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



CHAPTER 3: FINANCIAL FRAMEWORK OF PRIVATE FINANCE PROJECTS

Value for Money test

25.  The cost of financing a project by traditional procurement will inevitably be less than the cost of private finance—the Government can borrow at a lower rate than can a private sector entity. Hence the economic case for private finance projects must rest on achieving better value for money either through cost savings in the management of the project (including more efficient recognition of lifetime costs and risks), or through the delivery of a qualitatively superior project.

26.  When assessing the procurement options for a given project, public authorities are required by Treasury guidance (the "Green Book") to make estimates of the costs of undertaking the project by the private finance route and by traditional procurement, so as to help determine which is better value for money.[10] The estimated cost imputed to procurement of a given project by traditional means is known as the Public Sector Comparator (PSC). Three key factors in determining the cost estimates of private finance and traditional procurement are outlined below.

COST COMPARISONS

i) borrowing costs

27.  Financing costs are an important difference between private finance and traditional procurement routes. Private finance projects are usually financed with high levels of debt, at risk in the event of failure (Olsen Q 459), which cost more in interest than Government borrowing through gilts, which takes no account of project-specific risks.

28.  The cost of debt for private finance projects pre-credit crunch was typically about one percentage point (60-150 basis points) above the nominal cost of government borrowing (NAO, p 87). Mr David Metter, PPP Forum, suggested that the overall cost of capital for PFI projects over 10 to 15 years had been about the reference gilt rate plus one and a half to two percentage points (Q 496).

29.  Publicly financed procurement benefits from the lower rates of interest at which the Government can borrow. In PFI projects the private sector aims to make up for higher borrowing costs by taking on, pricing, and managing project risks more effectively.[11]

30.  Even though the cost of debt in private finance projects will usually be higher than under traditional procurement, this factor alone does not rule out the use of private finance. The higher cost of debt reflects risks carried by the private sector and a margin for profit. And, apart from bearing risks that would otherwise fall to the public sector, private finance can offer other advantages over traditional procurement to offset the higher interest rates. We return to these potential advantages in Chapter 4.

ii) discount rates

31.  The capital costs of most projects under conventional procurement are paid in the first few years. In PFPs the costs to the public sector are deferred then spread over many years. In standard business practice, costs due to be paid in future—whether capital or revenue—are "discounted" relative to costs to be paid today. The later a cost falls due, the more it is discounted. When public authorities evaluate the relative merits of procurement routes in accordance with Treasury rules, they add up the discounted costs imputed to each year of a PFP to obtain its whole-life Net Present Value (NPV) (or notional cost), which can then be compared with the NPV imputed to the same project if undertaken by conventional means. The rate of discount applied plays a vital role in the outcome of the comparison: a higher rate makes the private finance NPV seem less.

32.  HM Treasury maintain a generic single discount factor, traditionally called the test discount rate, to be used by government departments to appraise policies, programmes and projects. Historically it was mostly used to decide whether or not to undertake public projects and which technique would be best. It has increasingly become important in helping decide between private and public provision. In April 2003 the standard Treasury discount rate was reduced from 6.0% to 3.5%. This was part of a process to achieve greater recognition and transparency of risk by accounting for it in expected cash flows. [12]

33.  Other things being equal, the reduction of the discount rate might have been expected to increase the NPV (or notional cost) of private finance options relative to conventional procurement and to tilt the balance more towards the traditional path as public authorities weighed their procurement options. But in practice the change seems not to have reduced the use of the private finance procurement route. This was in part because of a new emphasis on risks in traditional procurement, including the attribution of "optimism bias" to expected cash flows in the PSC, so that in many cases the overall appraisal has continued to favour private finance projects.

iii) optimism bias

34.  Calculations of costs imputed to a PSC are required to include an optimism bias (NAO, pp 127-129), which assumes a tendency to unwarranted optimism in cost estimates under traditional public procurement. The estimated cost by the traditional procurement path is raised by a percentage and the resultant higher figure is the PSC compared to the private finance cost of the project. The Treasury advises public authorities to generate their own estimates of optimism bias based on their own experience, and sector-specific studies.

35.  The optimism bias figures employed in PSCs are significant. For example, the NAO pointed out that the PFP for GCHQ's new headquarters project relied solely on the highly uncertain assumption that procurement by conventional means would have over-run its budget by 24 per cent and expressed scepticism about the uses of optimism bias (p 129). Dr Chris Edwards, University of East Anglia, said: "The average runover in 2002 was running at about 13 per cent for fairly routine projects like general hospitals, and since then it has actually been reduced" (Q 297). Mr Ed Humpherson, NAO, told us that "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" (Q 256).

36.  The NAO is sceptical about optimism bias uplifts in the context of Public Sector Comparators and about applying optimism bias solely to estimates of public sector costs. The projected costs of private finance projects may also be subject to optimism, although not necessarily at the same level as in conventional public sector procurement, and in practice any overruns would normally be met by the private sector.

37.  The addition of optimism bias may in many cases have had the effect, even at reduced discount rates, of tilting the comparisons of net present value which public authorities have to make, in favour of PFP and against conventional procurement. We recommend that, in order to reach a fairer basis of comparison, where a percentage uplift for optimism bias is added to the estimated Net Present Value of Public Sector Comparators, an appropriate rate of uplift should also be added to estimates of the NPV of the cost to the client under PFP.

Limitations of Value for Money test and Public Sector Comparators (PSCs)

LACK OF INFORMATION ON PUBLIC SECTOR COSTS

38.  Witnesses emphasised the lack of data on traditionally procured projects necessary to make realistic value for money comparisons with private finance projects. Mr Olsen said: "I simply do not have enough reference data to compare it [private finance] with the traditional procurement method" (Q 429). The Lift Council wrote that "it is a challenge to compare the costs, performance and quality of [private finance] projects and those procured using public capital as the data for the latter group is historic and some costs, e.g. on-going maintenance and life-cycle, simply do not exist" (p 183). Similarly, Dr Stone stated that "there is very little useful data about conventional procurement" (Q 1).

39.  The NAO view is that: "We have yet to come across truly robust and systematic 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" (p 80). They also point out that "the main reason that we have not seen such costs comparison is because departments do not collect data on whole-life costs of projects in a systematic way:

  • Central Government rarely collects data from Local Government funded projects or devolved funding.
  • PPP costs are rarely collated centrally, and where they are, they are hardly ever updated for contract variations.
  • The costs of ongoing services for conventionally procured buildings are rarely monitored, making whole-life costs very difficult to compare.
  • Different procurement routes collect data on different bases" (NAO p 105).

40.  It is difficult to compare whole life costs because PFP costings include maintenance and other services over many years while costings of conventional procurement generally do not. We recommend that, in order to make possible proper comparisons between privately-financed and traditional procurement, the Government should collect on a whole-life basis cost data on some comparable traditionally-procured projects. Better data would help public authorities achieve good value for money, the main criterion of successful procurement.

HOW ROBUST ARE VALUE FOR MONEY TESTS?

41.  In the NAO's view PSCs "cannot be relied upon as a sole source of assurance. They are susceptible to manipulation" (p 102). Mr Humpherson added that "you should never regard the PSC as a pure pass-fail test and the only arbiter of value for money" (Q 257). The NAO also took the view that "financial modelling is error-ridden and given undue influence" in the choice of procurement route (p 102).

42.  Dr Stone said value for money tests omitted potential benefits from delivering the project earlier by the PFP route: "The assumption is that however you deliver the service, the service and benefits to society will be identical, but if you deliver a new hospital or a new school earlier than would otherwise be the case I would contend that there are social benefits from that that matter and those are not measured. We assume that the results are unvaried and I think that is plain wrong" (Q 13).

43.  Mr Humpherson emphasised that deciding which procurement route to take is "more than just a contract versus a model" and that the procuring authority is expected to look at a wide range of other factors, some fairly subjective, in addition to cost, such as assessing and valuing the flexibility of the different procurement options, and whether the public authority is absolutely sure that the prices quoted by the contractors are fair and reasonable (QQ 258-260).

44.  A Value for Money test based on imputed costs of a Public Sector Comparator (PSC) should be a useful tool in assessing the relative costs and merits of private finance and traditional procurement. But its value is limited by shortage of relevant data and by the selective inclusion of optimism bias. Even if these deficiencies were addressed, as we recommend above, public authorities should not rely solely on PSCs when choosing a procurement route.

A National Infrastructure Bank?

45.  Commercial banks are not the only source of finance for Private Finance projects. The Treasury Infrastructure Finance Unit (TIFU) was set up last year (cf. paragraph 23 above). The European Investment Bank (EIB), which lends on a not-for-profit basis, and has AAA status, is a very significant finance provider and has lent €3-4bn. of funding for PFPs in the United Kingdom since 2005. The financial crisis has increased the EIB's attractiveness as a source of funding for PFPs and it committed over EUR 1bn in 2009 to projects in the UK (p 16).

46.  The role of the EIB raises the question whether Private Finance Projects might benefit from the presence in the market of other providers also able to offer keenly competitive finance at commercial standards of rigour and due diligence. Asked if there might be a role on these lines for a National Infrastructure Bank (NIB) in the United Kingdom, Mr Simon Brooks of the EIB replied that "nobody in Europe needs to introduce a NIB because they have got us!" (Q 75). In reply to a similar question, Mr Paul Davies of PwC saw value in an NIB which complemented the market on the lines of the Treasury Industry Finance Unit (TIFU) or acted as a relatively economical lender alongside private sector banks. But an NIB designed to crowd out private sector lenders could deprive the market of well-honed skills (p 234).

47.  The Economic Secretary to the Treasury said he was "very interested in the idea of a national infrastructure bank" and referred to the recent announcement of the setting up of Infrastructure UK[13] "looking at ways in which infrastructure can be financed" (Q 619).

48.  One role for a National Infrastructure Bank might be to help channel pension fund finance into infrastructure projects, which could fit well with the funds' longer-term liabilities. The scope seems significant. A report by the OECD[14] estimates that $500billion worldwide could be invested in infrastructure if 3% of total global funds held by pension funds could be accessed (Ms Kate Mingay, Department of Transport, supplementary evidence, p 249). A non-profit investment bank could attract pension funds by offering an option in addition to gilts and long-term private sector investment.

49.  There may or may not be enough lenders in the market already to finance public infrastructure, even in a period of restricted credit such as we now face. It is too early to tell whether the Treasury Infrastructure Finance Unit (TIFU) will bridge the gap. The pros and cons of establishing a National Infrastructure Bank should be kept under review.

Off-balance sheet treatment of private finance

50.  There has long been controversy about the treatment of PFP liabilities in public accounts. Public bodies are expected to choose the best procurement route to deliver public service and good value for the taxpayer. But many witnesses said the reality was very different with the choice substantially skewed by institutional bias towards PFPs, often, in their words, the "only game in town".

51.  Sir Peter Dixon, University College London Hospitals, said of PFPs: "In health … for the last ten years it has been the only source of finance and therefore one has used it." He added: "Where local government did use PFI for housing improvement, it was typically because they had no other source of capital funding" (Q 310). The Foreign and Commonwealth Office reported: "We specifically would not have had sufficient capital funding to build the Berlin Embassy without PFI" (p 303).

52.  Many witnesses believe that the Government prefers PFP because many PFPs have been off public authorities' balance sheets on the grounds that the balance of financial risk was with the private sector (Centre for International Public Health Policy at Edinburgh University p 132, BMA p 254).

53.  The National Audit Office concluded: "Public authorities often have no alternative source of funding and feel pressured to use private finance because its treatment in financial accounts and budgets make it seem more affordable from the public authority's perspective." The NAO found this not only affected how a project was funded but often led public bodies to "shape the project to ensure it is off-balance sheet" (NAO p 86, p 95).

GOVERNMENT AND NATIONAL ACCOUNTS

54.  Accounting rules consistent with UK GAAP (Generally Accepted Accounting Practice) are used by economists to determine how PFPs are treated in the National Accounts, which cover the entire economy and include Public Sector Net Debt.

55.  Until April 2009 UK GAAP was used by accountants to put together public sector financial accounts. So, until April 2009, a PFP was recorded the same way in both the public authority's financial accounts and the National Accounts.

56.  UK GAAP only included the liabilities if the balance of risk and reward was with the public sector, and excluded them if the balance of risk was deemed to be with the private sector. Interpreting the balance of risk was left to individual public bodies and their auditors. This led to most PFP deals being off-balance sheet. Around 78% (£22 billion) of operational PFPs in England by capital value are not recorded on the balance sheet of public sector financial accounts and are thus excluded from the Public Sector Net Debt statistics part of the National Accounts (NAO p 95).[15]

57.  From April 2009 departments are required to issue accounts using IFRS (International Financial Reporting Standards). Under IFRS those assets which are controlled by the public sector—which include most PFPs—will be brought on to the departments' balance sheets. The IFRS criterion of control differs from the UK GAAP criterion of risk; thus the department accounts and National Accounts will conflict.

58.  To resolve this conflict the Treasury has decided that departments should also produce a second set of accounts in line with the old UK GAAP basis which will be consistent with the National Accounts. The NAO said, therefore, that they "expect that ... the majority [of PFPs] will not be included in statistics of Public Sector Net Debt" (NAO pp 95-100).

59.  There should be greater clarity about financial liabilities arising from PFPs. The Treasury's requirement that departments should run two sets of accounts, though an understandable response to the use of one accounting system within departments and another nationally, is far from ideal. Furthermore, national accounts solely on a UK GAAP basis give a misleading picture of overall liabilities by excluding most PFPs from figures of Public Sector Net Debt. We recommend that the Government should publish figures for total liabilities for privately-financed public sector procurement as a separate item alongside figures for Public Sector Net Debt. Brief statistical information should also be supplied as to the distribution of these liabilities across a series of separate categories that reflects differences in the extent of risk transfer away from the public sector.

60.  Inclusion of PFP liabilities in Departmental balance sheets, as now required, together with publication of aggregate figures of national PFP liabilities, as we now recommend, should provide a clearer picture of their economic significance. The motive widely imputed by witnesses to the Treasury for its perceived bias in favour of PFPs—their low profile in accounts—would also fall away.

61.  We recommend that, subject to the need to maintain control of public spending, the Government should take measures to remove institutional bias in favour of private financing of public procurement, so that public authorities can select it, or another procurement method, on a case-by-case basis according to value for money.


10   HM Treasury, The Green Book-Appraisal and Evaluation in Central Government, available at http://www.hm-treasury.gov.uk/d/green_book_complete.pdf Back

11   HM Treasury (2003), PFI: Meeting the Investment Challenge. Back

12   The reasons for the change in discount rate are outlined in HM Treasury (2002), The Green Book-Consultation Paper, Appraisal and Evaluation in Central Government. Back

13   Announced by the Chancellor of the Exchequer on 9 December 2009 to provide a new strategic focus in government across the full range of infrastructure sectors (Pre-Budget Report, Securing the recovery: Growth and opportunity. HM Treasury. Command Paper 7747, 9 December 2009). Back

14   G. Inderst, "Pension Fund Investment in Infrastructure", OECD Working Paper on Insurance and Private Pensions, January 2009. Back

15   This excludes the London Underground PPPs, which before the failure of Metronet had a capital value of about £18 billion and were on-balance sheet, but are not pure PFI contracts. Back


 
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