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


Examination of Witnesses (Question Numbers 224-239)

Mr Amyas Morse and Mr Ed Humpherson

3 NOVEMBER 2009

  Q224Chairman: Mr Morse, Mr Humpherson, thank you for being here and thank you for being patient as our session beforehand went on for rather longer than we had expected. We are very grateful for the NAO's contribution to our inquiry, and indeed in particular for your very impressive and authoritative written evidence. We have to ask you as ever if you could speak reasonably slowly and clearly for the benefit of the shorthand writer and the webcast. Would you like to make any opening statement or shall we move straight into questions?

  Mr Morse: I will be extremely brief, Chairman, thank you. Unfortunately we are in the position that the particular stenographer concerned has to suffer my contributions at the Public Accounts Committee quite regularly so I am hoping she will manage to get through! Thank you very much for the opportunity to give evidence. Our evidence is based on 12 years' work by the NAO looking at PFI projects and I am indebted to Ed Humpherson and the team for all of what you see in the document there. You will be aware that I am a relatively new joiner to the NAO. I think it is important to notice that there is no universal answer, as the report makes clear. Sometimes PFI is good value for money and sometimes it is not. There is still, in our view, and I listened to some of the later evidence you were given just now, a bit of a bias towards PFI in public sector funding arrangements, more of a push towards it than away from it, and we will say more about that perhaps. The current economic climate clearly makes PFI arrangements likely to be more expensive and that is a factor to be considered. It may indeed create a certain amount of pressure towards PFI deals but faute de mieux if people want to carry out large projects. PFIs represent £7.3 billion fixed costs for the Government and it is worthwhile thinking about that when you are considering the context of cost reduction, whatever the polite term for that is, that we are likely to be seeing over the next few years. I would add too that it is worthwhile thinking about the effect of having significant numbers of PFI contracts on the rest of a particular budget and a particular department because it does reduce the discretionary spend available. Overall in our report it is worth emphasising we have shown that project delivery under PFI contract conditions is generally reasonably reliable. We have not been able to make a quantified comparison between that and other forms of delivery. We simply do not have the data to do that, so we are saying that it appears on the data we have on PFI that it produces reasonably reliable results and that is one of the factors in it rather than saying to you it is universally superior, if I can put it that way, to other forms of contracting available to the public sector. Thank you.

  Q225  Chairman: Thank you. Picking up on a point you have just made I would like to go to paragraph 14 of the summary of your report which is quite unequivocal. It says: "We have yet to come across truly robust and systemic evaluation of the use of private finance built into PPPs at either a project or programme level. The systems are not in place to collect comparable data from similar projects using different procurement routes. Unless such systems are established, together with robust evaluation of the overall whole-life costs of alternative forms of procurement, Government cannot satisfy itself that private finance represents the best value for money option." That is quite unequivocal. How would you like to see this problem resolved and indeed could the National Audit Office itself do more in this area?

  Mr Morse: I think it is symptomatic. Certainly since I have been in this role it has struck me how little of a universal culture of evidence and measurement there seems to be in a number of complex government activities. There has been a lot of talk about evidence-led and objective decision-making but not an awful lot of it being counted on the ground, I would not say. Certainly in this space if you want to have a basis for making decisions of that kind you need to establish systemic collection of data and whole-life project costs and systematic and consistent evaluation of projects, embedding benefit realisation and using real data and not simply modelled data to test projects, so in other words as tough and realistic a set of tests as you can possibly can. If you want to be able to make valid comparisons that sort of rigorous and evidence- and information-based approach is needed. Of course the basis for doing that can only be built up over a consistent and determined effort over a period of time. We certainly will champion that. Forgive me just stepping aside from PFI for a second, one of the features of the next few years is likely to be the need to be able to make prioritised investment decisions and to say, "This is more beneficial than that," not on the grounds of assertion but on the grounds of actual demonstrable value generated and that requires a rigorous evidence-based approach. This is one example of the areas where such an approach would really be very helpful, and I agree it is a good example, so we very much want to try to set out what we mean by that and work with others who are interested to set forth our thinking on this.

  Mr Humpherson: Can I just add one further observation which is that we have done an awful lot in this space. We have a huge body of private finance work which is brought together in this report. We also have an even more huge body of work on conventional procurement, things like our annual report on major defence procurements and reports on IT-enabled change and on out-sourcing. There is a wealth of data from the National Audit Office. We have also brought those two bodies of work together. Only recently for example we published an update on some work we did to compare or consider the performance of construction under private finance and under conventional procurement and we have other comparisons as well. I would say we have been a little bit cautious on how far we have taken those comparisons—and perhaps that goes to the heart of your question, Chairman—for technical reasons because there are different sample frames, for good value-for-money reasons because we are not really convinced we are comparing like with like and because of an extra margin of caution about the theology here. There is lot of theology. There are people who say that private finance is good and there are people who say it is always and everywhere bad and we are very cautious about pitching our comparisons into that debate for our work to be misused. We hedge our assertions around with caution. There is a final reason, which is the most significant of all, which is that it is not us who signs the contracts, it is not us who proposes the contract model. Those are things done by government departments, local authorities and government agencies and we believe the responsibility for gathering the data and gaining assurance on value for money lies properly there. It is our job to cajole and to support and to lead the way but it is their job to provide assurance on value for money.

  Q226  Chairman: Does leading the way include providing a template?

  Mr Humpherson: Indeed we have done two successive templates. We produced a report in 1999[108] which considered how authorities could gain value for money from PFI essentially during the procurement phase. We updated that report in 2006[109] to extend the analysis into the delivery phase because of course these contracts have a 30-year life and managing their operational performance is just as important as striking a good deal at the outset. We have provided value-for-money assessment templates into the public sector. Indeed a lot of our specific reports also give hints to departments or recommendations to departments about the data they could be collecting to get a much stronger evidence base for future decisions.

  Q227Chairman: Have departments taken up what you have put in your template reports?

  Mr Humpherson: I would say in general the picture is rather mixed and of course it is disappointing that it is mixed. There are cases where departments have enthusiastically and with conviction implemented our recommendations. I can think of a recent example in the Building Schools for the Future programme, this enormous programme to renew every secondary school in the country. We made some very clear suggestions to the body responsible for implementing that set of arrangements about how they could collect data to ensure that over time they are continuing to secure value for money and they are getting the benefits that they hoped for. And they have put in place the arrangements to do that. There are examples of departments implementing our recommendations with conviction. There are a larger number of cases, I am afraid, where we have to continue to drive away at the same themes because we are not seeing the improvement that we hoped for.

  Q228  Lord MacGregor of Pulham Market: A number of our witnesses, particularly the major contracting firms who are engaged in PFI, have stressed to us not just the value-for-money comparisons but what they see as the real meta-practical results resulting from whole-life contracting for example in relation to better, cost-effective maintenance or indeed maintenance taking place in difficult years when it would not under traditional procurement. Can those benefits of whole-life contracting be achieved without recourse to private finance?

  Mr Morse: I think the answer is that they definitely can be but you have got to consider what it is about PFI that can provide unique qualities. One of the things is that you have actually got ring-fenced maintenance funding in a PFI contract and it is not very easy for somebody to help themselves to it to contribute to a departmental cut requirement. Replicating those wonderful conditions in another contractual context is not easy. There are things you can do. You can create trusts, you can do various things, but they do not have the inviolable quality, I would say, for the most part. It may be possible but difficult to do that in the same way as you can do within a PFI contract, so there is that to it. I certainly think you can make choices based on whole-life costs without PFI being involved and indeed I know that increasingly departments that do a lot of contracting are doing that. At a point in time if you have a choice between two decisions and they have differential whole-life costs you should have a consistent method of estimating those costs and take them into account in making the decision. Easily said; not all that easily implemented but it is beginning to be seen now. I spent three years in the MoD and I am aware that you have had quite a lot of MoD experience this afternoon already, but it was clear to me that that method of looking at the maintenance costs had taken hold in the MoD. Looking at and contracting for are not necessarily the same things and it is important to have flexibility and a genuine ability to hold the contractor to account and to deselect a maintenance contractor if necessary, and that can be hard. Combining a good supplier with a good maintenance contractor is not always the same skill- set, so I think the answer is it can be done in other ways but in PFI you do get this protection of the budget funds.

  Q229  Lord Best: You have answered this a little bit and it is about whether bundling together the build and the managing that follows always brings advantages. Did you have evidence that showed that privately managed facilities compared better or worse with those where there was the build and the management together in those facilities?

  Mr Humpherson: Yes, we have looked at that, particularly comparing the private finance context with other outsourcing contexts which is probably the cleanest comparison you can get here. And when we look at those, actually the private finance initiative bundle includes the construction, the maintenance of the asset and the provision of services over the contract life. Comparing that service element with the service element under an out-sourcing contract, there is not generally a great deal of difference between them as a general rule. There are cases where particularly good contracts have been struck in the private finance context and of course there are particularly good outsourcing arrangements, but we have not seen a general pattern that PFI bundling delivers better VFM on cleaning and other services through the contract life.

  Q230  Lord Best: So those making the case have been rather over-egging this one perhaps?

  Mr Morse: We think that there are advantages both ways, but if I may add just one thing, Lord Best, a lot of it comes down to the ability of the in-house team to be a smart customer for the services being contracted for. Sometimes in the past I used to be involved in business process outsourcing deals and the lovely people who were selling the contract would sign the contract and then they would walk out the door and another crowd of much rougher looking people with clipboards would walk in and their job was to run the contract. They had the contract in one hand and a calculator in the other, generally speaking, and their job was to drive the profitability of the contract by knowing everything which was a variation, by making sure they picked it up and by making sure they got the maximum out of you as a customer. You will sign a contract where the optimism is not in the numbers, the optimism is in the estimation of your capacity to manage your side of the deal and not be taken advantage of by a much more deeply commercially experienced counterparty, and you do see that an awful lot, particularly with the movement in jobs. You have somebody in the private sector who is sitting opposite who has probably done, roughly speaking, the same job in a number of companies for all their working life and then sitting opposite them there may be someone who is actually moving from job to job and this is part of their broadening experience and you do not get very many prizes for guessing who is likely to come out on top in that negotiation.

  Q231  Lord Tugendhat: I think that is a very real world observation. Could I approach it from a different angle. Some of these projects are now so very large and the risks are so very great, do you think that there is actually in reality a great deal of competition for the contracts or is the number of people able to do it very limited? One of the points which came up in the earlier evidence—I do not know if you were here at the time—was that both sides have learned as they go along and that the public sector has learned that the lowest bid is not always the best, and so if one is coming down to who can actually do it, in some cases there must be perhaps only two or even one who are at any given time able to do it.

  Mr Morse: That may well be true but of course you have got to deconstruct the contract and think that first of all there is competition for the actual provision and then there might be a party to the contract who is also going to compete for providing maintenance and you have also got the financial competition to conduct, so you are quite often talking about a team who is delivering the PFI contract from the private sector side rather than some super company doing the whole thing. That can lead to a restricted feel. Certainly what I saw, and I will pass to Ed in a minute, was it is important that the competition should be of a qualitative nature and should be very carefully thought out as to what really the drivers of quality are (not just price as you said) in the long run and what are they prepared to agree to in terms of contractual terms, even what I would describe as pre-negotiation of some of those terms. I am sorry, my commercial director bit is showing here. Sometimes you can say, "Look, in addition to the normal competition we expect you to indicate that you would accept certain terms in the contract before we even sit down which will allow us to hold you accountable in rather more tough ways than you might normally expect. Speak now or forever hold your peace. If you do not want to accept let us know and it will be taken into account". There are things like that you can try to apply which may allow you to get the competence. The competence of the organisation who are supplying you and their real ability to deliver is what you need to know. To be honest, the best sort of result is one where the contracting party is really competent to run the contract successfully for you. If you have got a contract that is successful, the thing is constructed or built on cost and on time and the services that come from it are efficiently organised and well delivered, then you may have a bit of a battle about just exactly how much margin they are going to make on it but I do not mind the discussion being around that. When you have really got a problem is when people put in for a contract and they do not have the strength and depth to allow them to resource the contract properly. Then everyone is in desperate trouble and it is all just a question of how much damage all the parties to the contract have to take. So it is worth making certain that the counterparties are really competent and have strength and depth.

  Mr Humpherson: Can I just come in and answer the element of the question about the fierceness of the competition and whether that is declining or stable or increasing over time. Perhaps unsurprisingly it is a very dynamic picture. Markets develop; they grow; they shrink. In some sectors we saw in the past quite an illiquid market with not many suppliers and we saw growth. The most dramatic example is in the waste sector and people who build waste facilities for local authorities under a PFI contract. That was a market with very few suppliers as recently as a couple of years ago and as a result of some quite skilled procurement management there are now more suppliers who pitch into the bids. Much the same thing could be said in the schools sector. General construction is pretty much the same as it has always been but there are some areas where you are seeing a trend towards greater concentration. The most striking is in what you might call the after market. Once the asset is built there is a tendency for the original backers of the project on the private sector side to sell their equity to secondary funds who specialise in doing PFI deals and there are fewer of those funds than there were and it is a trend towards concentration. The other aspect where we are seeing some concentration is in financing as a result of financial market problems. We see from the work that we do a general phenomenon that there is less project finance appetite around in the banking sector and as a result it is harder to get these projects funded. There are fewer people putting in less money effectively. That is not to say that deals are not going ahead. It is just much harder and there is less obvious financing competition. So it is a dynamic picture which does not accord to a simple answer I am afraid.

  Q232  Lord Eatwell: I would like to turn to the horror stories of IT projects. IT projects seem to go badly wrong whether they are public finance initiative projects or whether they are just public projects and yet IT outsourcing is a really fast-growing part of the private sector and very standardised in the private sector and it seems to work, so what is your view of the relative merits of PFI IT projects and publicly procured IT projects?

  Mr Humpherson: I will give a view and then maybe Amyas can come in after me. We tend to talk about IT projects as if there was this one thing called "IT projects" but of course in the modern world so many things which do not have IT on the label are IT-related. One thinks about things in the Ministry of Defence sector to do with contracts to train pilots using simulators. There is a big chunk of IT in those things and I do not think we would have a particular view that that IT-enabled kind of project is particularly inappropriate for PFI. If you look at the projects that you are referring to which seem to have problems, they are where it is not the provision of a bit of kit or a generic service but it is the provision of something which is going to transform business. It is using the IT to change ways of working where there is a whole extended nexus of issues beyond just the kit itself. There is the motivation of the staff, there are the business processes, there is a management culture. In those circumstances, it has proven extremely difficult to write down in a contract all of the risks that might arise and therefore the contractor can lay off for in their plans. I think it is in those circumstances of IT-enabled change projects that you see PFI at its least successful. Just as an aside, it is worth adding that it is not really always the case that those projects fail. There is a general view that IT projects fail but we have done work on IT-enabled change done conventionally which shows that these projects can be a success and they can bring significant benefits to the public sector. However, our general view would be IT-enabled change projects where you are trying to transform a business model is probably the least fertile territory in the whole public sector for PFI.

  Q233  Baroness Hamwee: Can I go back a bit to pick up some of your answers to Lord Tugendhat and I will explain why I want to ask the question. The local authority witnesses that we had said very bluntly that what they needed was flexibility rather than being driven to particular models of financing. So does it make sense to assess particular categories as being suitable for PFI or not rather than on a case-by-case basis? I suppose in other words what I am saying is is the focus of this inquiry wrong?

  Mr Morse: I suppose you could look at it like this: if you say that you do not know how long you are going to need an asset for, then evidently entering into a contract for a long period of time is going to cost you a lot of money, so if you think you might not need an asset for 25 years and you sign a 25-year PFI deal and you break out of it halfway through, drawing up a contract so that you can do that with relatively little cost, all of this expense has been incurred and you will suddenly have to pay it all at the end. If you really want flexibility you need to go to the whole basis. The same effects would be true if you did not have PFI. If you said, "I want to use a building but I may not want it in more than 15 years' time," actually you need to think about the sort of building so that it is capable of being used at the end of 15 years and if you have to write it off or sell it you can do so without too much cost. Certainly if it is a real probability you are going to break out early from a contract, you have to take that into account and not get tied into very long commitments, say on services and things of that sort, otherwise, quite understandably, you will find yourself paying penalties.

  Q234  Baroness Hamwee: So you are really saying that they should be thinking about the project rather than the structure but if that is the case, then how do they deal with the fact that credits are available for PFI projects but not for other types of capital?

  Mr Morse: I think the answer to that is if their judgment is, "I can only get funding for this under PFI and I must have some degree of flexibility in 15 years' time," that you will pay for that in a higher cost rate earlier on. That may be the only way you can get the project done but you are going to have to pay a risk premium of some kind. You can either pay it early or late. If you do not want the scandal of a huge payment at the end you are going to have to pay more to provide that flexibility earlier in the contract. If you set PFI aside, if you want flexibility, it always comes at a cost.

  Mr Humpherson: Can I just enhance that observation to say in answer to your question are you asking the right question, yes, you are, definitely, and in answer to your question is it sensible to look on a project-by-project basis or at whole sectors, I am absolutely with the Treasury on this: you have to do both. I would never want to sit here as somebody from the National Audit Office and say it is okay to ignore the value for money of individual contracts, some of which have very significant capital values, and say that does not really matter so long as it is in the right sector. Of course local authorities, agencies and government departments need to assure themselves of the value for money of whatever contract they are signing, but on top of that the programme approach to say there is a programme of private finance deals in the schools sector or the waste sector or in the accommodation sector or the roads sector, that is clearly sensible because it embeds the learning from one project to the next. Exactly the point Amyas was making about the need for the public sector to mimic the sense that in the private sector you have these people who do these things over and over again. It is absolutely deal-by-deal value-for-money assurance but with the learning sector-by-sector.[110]

We believe that the decision as to which procurement route to use should be made at both a local level, case by case, and on a programme level. It can be important to achieve VFM across a programme to use a standardised approach, and it is sometimes not appropriate to give Local Authorities complete freedom to adopt any approach they choose for a programme that is centrally funded and managed. For example, in our recent report on Building Schools for the Future we set out the argument the Department for Children, Schools and Families used for strongly encouraging Local Authorities to adopt a Local Strategic Partnership (Building Schools for the Future: renewing the secondary school estate, HC 65, 2008-09).

But on the other hand, it is possible to provide Local Authorities with a limited menu of choices, which would still achieve synergies and economies of scale across a programme. In part 3 of our written evidence to the committee we set out the way funding and budgeting incentives encourage the choice of off-balance sheet PFI. Again using the example of the Building Schools for the Future programme, the Department is funded on the assumption that 41% of secondary school renewal by capital value across England will use PFI (ibid). If it allows a Local Authority not to use PFI, it will normally seek to ensure another uses more PFI to make up the numbers.

  Q235Lord Moonie: You have mentioned risk transfer. Surely the main problem now with major IT projects is the private sector will not accept transfer of risk? Thinking about Connecting for Health and the desperate attempts of the Government and the NHS to find some way of getting some sort of success out of it, some of the payments that have been promised to some of the companies involved in the London area seem fairly extreme.

  Mr Morse: The first thing to say about risk transfer in connection with PFI is that risk transfer in the PFI context generally does achieve some genuine assumption of risk by the private sector that endures even if there is a failure. What it does not do is to say that they will pay for all the costs of putting the project right beyond a certain amount. That is not going to happen. Generally if a project goes badly wrong the biggest counterparty in the situation ends up picking up the tab and most often that is the government because the government quite often is not well-placed to let the project completely fail for all sorts of reasons I will not go into just now, so you find that in the end, if you take Connecting for Health, to let Connecting for Health go completely would be very damaging for a number of reasons, and therefore you are left with a strong negotiating pressure on either side and generally the most substantial counterparty ends off having to provide financial support or let the project fail, so I think that does occur quite frequently. The other difficulty is that in order to really keep out of risk on an IT project the customer has to be very disciplined and not start modifying the requirements of the system. In my experience that is quite rare. Once the customer in process starts saying, "What if you did this? Could you do that?" and once you start interfering in the design of the system, so to speak, and not doing that in a very disciplined way, you start owning the problem and accepting (not deliberately) risk which can be brought back to you. So if you have a contractual fight, your position has been degraded significantly by all of that. I am afraid this is something that private sector companies, and from my private sector experience I am used to this, find difficult to manage and they are probably much more heavily gunned in terms of protecting their commercial interests than the public sector so it is something that needs to be very, very tightly controlled.

  Q236  Chairman: While we are on risk transfer and given that most PFIs involve some risk transfer, should liabilities arising from PFI projects be recorded separately in the accounts to other liabilities?

  Mr Humpherson: By and large they are actually. Funnily enough, just before coming here I was looking at HMRC's annual resource account and their PFI liabilities are clearly separated out. Indeed, they also give disclosure of the buildings that they occupy which are not on their balance sheet because the risk has been transferred to their private sector partner. In terms of the financial statement of individual entities of government departments, there is reasonably clear separation and disclosure in the vast majority of cases of which I am aware. I think there is a separate point which is how they appear in the national statistics, what are called the National Accounts, which are used to determine figures about GDP for example and public sector net debt and of course that is obviously a question for the statistician. We are an organisation at the National Audit Office which likes disclosure and transparency so I think the more that can be disclosed and the more transparent things are we would support that.

  Q237  Lord Moonie: So it is outside your vires but your personal opinion would be that it should be disclosed?

  Mr Humpherson: I think it must help the user of whatever set of statements to have that information separately identified. Just to be clear, in most of the financial statements that we audit there is fairly thorough disclosure which separates out the relevant bits.

  Q238  Lord MacGregor of Pulham Market: There are a number of specialist PPP portfolio investor funds. Do they bring benefit to the public sector and bring additional funding to the market, even indirectly?

  Mr Morse: I think the answer to that is they can be a good thing for the market but the risk that you have is that they will use their group capability to extract better terms for themselves and so far we have not seen that involving better terms being passed on to the public sector. So I think they are definitely realising benefits by being there but we have not yet managed to see really effective extraction of a share of those benefits back into the public sector. There are risks as well because when you find yourself with a strong consolidating counterparty they begin to be able to drive more consistently the deals that they will accept and they begin to dictate terms rather more so we could find ourselves facing tougher and more savvy counterparties as a result.

  Q239  Lord MacGregor of Pulham Market: Are there any problems about the risk having been transferred from the original provider to these funds and therefore there are difficulties in the acceptance of private sector risk?

  Mr Humpherson: I cannot think of a situation where that has been an issue. I think the short answer is no. It could be that there may be some examples of which I am unaware but I do not think the equity transfer of the shares is really perceptible at the project level. Maybe a letterhead changes perhaps but—


108   <ep<nh Examining the value for money of deals under the Private Finance Initiative (HC 739, 1998-99). Back

109   <ep<nh A framework for evaluating the implementation of Private Finance Initiative Projects (Report by the National Audit Office, 15 May 2006). Back

110   <ep<nh Having reviewed the evidence provided by the local authority witnesses referred to by Baroness Hamwee in Q233, we would like to add the following additional evidence: Back


 
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