of an illusion, to use Professor Whittington's words. Is it that the medium-sized risks are transferred allowing a change of definition that governments will grasp if they can? The medium term risk—not that the contractor goes bust but simply that it costs a lot more than they expected and they have to take the hit; it is the small-scale things that go wrong which do fall to the private sector organisation, the contractor, to pick up the pieces because that is what the contract says, even though the big risks do, ultimately, still remain a public sector activity with the public sector. Have I mystified you even with the question?

  Ms Matheson: You are right in the sense that, of course, ultimately, where is risk, and that is one of the issues about how do you define and decide the point at which risk becomes a liability and at what point should it be included in whatever accounting standard. That is one of the real measurement difficulties with any system that you have. I am not quite sure what the question is that that leads to.

  Q132  Lord Best: Let me put the formal question here, about the transfer of risk between a public body and a private company. How do you set about determining the risk transfer between the two, the public body and the private company, or special purpose vehicle?

  Ms Matheson: The short answer is we do not; that risk is the risk as it appears in the audited accounts. So, as statisticians, we do not do that.

  Q133  Chairman: Perhaps we can address it to Professor Whittington.

  Professor Whittington: I will try and answer that, if you like. Under the FRS 5 approach, which is the one that has historically been used in the UK and is widely used abroad as well—Australia and New Zealand and other places—you, first of all, as I said, would strip out the construction risk, to start with, because somebody bears that anyway, in creating an asset. The PFI contract is for the use of the asset for a service once the asset is constructed. You would also look at the end of the contract and look at who gets the asset at the end, because that is usually very informative with PFI contracts; they are often for less than the life of the useful asset, despite the discussion we had earlier. If it reverts to the government then, of course, the government is bearing the residual value risk that is stated at the end. You would then analyse in detail and make a judgment on the terms of the contract itself. Of course, we talk about PFI—one of the difficulties is there are so many different contracts with so many different terms; who covers what risk within a contract; do you give a fixed price, do you have a variable price; do you have toll roads, do you have shadow tolls—it goes on forever. You have to analyse the contract and make a judgment. That is where, I am afraid, FRS 5 really was let down or let itself down because these interpretations done by people who have incentives to keep things off balance sheet, inevitably, lead to things going off balance sheet. It is unfortunate that is the way it is. That is why the new IFRS approach is becoming predominant because that emphasises control rather than risk, although, in fact, as I hinted earlier, it is another way of expressing it, because the risk transfer was never solely what FRS 5 was about. What we were trying to do on the ASB in those distant days when we concocted FRS 5 was to deal with off balance sheet financing by private companies. That is often done by what are called "auto pilot vehicles" which run themselves, so there is not any control; they run themselves, so you cannot look at control and you have to say: "Well, whoever, at the end, gets the variable returns must surely be the person in control", because unless they are very stupid they will have put something in place, even if it is not visible, that makes sure they can avoid the worst happening if possible. So that is why FRS 5 was there. There was always an element in it of: "Well, who gets the benefit? Who controls or manages the thing?" The IFRS view of control is that it has two wings; one is power, which we normally think of as the power to direct in some way—the power to determine the public sector service: the quality, the price—but the other is that the power has to be directed for the benefit of the person exercising power. In the case of government, obviously, that means they have to be able to direct it towards their ends, and that, if you like, is a risk or rewards approach because you are saying: "Who gets the benefits; who bears the risk, in the end, of service?" So the two approaches are not so different, but the way IFRIC 12 has been drawn up, the rather stark way it is drawn up, puts people on notice that there is really, almost, a rebuttable presumption that things are on balance sheet, and I think that probably counteracts the temptations leading to poor judgment.

  Q134  Lord Griffiths of Fforestfach: My Lord Chairman, I wonder if I can ask Mr Grice a question, because I have only been involved in one major PFI contract, which is the outsourcing of property services to the DHSS, then the Department of Employment, now the DWPP—a 20-year contract—when we, in winning the tender, took on tremendous risk, namely, that we had thousands of properties, some of which the Department said: "We will never want to get out of"; some of which they said: "We want to get out of now" and some of which they said: "We may want to get out of". For those properties we took the risk that if they got out we would be able to re-let them on terms which were reasonable, and we took on other risks. My understanding was that when this was set up the Treasury, in agreeing to a PFI project, said: "One of the key criteria for something to be a PFI project" (regardless of accounting, for a minute) "was that there has to be a material transfer of risk from the public body to the private body. Is my understanding correct?

  Mr Grice: It is a little while ago since I was directly involved with PFI schemes, but the basic proposition was that the risks should be borne by the party best placed to bear the risk—that would be the way to get the maximum welfare for the country. That, I presume, is still the underlying presumption. We use the accountancy rules simply to give us a judgment based on the professional accountant's judgment, rather than our own, as to whether that risk transfer has taken place or not. That determines the position that we reach.

  Q135  Lord Griffiths of Fforestfach: Can I ask you: is the professional accountant the best person to give you that judgment?

  Mr Grice: The professional accountants, we will expect, will be the people who will go through and analyse where the risks were borne and how the mechanism had applied. I think we would not feel that we could add value, as statisticians certainly, in second-guessing in all 800 schemes, or whatever. There is one other point in this discussion, if I might, and that is, really, to put these numbers in context. The figures that we have are that there are approximately 800 or so PFI/PPP schemes in being, and the capital value is something of the order of £64 billion. Of those, under the rules which Professor Whittington has doubts about but which, nevertheless, are the ones we use for national accounting purposes and public finance purposes, approximately £25 billion or so are actually on balance sheet under those rules. As it happens, some of the larger schemes which would not be caught by those rules—London Underground schemes—are ones where we judge, in any case, that the PFI counterpart is part of the public sector because of the control. Again, that leaves us, when we take that into account, with something of the order of £5 or £7 billion of schemes at issue. Now, £5 or £7 billion is, obviously, a large amount of money, but that compares with the public sector net debt (and we published a new figure this morning), and that was £825 billion. So the amounts we are talking about here, in relation to the overall public finance, are not negligible, of course, but they are actually not that large in relation to the totals of the public finances that we are talking about.

Chairman: Material, but only just.

  Q136  Lord Tugendhat: This is a very technical discussion and I must say I am having some difficulty in following a great deal of it. I would like to ask one of the simpler questions on this list, and that is how does the UK treatment of these liabilities compare with elsewhere in the world? I do not mean in Europe because that point has already arisen, but looking beyond Europe but within the OECD area.

  Ms Matheson: They, too, follow the system of national accounts—the UN system of national accounts that the European system is based on. So although the UN system is voluntary, the expectation is that that is what countries will follow.

  Q137  Lord MacGregor of Pulham Market: Can I just go back to Mr Grice's figures, in that supplementary point you made? You told us where £32 billion were, and the overall figure was £64 billion. The gap between the two, the other £32 billion, how is that accounted for?

  Mr Grice: On my figures something in the region of £25 billion would be accounted for—that is actually on balance sheet of the total—and something of the order of £18 or £20 billion would be accounted for by the London Underground schemes, and it is the rest which is really at issue.

Lord MacGregor of Pulham Market: Thirty-six, but not £5-£7 billion.

Chairman: Twenty billion. If you could give us a little note on that, that would help.

  Q138  Baroness Hamwee: I am very relieved by what Lord Tugendhat confessed, because I feel much the same! This, I think, is a political question rather than a statistical one. If liabilities appear on the national balance sheet as a matter of fact, depending on how each is treated but regardless of how much risk is transferred, is there a risk of missing important information?

  Ms Matheson: Again, I think I have to go back and say it depends on the purpose and what is the information that you are trying to establish.

  Q139  Baroness Hamwee: Let me put it a different way. Is there a difficulty in interpretation, then? I can absolutely follow what you are saying about it depends on the purpose, but are we in a situation where we are making life difficult for ourselves in producing information which does not facilitate analysis and interpretation?

  Ms Matheson: Again, I will ask Joe to come in but I refer back; there are the national accounts and we discussed the national accounts framework and what we are obliged to do. There is additional information in order to be able to understand public debt, and I think this falls into: "What is the additional information that the public needs in order to have transparency about what is actually happening", which is an important principle. There are real difficulties in measuring, interpreting, understanding and classifying what the range of information should be, but that is why we have been looking to see what additional information ought to be made available and could, practically, be made available. We have talked just about the PFI schemes, and 800 schemes—a lot of them very, very complex—each of them having their own separate arrangements, so just understanding what is happening there is a mammoth undertaking. Going beyond that, the difficulties of interpreting do not disappear just because you have something on balance sheet or off balance sheet.

  Professor Whittington: That is a very good question you put, really, because people do tend to take numbers in accounts rather literally and they are usually first estimates that lead to further analysis. Just think of all the credit crisis, bad debts and the way people split them up into tranches and say they have different qualities, when you add them all up they show a total of liabilities. That is superficial, in a sense, but it is a start. People crave simplicity; they have got to start with something they can get their minds round, but it is certainly true that you do need to dig deeper into accounts. The problem there is (I have no doubt the national statisticians find the same problem) that if you do lots of notes people say: "You know, this is far too complicated—look how fat the accounts are". Unfortunately, that is the truth; the truth is complicated. So they are doing their best, their honest best, to give you a start.

Baroness Hamwee: I was not suggesting otherwise!

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