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


Examination of Witnesses (Question Numbers 240-259)

Mr Amyas Morse and Mr Ed Humpherson

3 NOVEMBER 2009

  Q240  Lord MacGregor of Pulham Market: But all the contract requirements remain the same?

  Mr Humpherson: Absolutely, in every case that I can think of. It is worth saying just as an additional point that there are direct benefits to the consolidating firm. They can extract economies of scale and they can manage their contracts in a more consistent way, and those are things which are not open directly to the public sector, which is why we have put so much emphasis on the public sector exerting whatever information powers it has to gather information across all of its projects and exert the counterweight. There is an indirect benefit which is worth touching on of this transfer of shares which is that it shows to future projects—a construction firm for example thinking of investing in a future project—that there is an on market for its shares if they want to exit. It gives them some confidence and that indirect benefit must be good for the public sector.

  Q241  Lord MacGregor of Pulham Market: And could bring additional funds too?

  Mr Humpherson: Exactly.

  Lord MacGregor of Pulham Market: You have answered the second question I was going to ask.

  Q242  Lord Eatwell: Could I just follow up on that. The experience in financial services is that this is disastrous because the initiator of the contract, knowing that they can exit, is less responsible about the commitments they make in the contract. That is exactly what happened in the sub-prime mortgage case. Given these possibilities of exit that you have described, and a reasonably competitive environment, are you not then going to get rather less responsible tendering?

  Mr Humpherson: I think in the financial sector what people were worried about was the slicing and dicing of risk into ever smaller packages such that the originating risk is so far away from the person who holds it through a very long chain of bonds, into CDOs, in CDO- squared that you lose sight of it. Actually the opposite of slicing and dicing is what we are talking about here—I do not know what the culinary metaphor would be—you are congealing because you are bringing together a whole series of separate contracts under one house.

  Q243  Lord Eatwell: But the initial person has an exit possibility so therefore they are no longer responsible for the terms of the contract which they have negotiated. They have shifted the responsibility and sold it on.

  Mr Humpherson: Yes, but I do not think it was the shifting of responsibility that has been the concern in the financial sector; it is the slicing and dicing of the responsibility.

  Q244  Lord Eatwell: It certainly has. Leaving the comparison with the financial sector aside, you used the term "exit". You have somebody who is tendering for a contract who can then exit from the responsibility of fulfilling that contract and therefore it seems to me less obvious that they would be fully committed to a responsible tender.

  Mr Morse: Forgive me, it is not necessarily so in the way these deals are put together that all the people who are shareholders are actually involved directly in delivering it. They are parties to the contract as shareholders but they are not necessarily the body that is delivering an element in it, so supposing you were talking about the construction of a piece of defence equipment, there would be a particular party that was constructing that defence equipment. A change in the shareholding will generally not release them from their obligation to construct that piece of equipment so it is a more complex contractual structure.

  Q245  Lord Eatwell: The party taking the ultimate risk has changed.

  Mr Morse: I am not sure that is necessarily true.

  Q246  Chairman: Can I explore what Lord Eatwell is saying. We have had witnesses who have claimed that one of the benefits of PFIs has been the detailed scrutiny of the initial creditors, made not just at the initial tender but of the contract over time. That has been an additional discipline that has been of use to the PFIs. That discipline presumably could be at least watered down if not disappear if you securitise the PFI things themselves; is that not right?

  Mr Morse: Securitisation is a bit different from somebody succeeding to a shareholding. Just to say though if that means that somebody is prepared to pay for it, presumably there will be some conditions as to who then should be a credible or acceptable shareholder, and in most PFI contracts I have seen (I have not seen a vast many but I have seen a fair number) there is some approval process on the part of the customer, which is let us say the government, as to whether it can be just anyone or it has to be someone who brings something into the contract. If that is so, then to take on a contractual liability, unless there is in front of you a delivery contract or a construction contract or something like that where that liability sits with a particular party, this is the discussion we were having before, in other words, let us say we are talking about constructing a ship, something I know a bit about, you would have a contractor who was constructing the ship and then you would have various parties who would be involved as shareholders, not necessarily all constructing the ship. The ship construction contract will be placed separately and these shareholders would be above that, so I do not think the fact that you might have a change in shareholder would change the risk of constructing that asset successfully.

  Q247  Lord Eatwell: In this case we are talking about something different. We are talking about PPP portfolio investor funds. The whole point about such a portfolio is that you bundle together a series of projects believing that diversification in projects reduces the risk in investing in the project as a whole. The experience of those sorts of securitisations is that the due diligence, if you like, of the buyer portfolio is not the same as somebody who makes the initial investment and is totally committed, so in fact diligence disappears or fades, let us say, or evaporates on two levels: firstly at the initial contract and secondly on the due diligence of the investor.

  Mr Humpherson: I feel we could go round this for several hours. Just to be very clear on our view, we are not free of concern about these consolidations of ownership, but our greater concern is that it creates a sort of asymmetry of commercial power between the atomised public sector on the end of a whole load of individual contracts and a concentrated private sector. We have thought a little bit about the risk that you raise and if there was evidence that there is deterioration in the due diligence that would indeed be a concern but on the basis of the evidence we have seen it is not the thing that worries us most.

  Q248  Chairman: This is an area of obvious interest to the Committee. Would it be reasonable to ask if you could give us a little note on that? We would find that very helpful.

  Mr Humpherson: Absolutely, we are happy to do that.

  Q249  Lord Tugendhat: Could I ask a completely different question. We have had a lot of talk in all the sessions about capital projects and that is really what it has been about, but the CBI has raised a question as to whether you could not use private finance to deliver services. They have thought about teachers and nurses and that obviously is a very different ballgame, but what would be your views on that?

  Mr Morse: I think the answer is it is certainly feasible to do it and if you look at some of the contracts that exist now, let us say the prison contracts, they are contracts with a large service element, so if you say do they have to involve the construction of prisons, well, actually that is not absolutely essential to organising and running a prison and providing what they probably would provide, which is systems to support a way of working which were somehow different to those which were traditionally imposed under prisons, so what you see if you actually go and look at any PFI prison is that it is organised somewhat differently to traditional prisons. There is some investment and then there is a new way of working and possibly rather more differentiated pay scales, and so I think using people and using systems differently to deliver is perfectly possible. Because of the fewer front-end costs element in that I would say it does not necessarily require the formality of a PFI contract in order to make that work.

  Q250  Lord MacGregor of Pulham Market: Is that not quite close to outsourcing of the service?

  Mr Morse: Yes, it is quite close.

  Q251  Lord Tugendhat: But I think it is different from outsourcing because coming back to the hospital experience I mentioned earlier it seems to me it is one thing for a hospital to make use of agency nurses and nurses from different places because they then have to fit in with the rules and the spirit of the place where they are working, but like a private military company, as it were, if you went to Nurses Incorporated who provided you with a whole batch of nurses on a contract for a given period or for a given function, they would have a corporate culture and a set of corporate loyalties and promotion ladders and so forth which would be different from the place where they were working which is not the case with outsourcing.

  Mr Morse: That is fair but again just to come back to the prison example, which is quite a concrete example, what is very clear is the criteria under which it is run. That is something that is being run by the private sector but under very strong standards and criteria not set by the private sector. What you find then is that the public sector is in a detailed regulatory and standard-setting role, not in the role of directly providing the management. If you want to go down that road the public sector does not disappear from the picture. It has to be very specific about what it wants if it is going to be able to contract that way and get consistent service.

  Q252  Lord Tugendhat: Correct me if I am wrong but my impression is that you have a private sector prison and it has all the warders and all the staff and so forth. There is not within that prison a mix of the private sector employees and regular prison officers.

  Mr Morse: I just do not think I can speak with certainty about that, to be honest with you.

  Mr Humpherson: I think it is a fascinating question, the supply of labour as opposed to the supply of an asset supported by labour, and you have mentioned nurses or teachers. One also perhaps thinks about the social care sector. It is a fascinating question. To answer it, I think it is probably a good idea to go back to first principles and say could those contracts be provided under a PFI-type of arrangement? I suppose our first principle in PFI is that there is a reasonably predictable fixed and definable public sector requirement, for the reasons that Amyas has suggested, and if you think there is going to be any change in the requirement over the term of the contract it is probably not a good idea to enter into what is essentially a fixed price arrangement with commitments for the long term. On top of that PFI can, but does not always, bring the benefit of innovative management approaches, a degree of risk transfer and due diligence at the outset so that the contracting parties look at the risks and very carefully allocate them between themselves and those taking the risks on the private sector side and also some kind of whole-life consideration embedded into the contract at the outset, a credible commitment as we were talking about earlier. If you think about those principles of PFI and how many of them might apply to the PFI supply of labour as opposed to labour embedded with an asset, I am not entirely sure. Obviously you would have to be sure that the requirement was fixed for the term of the contract and I guess that is something the procuring authority would know. Perhaps you can get innovative management but the benefit of risk transfer and due diligence and the whole-life maintenance seem to be concepts that do not quite fit with the scenario. I suppose my answer is by all means consider some form of medium-term contracting for the provision of labour services but do not take lock, stock and barrel the PFI model which has the specific characteristics which are designed really for the problem it was created to resolve.

  Q253  Lord Eatwell: Coming back to a bit of an old chestnut here which is that several people have commented on the way in which the development of PFI contracts has had an impact on traditional procurement and traditional procurement techniques have improved side-by-side. If that is so, is the optimism bias added to public procurement now outdated?

  Mr Morse: I think we have always been professionally sceptical about it, and I heard some of the remarks that were made earlier and saying let us assume there is a bias and just put it in. No, we would look at every project on its merits and look at the quality of evidence and, as I said at the beginning, insist on rigorous evidence and evaluation rather than saying let us assume that there is optimism there. So (i) we do not think that it was appropriate in the first place and (ii) yes, I think things have been learned, but you are still left with the point that you do not have the degree of protection from summary decision-making. I have seen PFI contracts being put in place alongside non-PFI contracts for the same amount and value and, generally speaking, there is a much more deliberate approach to evaluating risk in PFI than in non-PFI. It cannot possibly be because people do not realise what is happening with PFI contracts because they have quite often been working on them so it is more that you just do not have a shortcut option when you are doing PFI because you have to convince the outside financing counterparties that all the risks have been understood and nailed down tightly. It is very difficult to reproduce that degree of discipline and not be bounced by impatience in the public sector without contractual protection. I think that while it has improved the degree of deliberate due diligence and discipline that is associated with it, it is always going to be a bit more difficult to sustain.

  Q254  Lord Moonie: Just a slight variant on that as a cynic. Surely optimism bias is something that has been introduced to the figures to ensure the public sector do not win the business?

  Mr Morse: I could not possibly comment!

  Q255  Chairman: Can I put the question slightly differently. Have you had a chance to look at how many PFI projects would have failed to come forward had the optimism bias not been there?

  Mr Humpherson: Could you take me through the question again please.

  Q256  Chairman: I will repeat it in slightly different words. If you took the optimism bias out of the calculations how many projects which essentially became PFIs would not have got over the hurdle?

  Mr Humpherson: Optimism bias has been a crucial contributor to the PFI net present value being lower than the public sector comparator net present value in a very large number of cases we have looked at. Indeed, what we have tended to see as a general rule is two numbers clustering quite close together so if you took the optimism bias out of one of them it would make the public sector comparator lower.

  Q257  Lord Eatwell: Higher not lower.

  Mr Humpherson: The PFI NPV would be higher, you are quite right, thank you for that correction. Does that mean we believe that those deals would therefore have failed the value-for-money test? No, because we have always felt quite consistently probably from the first report we ever wrote on this back in the 1990s, that you should never regard the public sector comparator as a pure pass/fail test and the only arbiter of value for money because there are so many more aspects to value for money than simply comparing a deal in front of you to sign with your hypothetical estimate of what it might cost. You need to be sure that the costs being proposed by your private sector contracting party are reasonable costs on their own terms. You also need to be sure that you have a long-term need for the asset. All of those sorts of things are absolutely crucial. The direct answer to your question is that the optimism bias does shift the numbers.

  Q258  Chairman: I want to be absolutely sure. Had there been no optimism bias then there would probably have been far fewer PFI projects? Is that right? Is that what you are saying?

  Mr Humpherson: That is a counter factual that I cannot answer. What I can say is if you took the optimism bias out of the number the PFI net present value would be higher than the public sector comparator so it would look as though PFI was more expensive, if I can put it bluntly. However, I am not going to say that would have meant fewer PFI deals would have been signed because I think the reasons for signing PFI deals, whether they are value for money or not, is more than just a contract versus a model.

  Q259  Chairman: So other reasons would have been brought to bear to make sure these were PFIs rather than ordinary public procurement?

  Mr Humpherson: I think the procuring authority would look at a wide range of sources of assurance. At least that is what we would expect them to do. One thing is this public sector comparator: how much would it cost us to do it conventionally. Another would be are we sure that we need this service for the amount of time and we are not tying ourselves into something which we are going to then regret as we need to unwind it? That is valuing flexibility. Another is looking at the costs proposed in the model put forward by the contractor. The contractor is saying we will provide you the hospital or the prison or the school or whatever for a fixed price, and you have to be absolutely sure that those fixed prices are fair and reasonable and, just as you do in any contract, you would say is this what it should cost.


 
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