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

Examination of Witnesses (Question Numbers 480-499)

Mr Adrian Ewer, Mr David Metter and Mr Paul Davies


  Q480  Lord Tugendhat: PFI is obviously firmly established in relation to physical assets, though given the constraints which are clearly going to apply to public expenditure over the next few years, do you think there is any potential for extending this form of operation to the provision of different sorts of service, clinical or teaching to take two examples, or any others that might come to your mind?

  Mr Metter: I think PFI is best suited to projects which require capital because there you get the benefit of the debt providers and the equity providers to create discipline on the contract, to make sure the contract works efficiently and that is what drives the efficiency. If one takes the capital away, for example in schools projects where it is just a refurbishment project and no new schools are built, or the moves for the NHS to put all the community workers in some kind of service company which the private sector then manages, I think those projects are more difficult. It depends whether you take the point that it is the finance which is providing the discipline on the contract, that is driving up the efficiency or whether without the finance you would still have the same ability from the various parties to drive the efficiencies. You could take the finance out and go back to traditional procurement and deal with the problems there where you have a public sector which is not really incentivised to drive efficiency. They might want to but actually when you get down to it, they are not personally incentivised to drive efficiency, particularly in the areas of procurement in the various departments. It has not previously attracted the best human resource. So you have this problem of how to drive the efficiency and PFI has enabled that driver to be taken out of the public sector into the private sector. If one does not take that point, then one can have service projects and the public sector can be the principal in the process.

  Lord Forsyth of Drumlean: I resisted the temptation to respond to your opening remarks about how PFI had been identified with the Labour Government. I think it was actually started by us and one of the reasons that I was very enthusiastic about it, even though on my birthday I had to open the Skye bridge with 1,000 demonstrators led by Robbie the Pict, was that you could actually go beyond simply transferring financial risk and in the example you gave of prisons, although you could not ask the private sector to take the risk for how many people there were in prison, you might be able to take the risk on how many people were released from prison and did not come back and the whole business of rehabilitation in prison and the running of the Prison Service. Prisons are not just buildings with facilities, they are places where people go and hopefully they are rehabilitated and do not come back. Therefore you could transfer that risk in that way. Similarly with the Skye bridge, the contractor was taking the risk as to the volume of traffic which would go across that bridge. As it happened, the traffic volume went up enormously because it turned out that quite a lot of people were not actually paying for the ferry which had been the previous method of crossing the waterway. Are you not being a little unambitious? This was originally sold as an idea which would enable a real transfer of risk in the provision of services and facilities. It is not just about financing. If you make it just about financing, it is much more difficult to justify.

  Q481  Lord Griffiths of Fforestfach: May I just add to that before you answer it? I always thought that PFI was really to take over where privatisation could not go. Nobody suggests that you should privatise all schools in Britain, whereas you can clearly privatise British Steel. The idea was that we get the resources, the innovation, the enterprise of the private sector into the public sector. I have to say, in a number of our sessions, I just wonder whether simply looking at the financing we are really missing this bigger picture which I always thought was effectively the case for privatisation in areas where privatisation could not easily be applied.

  Mr Metter: I agree with you but a lot of the boundaries are political. For example, there is a very clear boundary in the hospitals about what the PFI project can do. The PFI project does not get involved in medical services or nursing services or many pathology services, where it could. The PFI project could provide all the nurses; equally in schools it could—

  Q482  Lord Forsyth of Drumlean: Sorry to interrupt you, but you have said that it should not, in answer to Lord Tugendhat's point.

  Mr Metter: No, but if it were done as part of the hospital project. In a hospital project we have a project to build a whole huge hospital and we have a whole range of services which we provide which are what we call soft services, services like laundry, cleaning, food; many of the services which feed directly into patients are provided by PFI. A natural extension of that would be to provide nursing services, but that is a red line. Equally with the schools, there is no reason why some of the teaching could not go into the PFI project. On the roads there have been moves to make congestion reduction part of the payment mechanism and one could add other things on but it all comes down to how you measure it and what it is going to cost. Certainly we are not the drivers of that; we are responding to public sector opportunity.

  Mr Ewer: In theory you are right. There is no reason why the private sector could not embrace the provision of the service rather than just provide the hardware from which the service is delivered. I would agree with Mr Metter in terms of the politics around it probably being no, the private sector will keep its hands off the bit about delivering clinical services or teaching. There is no reason why we could not, as a private sector, include in our consortium an organisation which was providing teachers. What needs to happen there is that the public sector needs to be focused much more on monitoring and measuring outcomes and less fixed on the cost of providing the hardware which is where the fixation seems to be. I do not believe the public sector is doing enough to measure outcomes. If it were to look at schools which had been delivered under PFI, I think it would see the outcomes have improved as they do if you give teachers and students new facilities that they feel proud of, that they can breathe more in rather than facilities which are poorly maintained. Measuring outcomes is very important. If that is properly measured, I think the public sector might then allow the private sector to look at embracing the services side.

  Mr Metter: There are indirect benefits. I was up at one of our projects which is called Cathkin High School, which is a new secondary school in Glasgow. It is a brand new school in a very deprived area and this school is creating a social transformation in the area. Twenty-five per cent of the children who go to that school are socially deprived; they are not fed properly at home. So the school is actually providing them with a centre of improvement and improving their lives and actually, rather than being in a rundown old school, as they used to be, which was no better probably than their houses or some of the amenities they used, they have this new building which they are all very proud of. That is why I suggested earlier that it would be useful to visit some of these projects because one can see there is a huge social transformation going on in areas where new amenities have been built in areas which have been deprived. Hairmyres Hospital in Glasgow also. If one looks at what their hospital was like before and the kind of medical treatment people were getting compared with what they are getting now, one can see there is a huge case for ... I am not suggesting PFI. You could build these hospitals and schools using any mechanism you wanted to, but they do create an engine for social transformation. A new hospital in Walsall and the whole city is using it as an anchor for regenerating the whole city.

  Lord Levene of Portsoken: The point that Lord Forsyth of Drumlean was making was absolutely right. I remember when we started this whole thing it was under an initiative, which I am sure you will remember, called Competing for Quality. We had a lot of work, successful work, undertaken by companies like Serco and Capita which actually took on the whole responsibility for service, included in which may well have been the building, construction, modification of a facility. Within their contract they might go and raise the money separately but I am just wondering to what extent we have become a bit too fixated on where the finance is coming from.

  Q483  Chairman: We have missed an earlier question which we were really going to ask and you have come to it. Many of the benefits claimed for PFIs are not to do with the financing at all, but it is the fact that the private sector is actually doing the construction and doing the service stuff and that it is looking over the long term and you have bundled contracts. A lot of the pluses are there. Many of the detractors of PFIs have said that the main con, not one which you have mentioned, is the private cost of capital. Private finance is inherently significantly more expensive than if the Government were to raise the finance. One of the questions we wanted to put to you was whether it is possible to get your cake and eat it, in other words perhaps to have a national infrastructure bank which is able to take in money at government rates rather than rates which the banks themselves or private banks would produce and yet have the same contractual arrangements in terms of bundling, of long-term view, good due diligence and the provision of the services by the private sector. Is it possible to combine the two?

  Mr Metter: On the first point, which is this idea that the Government can do it more cheaply than the private sector because it can borrow more cheaply, I see that as a subsidy because there is a market price for this type of project, this package of buildings and services, which is driven out by competition. We have a competition and provided the competition is fair, it is going to drive out the market price. If the Government then go and choose to offer capital to this project at a lower rate than the market would command, it amounts to a subsidy because actually the project risks are the same. That is how I see it. So the Government have a policy choice. They can decide they are going to subsidise all these projects, they are going to borrow money cheaply in the gilt markets and they are going to pay for these projects. The second thing is that they then take on the responsibility for being able to deliver these projects on cost and on time. There is no or limited risk transfer there because it is dependent on contracts it has been able to negotiate with various contractors and because they do not have finance at risk as the government is paying them directly. If we go back to traditional procurement, it is getting back pretty close to that, I can tell you anecdotally, when I was a young engineer on the Thames Barrier 30 years ago where I used to spend my days, all I used to do was fill in claim forms. I was a graduate engineer on that site and my job was to fill in claim forms. That was how traditional procurement worked. There was a price but the contractors were not concerned about the price, they were concerned about the claims. The entire commercial activity was directed towards claims. The whole thing became very confused and that was why we went to PFI procurement. You can now unpick it and say let us take finance out and can we deliver these projects in the same way? First, the government departments would have hugely to staff up because actually one thing PFI does is to outsource a huge amount of intelligent procurement resource. Imagine the NHS, Department of Health, trying to procure 100 hospitals over the last 10 years. It would not be able to with its current staff. There are those issues: does it have the human resource, would that human resource be energetic enough to be able to deliver these projects? The answer ought to be yes, why should they not, why should a government department not be able to do this. The question is why they are not able to do this. It all has to do with productivity and why the public sector productivity is so low? I do not think anybody has been able to answer that question. In theory, I agree with you that you can take the finance out. I will just give you an example. We won a hospital project in Vancouver and the debt markets are currently very expensive as a previous witness said to you. With debt costing what it is costing today, the whole value for money equation changes. The Province of British Columbia was not prepared to pay the sorts of debt levels that were required so they have stepped in and put in the money themselves but they have left the equity in there because they want the equity to manage and take the responsibility for the project.

  Q484  Chairman: Yes, you might well have a hybrid.

  Mr Metter: That is the debt out of it and I agree with you that you might have to take the debt out of it if you want to go forward because the debt now is very expensive. The question is whether you chuck the equity out. That comes down to whether one believes in markets and the private sector.

  Q485  Chairman: That is another point and a very important point. I was particularly talking about the debt. Incidentally, when you were talking about risks, of course the risks of a project are inherently the same whether it is a publicly financed project or a privately financed project. The issue is who bears the risks. As you said in answer to an earlier question, at the end of the day, if you have a strategic asset like a hospital or school or whatever, then ultimately the Government, that is the taxpayer, bears the risks if there is some catastrophic failure. In banking format this is called moral hazard and in a sense there is a feeling that there is perhaps a little moral hazard associated with the PFIs as well. I come back to it. We had the European Investment Bank as earlier witnesses here and the European Investment Bank have just as good disciplines in terms of looking at projects as a normal bank would from the private sector. If you were financed by the equivalent of the European Investment Bank in the UK, like a national infrastructure bank, then on the face of it you could get the benefit of cheaper access to capital and all the benefits, including the equity incidentally, of private ownership and private operation of the project itself. Is that not so?

  Mr Metter: I agree with you but the Treasury have this bank at the moment called TIFU where they are leveraging Treasury money into projects where it is necessary. I think they are not cutting the price at which they are offering funding to the project, which is quite right. They are taking the margin themselves which is the right way to do it. Clearly they could offer a subsidy to the projects if they felt that was in the public interest.

  Q486  Lord Levene of Portsoken: You mentioned before that you were getting pension funds interested. How do you sell involvement in one of these projects to pension funds? What do you tell them are the attractions for them to become involved in the financing?

  Mr Metter: Firstly one should recognise that what we do in the equity capital markets is quite low risk in global terms. What we explain to pension funds or any investors who want to come into our funds is that we are involved in low risk infrastructure projects and what I mean by low risk is that we do not take patronage risk. We are not investing in projects where there is a usage fee, road tolls; there are many infrastructure projects where we do not do that. Our risk is whether we can build a project and whether we can deliver the service and then we get paid. That creates the risk profile and that is very attractive to many pension funds because many of the UK pension funds follow an investment process called liability driven investment. They have worked out what their long-term pension liabilities are and they need to finance those and matching PFI-type income helps them to do that. They are very keen on that. Our PFI income is also index-linked so in terms of smart pension funds, when they invest in our project they are effectively getting index-linked returns for 25 years which is very attractive to them.

  Q487  Lord Levene of Portsoken: May I ask Mr Davies a question? I have seen your CV. You mention the M25 road widening. How long ago was that?

  Mr Davies: It closed this year.

  Q488  Lord Levene of Portsoken: Was that a project which you started from scratch or which you took over? I am just interested to know how a large public sector project like that, which in the normal way would have been run by the private sector, would tend to run over budget and whether you took it on and from start to finish it ran to time or whether you had to do a lot to change it, just as an example.

  Mr Davies: By way of example. Yes, PwC advised on that; we advised the public sector, the Highways Agency, throughout the project. It started with us, sitting with them, working out exactly what—

  Q489  Lord Levene of Portsoken: How long ago was that?

  Mr Davies: About four and a half years originally, but the intensity of work grew over time. You decide with them what is affordable, exactly what outputs you require, you develop those into output specifications, you work out how you are going to approach the market and the contractual structure, then you invite bids and you have made sure that it was done in a way which would invite competitive bids. We had a number of bidders, narrowed it down to two and then finally chose one, the preferred bidder, and negotiated with them to financial close.

  Q490  Lord Levene of Portsoken: To get to the point we were just talking about, was it just to do the construction work or did it also encompass, for example, working with whoever was going to reorganise the traffic on there as part of the whole programme?

  Mr Davies: The whole programme. They are being measured on the construction, the operation and the efficient running of traffic during that period. For instance, if you are driving round the M25 you will see lane closures, you will see movement between lanes, all of that is part of their programme, they manage, they get rewarded if it is run efficiently and they get deductions if there is greater congestion and they do not do it efficiently.

  Q491  Lord Levene of Portsoken: Was it one contractor or a consortium?

  Mr Davies: It is a consortium.

  Q492  Lord Levene of Portsoken: And they performed more or less on time, did they?

  Mr Davies: Yes; so far, absolutely and they have taken over the full operation and everything worked. They did immediate clearance of the area and the evening of financial close they were on site doing it. So far yes; on time and on budget.

  Q493  Lord MacGregor of Pulham Market: A wind-up question. You heard what our previous witnesses said about the effect of the credit crunch and I wondered whether you could just project forward as to what you think the impact of the credit crunch will be on the long-term impact on funding of the PFI.

  Mr Davies: May I start and maybe talk about the M25 as an example?

  Q494  Lord MacGregor of Pulham Market: Are you answering the old question or the new question?

  Mr Davies: The new question.

  Q495  Lord MacGregor of Pulham Market: I have not finished the question.

  Mr Davies: I do apologise.

  Q496  Lord MacGregor of Pulham Market: I really want to address this to Mr Metter. I understand the point about LVI but my impression is that most of the LVI arrangements at the moment are with long-term gilts and long-term bonds and so on. I am not fully aware of the big impact of what you have been talking about for the pension funds. How is that being marketed at the moment? Do you see that as a way of overcoming any short-term difficulties with the bank market and so on?

  Mr Metter: I think we are going to go through a difficult period with PFI because I do believe it is driven by government will, ministerial will. They really have to want to build schools and build hospitals for some kind of political purpose and that gets the wave going. We see that in Canada now where they have overcome the problems. We do not have that at the moment. We have had a very slow deal pipeline for the last two or three years. There are not that many new UK PFI projects coming through. Then when you overlay the problems in the debt markets on top of that, it makes it even more difficult, particularly, as I mentioned earlier, as it is a trade-off between various stakeholders. For example, for equity, the new debt arrangements are very bad, these ideas of semi-perms and banks requiring really tough terms to provide long-term finance starts unpicking the equity investment case. There has been £60 billion of PFI projects and 90% of that is being provided by way of debt, that is about £54 billion. Long-term debt has been raised effectively by the Government in very, very strong credit markets, so the other side of the credit crunch has been that the Government have been able to raise the funding very cheaply. The banks have been providing debt at around about 50 basis points above the reference gilts for these projects. Today it is costing £350 basis points above the reference gilts so it is becoming much, much more expensive. The question now is whether 50 was the right price. It was a very good deal for the Government. If you look at the overall cost of capital for PFI projects, which is what people should look at, you will find that the overall cost of capital for PFI projects through the 10-year to 15-year period has been about the reference gilt rate plus about 1½-2%, depending on how you measure the equity return. The Government have been able to raise this money indirectly through PFI, lock it into these contracts and have the benefit of all the infrastructure in what, time will tell, have been very, very favourable terms. I do not think we are going to see this for some time. The question is whether this national investment bank might be the answer because they might be prepared to provide the debt to these projects on terms which mirror the terms that were previously available.

  Q497  Lord MacGregor of Pulham Market: Does that also mean you think it is going to be more difficult to market to pension funds?

  Mr Metter: We are quite a specialist fund manager and we do not market to our investors because we have got to know them over the years and we add new pension funds in. They have fairly sophisticated teams who are investing across the infrastructure area so that was tough for them as well. We find that with pension funds generally, most investors who we might go out to try to raise funds from today would find it very tough because they have lost so much money in the last few years.

  Q498  Lord Griffiths of Fforestfach: It comes down to performance indicators. You made a very convincing case that we should be broadening performance indicators to get at the final outcome. Mr Metter, you gave the example of this school in Glasgow and I am sure a new school has a terrific impact on the culture of a school. However, we might have some civil servant from the Department for Education come along with a very sceptical turn of mind asking whether we know, for example, the quality of entry of the pupils who come into this new school compared with what you are benchmarking it against or the quality of the teaching staff, whether that has changed, or the quality of the head or the senior leadership of the school that you have, if it is an academy, what role the sponsors play, the question is how difficult it is to isolate in the example of the school that you gave in Glasgow—and I believe it is clearly having a changed effect—the contribution of the building as opposed to all these other factors?

  Mr Metter: If you look, the general GCSE attainment has been measured and there has been a lot of improvement in PFI schools because we measure PFI schools, but actually it is probably also the case for any new school where children have a better environment. So how much extra is the PFI school offering? A lot of the PFI services are not interfacing with the children but interfacing with the staff at the school. Their lives are hugely improved and headmistresses and headmasters do not have to do all sorts of things they previously did. My guess is that it is the new school which is transforming the environment, so if you can get them a new school, that is 90% of the way there. We had a school in Aberystwyth and when they opened that school in Aberystwyth the Mayor of Aberystwyth said it was the best day in Aberystwyth's life since 1876 and they had been trying to get a new school for 125 years. Okay, maybe they said that to make us feel good but I think there was some truth in it. You just cannot get new schools. PFI has been able to deliver hundreds of new schools. It is changing now because Government are going soft on the Building Schools for the Future programme. It is now becoming the Refurbish Old Buildings project, not new schools.

  Lord Griffiths of Fforestfach: Aberystwyth is a master stroke in convincing us of the case.

  Q499  Baroness Hamwee: If you have figures which you think are valuable on the performance of the schools which you have been involved with or which have been produced by PFI, I would be very interested to see those, if that is possible.

  Mr Metter: May I once again invite you to come to visit some of our projects.

  Baroness Hamwee: We have heard that and I am sure the Chairman is going to discuss that with us afterwards.

  Chairman: We will draw a line under it now and thank you very much for your time with us and your obvious enthusiasm for PFIs. We have indeed noted your invitation, although I think you will find that around this table there is quite a bit of experience of PFIs in one fashion already. We will get back to you if we feel the need to follow that up. Thank you very much.

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