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


CHAPTER 2: BACKGROUND

TRADITIONAL PROCUREMENT

8.  In traditional public procurement, infrastructure projects were directly funded by the public sector and included in the definition of public sector spending. Once the completed project was handed over to the public sector client, the private contractor's involvement ceased. In the words of the Institution of Civil Engineers, "Traditional procurement models separate some or all of design, construction and maintenance of infrastructure projects" (p 312).

9.  Traditional procurement did not enjoy a high reputation for efficiency. Most witnesses drew attention to cost overruns and delays. As the LIFT Council put it, "… back when projects were traditionally procured, research undertaken by the Department of Health made clear that the vast majority of such projects were built late, with significant cost overruns and a high proportion ended up in court cases with contractors" (p 183). A study by Mott MacDonald of 39 large UK infrastructure projects procured by conventional means found that completion time exceeded estimated duration by 17%, while capital expenditure exceeded estimates by 47% on average.[1] Not all witnesses agreed: Professor Allyson Pollock of the University of Edinburgh said that, according to a study of 1999 on cost and time overruns in NHS estates "… there is really no evidence at all ... of poor [contract] performance" (Q 272). But this was a minority view.

10.  Imprecise definition by public authorities of their requirements was often at least partly to blame for poor procurement outcomes. Mr Steve Allen of Transport for London said that "one of the principal causes of cost overruns on public procurements is the procuring authority changing its specification repeatedly" (Q 378). Sir John Bourn took a similar view: "One of the major difficulties of the traditional, conventional procurement of projects—construction projects, defence projects and also, I would imagine, projects in the field of social welfare—has been the constant alteration of them and it is the constant alteration which accounted for so much of the delay and extra expense" (Q 364).

11.  We heard evidence that the public sector is seldom held accountable for shortcomings in public procurement projects. Dr Tim Stone of KPMG said "There are very few people in the system who actually understand the whole life consequences of decisions" (Q 3); "… the data around public services is shockingly poor" (Q 5); "Because the data is not there … the risks can be swept under the carpet when they go wrong" (Q 10). In the CBI's view, "Service failure is seldom quantified or penalised in traditionally procured, publicly funded services. The absence of rigorous evaluation systems limits the public sector's ability to assess the benefits of their investment in a number of areas, including how outcomes were achieved, whether benefits outweighed costs and if users were satisfied" (p 51).

12.  Many witnesses also took the view that in traditional procurement there was often inadequate provision for maintenance. The PPP Forum referred to "historically chronic under-maintenance and lack of investment" which "led to the severe deterioration of assets" (p 217), a view shared by Mr Allen, who said that "… all too often in a wholly public procurement you start off with an underestimated cost and the authority tends not to budget properly for maintenance of the asset over its life" (Q 377).

13.  There was a fall over many years in the share of national resources devoted to public investment. Public sector gross capital formation as a percentage of GDP fell almost continuously between 1975 (8.9%) to 2000 (1.7%). A significant part of this decline is explained by the sharp decline in local government investment between 1976 and 1982 and the impact on public corporation investment (as previously defined) in the 1980s as a result of the privatisation programme. However, central government investment also fell in the 1990s (1.4% in 1991 to 0.4% in 1999).[2]

14.  AGAINST A BACKGROUND OF SHORTAGE OF FUNDS AND DOUBTS ABOUT CONVENTIONAL METHODS OF PROCUREMENT, IT WAS CLEARLY IN THE PUBLIC INTEREST FOR GOVERNMENTS TO LOOK FOR NEW, EFFICIENT AND COST-EFFECTIVE WAYS TO MEET DEMAND FOR NEW PUBLIC INFRASTRUCTURE.

THE BEGINNINGS OF THE PRIVATE FINANCE INITIATIVE (PFI)

15.  Private finance projects, such as the Dartford Crossing and Second Severn Crossing, predate the PFI. From 1981 such private investment in public projects was governed by the Ryrie Rules which laid down that any privately-financed solution must be shown to be more cost-effective than a publicly-financed alternative, and that privately-financed expenditure by the nationalised industries could not be additional to public expenditure provision, which would be reduced by the amount of any private finance borrowed.[3] Any role for private finance in increasing investment in public infrastructure was thus ruled out and the benefits sought were mainly efficiency gains.

16.  These restrictions were largely removed by 1990. The Private Finance Initiative was formally introduced by the then Chancellor of the Exchequer, Norman Lamont MP, in the Autumn Statement of 1992. He stated that "any privately financed project which can be operated profitably will be allowed to proceed, … Government will actively encourage joint ventures with the private sector, where these involve a sensible transfer of risk to the private sector" and "public organisations will be able to enter into operating lease agreements with only the lease payments counting as expenditure and without their capital budgets being cut".[4] The scope of private finance to increase investment in public infrastructure was thus recognised. By 1994 the Government explicitly acknowledged that "the private sector's contribution is additional to public provision",[5] and the Chancellor stated that private sector finance would be the main source of growth in public investment.[6] Thereafter Treasury approval for public-sector funding for capital projects was not usually forthcoming unless private finance options had been explored and found uneconomic. This institutional bias in favour of private finance has continued in various forms under successive Governments.

17.  In PFPs, building contractors, facilities managers and service providers typically form a consortium and take shares in a Special Purpose Vehicle (SPV) which signs the contract with the public authority. It usually brings together construction with maintenance and certain services ("bundling") which the SPV undertakes to provide over a long period such as thirty years ("whole life"), in return for fixed annual payments starting when construction is complete. The SPV, which retains ownership of the building, finances its construction by borrowing (usually 85-90%) and owners' equity (10-15%).

18.  Relatively few PFPs were implemented before 1997. No long-term PFP has yet run its course.[7]

EXPANSION OF PRIVATE FINANCE PROJECTS (PFPS)

19.  After 1997 the Labour Government accepted that private finance should continue to play a role in provision of public infrastructure and set up a Treasury task force to encourage what were now known as Public-Private Partnerships (PPP). With the Government's support, the number of deals increased sharply, so that by 2009, as Mr Joe Grice of the Office for National Statistics told us, there were "… approximately 800 or so PFI/PPP schemes in being, and the capital value is something of the order of £64 billion" (Q 135). Despite rapid growth, PFI/PPP projects still accounted for only 10-15% of local authority capital investment over the last five years (Mr Richard Buxton, Local Partnerships, Q 79). In some sectors, however, PFI's share of investment is clearly higher: Ian Pearson MP, Economic Secretary to the Treasury told us that "... 70% of hospital schemes have been delivered by PFI; round about 60% of new schools have been delivered through the PFI group" (Q 592).

20.  The PFP model has also been used by organisations outside the public sector to finance major new building and renovation projects of housing associations. In such cases there can be no benefit in terms of the level of public sector debt since borrowing by housing associations does not count as public spending. But as well as sharing the other benefits and drawbacks—attributed to PFP—use of this model enables housing associations to finance developments off their balance sheets and thereby to extend their work without reducing the security they provide for other borrowing.

21.  The rapid growth of private finance projects over the past decade or so is striking and has played a significant role in the expansion and renewal of the nation's infrastructure.

IMPACT OF THE CREDIT CRUNCH

22.  The impact of the banking crisis in 2008 was bound to affect the supply and cost of private finance. In 2009 the value of completed PFI/PPP deals is reported to have been £4.24bn, the lowest annual total for a decade.[8] Mr Adrian Olsen of Bank of Ireland told us that "… the shortage of both capital and liquidity … has had a significant effect … on the availability of bank debt" (Q 420). At the same time, the prospective squeeze on public expenditure will also reduce the funds available for public infrastructure projects.

23.  The Government set up the Treasury Infrastructure Finance Unit (TIFU) in March 2009 to lend to private finance projects struggling to raise funds from commercial banks.[9] By the end of 2009 TIFU had only made one loan of £120 million to the Greater Manchester Waste Disposal Authority's PFI project. However, the PPP Forum welcomed its creation, saying confidence had been bolstered "simply by its existence". The availability of commercial lending to some projects "has been due in some part to the backstop that TIFU provides … allaying funding concerns that might have otherwise stalled deals" (p 221).

24.  Despite the scarcity of private finance, there are few advocates of a return to the old system of public procurement in those sectors where PFPs prevail. But PFP payments are contractual commitments and, as public spending is constrained, could have an adverse impact on the budgets available to public authorities for other, non-PFP, expenditure. They could, for example, exacerbate any budgetary pressures arising from unforeseen bunching of commitments and demands in a given financial year. The Government should monitor and control year by year the impact of PFP commitments on the budgets of Departments and public authorities with a view to ensuring that delivery of essential public services in future years is not unduly constrained or jeopardised by such commitments.


1   Grimsey, D. and Lewis, M., Public Private Partnerships and Public Procurement, Agenda, 2007, Volume 14, pp 171-188.  Back

2   'Trends in Public Investment', Tom Clark, Mike Elsby and Sarah Love, Fiscal Studies, 2002, vol 23, no 3, 305-342. Back

3   PA Grout, The economics of the private finance initiative, Oxford Review of Economic Policy, 1997; vol 13 pp 53-66. Back

4   HC Deb 12 November 1992 col 998. Back

5   Financial Statement and Budget Report, November 1994, cited in John Hall, Private Opportunity, Public Benefit, Fiscal Studies,1998, vol. 19, no. 2, pp 121-140. Back

6   HM Treasury, Private Finance: Overview of progress, News release 118/94, 8 November 1994 which was cited in House of Commons Library Research Paper, The Private Finance Initiative (PFI), 18 December 2001. Back

7   The Skye Bridge PFP was bought out by the Scottish Government in 2004. Back

8   "Financial Times", PFI feels the pinch, 15 January 2010. Back

9   HM Treasury, The Infrastructure Finance Unit (TIFU) available at
http://www.hm-treasury.gov.uk/ppp_tifu_index.htm 
Back


 
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