CHAPTER 4: PRIVATE FINANCE IN PRACTICE |
PFPson time and on budget?
62. One driver behind PFPs was the cost overruns
of traditionally procured projects. Data is limited but a survey
in 1999 found that in 73% of construction projects costs to the
public sector exceeded the price agreed at contract and 70% of
projects were delivered late. The lion's share of projects surveyed
were traditional procurement.
63. Traditionally procured projects that ran
over budget include the Thames Barrier, Scottish Parliament, British
Library and Phase III of Guy's Hospital in London (PPP Forum p 218,
John Laing p 211). The problem is international. For example,
a survey of over a hundred major traditionally procured transport
projects, mostly in Europe and North America, found that substantial
cost escalation is the rule rather than the exceptionfor
rail, average cost escalation is 45%, for tunnels and bridges
it is 34% and for roads 20%. The projects were completed between
1927 and 1998.
64. Although not directly comparable, NAO surveys
suggest many more PFPs are completed on time and on budget. A
2003 survey by the NAO showed less than a quarter of PFPs were
delivered late and a similar proportion running over budget.
65. Payments to private finance contractors do
not start until the building is completed. As contractors usually
have financed the project with some equity and lots of debt they
apply rigour in planning and execution so that more private finance
projects are on time and on budget.
66. The banks providing the debt finance add
another layer of due diligence designed to help ensure projects
are successful and loans repaid. Ms Mingay said: "The advantage
of private finance debt is that it does do that upfront due diligence
on behalf of the lenders and the contractor is suitably incentivised
to work through any problems and not walk away from their obligations
through the life of their contract" (Department for Transport
67. NAO surveys also suggest the gap between
the performance of traditional procurement and private finance
is narrowing. A survey of projects scheduled to be completed from
2003-2008 found 31% of those procured under PFP were delivered
late and 35% ran over budget which suggested a weaker performance
than the 2003 survey. Under traditional procurement 37% were delivered
late with 46% over budget.
68. The NAO surveys indicate that the performance
of traditional procurement has improved. Ms Margie Jaffe of Unison
said: "Procurement has moved on apace since the days of the
1960s and 1970s which was the last big construction phase"
69. There is strong evidence that PFPs have a
better record of on time and on budget delivery than traditionally
procured projects, although it appears this gap is narrowing.
Nonetheless, too many PFPs are delivered late, albeit contractors
rather than public authorities are liable to the consequent financial
70. Bidding processes for PFPs are longer because
private finance contracts are more complex, including servicing
and maintenance over 25-30 years, while traditional procurement
contracts only cover construction. Although more PFI projects
are completed on-time and on-budget, some witnesses argued this
masked large cost increases which arose during the much longer
bidding process. Ms Jaffe said: "Mysteriously, the price
between the outline business case, which is at the start of that
process, and the final business case at the end goes up fantastically,
and so for the first wave of PFI hospitals, for example, it was
mostly between 20 and 220 per cent. Some of that may be the public
sector saying we want you to add all the twiddles and it has got
to be gold-plated and so on, but a lot of it is because the consortia
are protecting themselves from failing to provide to cost"
71. These price rises often occur during the
preferred bidder stage when the public sector enters into exclusive
negotiations with one consortium. The Centre for International
Public Health Policy at Edinburgh University noted: "During
this period, the private sector can 'hold-up' the public sector,
pushing up prices
meanwhile, the scope for public authorities
pulling out of such negotiations is limited by the unavailability
of other procurement routes" (p 133). The Centre added:
"A project that is delivered to time and to budget (in post-contractual
terms) may represent poor value for money if the price paid for
the risk transfer that led to that outcome was too high"
72. The National Audit Office found preferred
bidder negotiations lasted on average 15 months for PFPs finalised
between 2004 and 2006. In one third of these projects the value
of the contract varied on average by 17% (upwards and downwards)
of the total project value. The NAO conclude: "Value for
money is most at risk during the final stage of negotiations,
when negotiation is with a single preferred (or final bidder)
and competitive tension is at its weakest" (p 107).
73. Common EU proceduresknown as Competitive
Dialoguewere introduced in 2006. They seek to eliminate
changes late in the procurement process. But the NAO reported:
"Our recent study on Building Schools for the Future found
some early indications that at least some changes are still being
made late in the process. Kent County Council's project experienced
seven months delay after the selection of final bidder" (p 107).
74. Preferred bidder negotiations are not exclusive
to PFPs and are widely used in conventional procurement projects
as well. While competition is reduced at the preferred bidder
stage, it should be easier during this stage for a public body
to walk away from cost increases than after construction has begun,
as can happen in traditional procurement.
75. Substantial price increases are undesirable
late in the bidding process whatever procurement path is chosen.
Despite the longer bidding process under PFPsand the associated
higher coststhe greater likelihood of projects being completed
on time and on budget after the contracts have been signed can
be a benefit worth some extra expense to the public sector at
the initial stage.
76. A key benefit attributed to PFPs is that
risk is transferred from the public sector to the private sector.
77. PFPs aim to allocate risks to the parties
best able to manage them. This should lead to better management
of risk overall which should be more cost efficient (NAO p 88).
But not all risks can or should be transferred to the private
sector. Dr Stone said: "You have to understand what risks
both sides can and should manage and control" (Q 10).
WHAT RISKS ARE TRANSFERRED TO THE
78. The private sector is usually best placed
to manage construction risksuch as building on time and
on-budgetand the risk of providing maintenance over the
asset's lifetime (Mr Buxton Q 91). Private contractors have
a greater incentive to build a project on-time and on-budget as
they only start receiving payments once construction is complete.
Making the private sector responsible for maintenance aims to
encourage the contractor to build a high quality asset that will
require little maintenance over the course of the contractusually
79. Besides construction and maintenance, it
is unclear what other risks the public sector seeks to transfer
and to what extent. Ms Rachel Lomax said that when she was Permanent
Secretary at the Department for Work and Pensions private finance
would not be used for a core function of the Department: "There
is just no way you can transfer the risk of something which is
fundamental to the Department's purpose and statute." As
a result the Department for Work and Pensions did not use private
finance in benefit administration "because we felt that was
what the Department was all about". Private finance was instead
used to provide medical services, which are not a core function
of the Department (Q 216).
80. With private finance projects so far, the
public sector usually retains risks related to demand (Mr David
Belton, Sheffield City Council, p 281). So if the local population
falls so much that a PFP-built school or hospital needs to close
then the public sector bears the costs of closing it before the
private finance contract expires.
81. Construction and maintenance risks are usually
seen as suitable for transfer to the private sector; whereas activities
over which the private contractor is seen as having little or
no influence have not been transferred.
82. Special Purpose Vehicles (SPVs) set up by
contractors to deliver a given PFP often seek to rearrange the
terms of their borrowing once building is complete. Lower interest
rates may well become available because the risk of problems arising
during construction has been removed.
83. At first, contractors kept the gains from
refinancing PFPs. The Government then negotiated arrangements
with the private sector to share the refinancing gains. For PFP
contracts signed since 2002 the public sector is entitled to 50%
of the gains from the refinancing. In 2008 the public sector's
share of the gains rose to 70% for some new contracts. In pre-2002
contracts with no mechanism to share in the benefits of refinancing,
the public sector receives 30% of the gains (NAO p 109).
84. The NAO, which criticised the Norfolk and
Norwich Hospital refinancing for securing for the public sector
only 29% of the refinancing gain while increasing the contract's
termination costs, said of the refinancing : "New sharing
arrangements appear to be working well, but there have been exceptions"
85. We welcome the Government's action to secure
for the public sector a substantial share of refinancing gains
in PFPs. We recommend that the Government should continue to learn
from experience in order to ensure that the public sector enjoys
a fair share of benefits from improvements in financing arrangements.
WHAT HAPPENS WHEN THINGS GO WRONG?
86. Critics, such as Unison, argued risk transfer
in PFI projects is "often illusory". They added: "Failed
PFI contracts, on too many occasions, have had to be rescued by
the public sector meeting additional costs" (p 258).
87. However, Mr Metter argued risk has still
been transferred because when the Government has to rescue a project
the private sector has already been hit hard: "By the time
you get to that point, the equity will have lost their money,
the debt will have lost their money, the contractors will probably
have lost their money, the insurers will probably have lost their
money and then you get to the point where the Government stand
in. For the most part business risks are transferred very, very
successfully" (Q 469).
88. The PPP Forum lists the National Physical
Laboratory, Cornwall Schools project, Dudley Hospital and Croydon
Tramlink as projects where the private sector lost millions of
pounds which shows, it argues, that risk was transferred (p 219).
89. Mr Adrian Ewer of John Laing relayed his
experience of building the National Physical Laboratory. He said:
"We lost £60 million on the construction and we
basically lost our equity as well and the private sector in total
lost over £100 million on that project" (Q 470).
90. Mr Ewer argued the private sector lost out
due to risk transfer while the public sector was largely protected
and ended up with high quality laboratories at a good price. He
said: "We kept pouring money into this black hole. At the
end of the day also the public sector has an excellent asset which
delivers 98 per cent of what the scientists required
and paid a lot less for it than it would have paid if we had known
what we were trying to build in the first place" (Q 470).
91. But the NAO were less positive about the
laboratories meeting the needs of the public sector side, overseen
in this case by the former Department of Trade and Industry: "The
contract protected the taxpayer effectively from the wasted costs
of construction and the termination was value for money. But the
project did not achieve the DTI's aims" (p 89).
LESSONS FROM THE SPECIAL CASE OF
92. With the National Physical Laboratory the
private sector clearly had taken on some risk and lost funds when
the project went awry. But the private sector fared much better
when Metroneta consortium upgrading the London Undergroundwent
into administration in 2007.
93. The London Underground PFP was a unique case.
Unlike most other private finance projects Metronet was not building
a new asset but maintaining and upgrading an existing asset. Furthermore,
Transport for London guaranteed 95% of Metronet's debt obligations.
Debt guarantees are not part of standard private finance contracts.
94. The NAO said: "As a consequence of this
guarantee, Metronet's lenders did not protect their investment
as anticipated because only five per cent of their investment
was at risk" (p 88).
95. So when Metronet failed, the Department for
Transport had to make a £1.7 billion payment to help
Transport for London meet the guarantee of Metronet's borrowing.
The NAO estimated a direct loss to the taxpayer of between £170 million
and £410 million (p 88).
96. Mr Allen said: "The banks being 95 per
cent guaranteed did blunt some of the incentives that you usually
expect to see from private finance and some of the rigour that
you look for in terms of their policing of the contracts"
97. The guarantees stemmed from the public sector's
uncertainty over whether Metronet could borrow enough funds. Mr Allen
said: "I think there was a perception at the time that this
was what was required, you had three large contracts to design
and a limited appetite in the bank market to provide that debt
and they wanted some contractual underpinning in order to take
on those risks" (Q 387). Mr Allen went on: "I am
not sure that the economic arguments were very strong; I think
it was more a pragmatic argument of what you needed to do in order
to sign a contract" (Q 387).
98. Mr Allen added that any private finance project
which needed such extensive underwriting as Metronet should serve
as a wake-up call that there may be problems ahead. He said: "When
somebody says that in order to get these contracts away we need
to be able to offer this sort of underpinning to the banks ...
that should be a very strong warning light that this is not a
contract that can be let to the market on a sensible basis"
99. Furthermore, the companies behind the Metronet
consortium put relatively little of their own moneyor equityinto
the project. When a company collapses the equity is usually lost.
Banks usually get first claim on remaining assets to repay as
much of the outstanding debts as possible. Usually nothing is
left over for shareholders. So if shareholders have put lots of
equity into a company they will be very reluctant to let it collapse
because they will nearly always be left with nothing.
100. But when "shareholders have a very
limited amount of equity in the company there comes a point when
actually they would rather let the company fail than continue
to support [it]," said Mr Allen. He added: "The
risk you transfer effectively to the company is limited by the
amount of equity that the shareholders put in, in the first place,
and if the risks that the company is trying to bear are larger
than that it may be that shareholders walk away from it. That
is certainly what happened with Metronet" (Q 387).
101. The failure of the London Underground Metronet
PFP gave private finance projects in general a bad name. Yet this
project was exceptional because huge debt guarantees together
with a typically narrow equity base limited risk transfer. We
recommend that the state should not guarantee large amounts, and
a high proportion, of debt as a means to make highly geared PFPs
happen. For such exceptionally large and complex projects alternative
procurement approaches should be used.
Bundling of construction, servicing
and maintenance into whole life contracts
102. A fundamental aspect of PFPs is that the
builders will also be contracted to maintain the building over
25-30 years. This encourages the contractor to put up a more durable
building, requiring less maintenance over its lifetime. With lower
maintenance costs the contractor can make higher profits.
103. Most witnesses agreed PFPs led to better
maintenance than had been the case under traditional procurement
(for example see NAO p 90, International Project Finance
Association p 316). Previously, under traditional procurement,
a contractor put up a building and there was usually no further
involvement. So the contractor did not have an incentive to build
an asset that required little maintenance.
104. Furthermore, under PFPs, maintenance which
the private contractor provides is ring-fenced for the length
of the contract and funded by the public sector. The NAO reported:
"PFI provides a contractual guarantee that the public client
will fund the ongoing maintenance of the building" (p 90).
In the past, using traditional procurement, maintenance was not
ring-fenced. So maintenance was often cut when public sector budgets
were squeezed: (Sir John Gieve Q 214, Ms Susan Anderson,
CBI, Q 149). According to the NAO having maintenance ring-fenced
under private finance projects ensures problems are not left to
fester which might otherwise cause damage requiring more expensive
work to be undertaken later (p 90).
HOW MUCH DOES BETTER MAINTENANCE
105. Better maintenance is, of course, good.
But some fear it has been too expensive. Dr Mark Porter,
chair of the consultants committee at the BMA, said: "Anything
can be bought but the price at which it is bought is too high,
we would say" (Q 559).
106. The Foreign & Commonwealth Office, which
used a PFP to build and service the British embassy in Berlin,
reported: "Our own experience with Berlin indicates that
we have a very well designed and built-to-time embassy which is
operated and maintained to an extremely high standard against
agreed performance measures. It is doubtful that traditional funding
mechanisms would give us the same high quality of maintenance.
However, this has come at a very high price" (p 302).
107. Due to data limitations the NAO could not
say whether maintenance under private finance was cheaper or not.
They said: "Whether it will lead to an overall reduction
in whole-life costs would be very difficult to prove" (p 90).
108. Private finance has led to a much needed
focus on maintenance of public infrastructure. Public authorities
should however keep a watchful eye on the price paid for what
is on balance a positive development. We also recommend that the
Government should promote the bundling of construction and maintenance,
and whole-life costing, in all public procurement, whether privately
financed or not.
MANAGING AND MONITORING CONTRACTS
109. For the public sector to benefit from bundling
services and maintenance together the private sector providers
have to be managed to ensure delivery is up to scratch at the
110. The NAO argued that public authorities need
to improve management of contracts: "A culture of focus on
making the deal rather than thinking about contract management
is still, however, prevalent in many quarters of the public sector"
111. Contractors disagreed on the quality of
staff they negotiated with in the public sector today. Mr Ian
Rylatt, Balfour Beatty Capital and CBI, said: "The competency
of the people we negotiate with and we bid to is leaps and bounds
from what it was before." He attributed the improvement partly
to greater experience with PFPs and the public sector recruiting
staff from the private sector with procurement skills (Q 153).
But Mr Dougie Sutherland, Interserve Investments and CBI, said:
"I find it amazing that we are still finding people on the
public sector side who are doing it for the first time. When I
look across the deals that we get involved in I think that there
are some really excellent teams and there are some very poor teams"
112. Monitoring and managing private finance
contracts has long been a weakness of the public sector, although
there have been improvements in recent years. We recommend that
public authorities should do more to maintain and improve commercial
skills of staff dealing with private finance projects, with emphasis
on long-term contract management as well as contract negotiation.
113. Investors in PFPs can sell their stakes.
Many argue that the secondary market is very beneficial and that
freedom to sell stakes makes it easier to attract funds to private
finance deals in the first place (NAO p 126, Mr Philip
Turville, Royal Bank of Canada Capital Markets, Q 424, Mr Olsen
QQ 445-448, Mr Metter Q 462).
114. Since the construction phase of a project
is the most risky for the contractor, once construction is over
"a project that is into its operational stage is often considered
to be a safer investment. Consequently the equity becomes worth
more and is attractive to a different type of investor seeking
a lower but more constant return" (NAO p 127).
115. We raised the concern that the ability of
contractors to sell their stakes may dilute one of the key positive
aspects attributed to private finance projectsthat the
bundling of maintenance into a contract encourages the contractor
to build a higher quality asset. If contractors know they can
sell out shortly after construction they might not be so diligent
about building low maintenance into an asset.
116. In the NAO's view this concern would normally
be met by pre-purchase due diligence carried by buyers in the
secondary market, so that a contractor with an eye on eventual
sale would still build a high quality asset. "Even if the
secondary market were leading to the shareholders undertaking
less due diligence, it is not clear what the effect on the contract
would be. The sub-contractors, lenders and public authority would
still need to work together to deliver the project and their due
diligence would still be crucial" (p 127).
117. There is some concern that construction
companies which can sell their stakes in PFPs shortly after a
project is operational may build a lower quality asset than if
they remained shareholders with responsibility for maintenance.
Although due diligence and checks by buyers in the secondary market
amongst other parties may meet this concern, we saw no empirical
evidence in this area. We recommend that the NAO should undertake
studies of the effects of secondary markets on standards of quality
Is private finance necessary
to get the benefits of bundling?
118. The PFP model has spread awareness of the
possible benefits of whole-life costing more widely, without necessarily
resorting to private finance. Sir John Bourn said: "It does
not rest simply on PFI, but there is no doubt that PFI was the
incentive to get this going" (Q 356).
119. While generally opposed to PFPs, Ms Jaffe
believed they had had the benefit of introducing the concept of
whole life costing into all procurement: "I think these lessons
from PFI have been and are being integrated into traditional procurement,
and if there is a lesson that you have to keep some money ring-fenced
for maintenance then I think that is one that we can carry forward"
120. The NAO noted: "Private finance is
not, however, the only way to ring-fence maintenance funding or
consider whole-life costs. The London Borough of Lewisham, for
example, has established a sinking fund to ensure its non-PFI
schools are maintained to the same standard as its PFI schools"
121. Witnesses said the skills acquired using
PFPs spill over into traditional procurement. For example, with
Crossrailwhich is mostly traditionally procuredassessment
of risk is "much more developed", having learnt from
the experience of PFPs (Ms Mingay Q 507). The Ministry
of Defence sought to improve its procurement by adopting PFP methodology
to evaluate all projects (Mr Jon Thompson Q 507). Mr Rylatt
said skills learnt by his company in PFPs were now used in traditionally
procured projects (Q 179).
122. Traditional procurement has also benefited
from the lessons learnt from private finance projects. Risk management
and due diligence appear to be better in the public sector as
a result of PFPs. These benefits need to be included when assessing
the total benefits of private finance.
123. Contractors cited examples where PFPs had
led to innovation. These included prisons where long wide corridors
enabled better use of CCTV and improved safety for inmates and
staff; hospitals where better designed corridors enabled smoother
transport of patients; and better road surfacing treatment which
reduced disruption to motorists (CBI p 53, John Laing p 211).
124. But public sector consumers of PFPsincluding
from the ministries of health, transport and defencedisagreed.
Jon Thompson, director-general of finance at the Ministry
of Defence, said: "We do not think there has been a tremendous
amount of innovation through PFI." (Mr Thompson Q 525,
Mr Peter Coates Q 525, Sir Peter Dixon Q 339).
Ms Mingay said: "When we think about PFI we do not see
it necessarily as a big area of innovation but more as a whole
life costing, providing better focused planning and integration
and that kind of thing" (Q 527).
125. There are barriers to innovation. During
the bidding process little time is devoted to innovative ideas
as it is only one factor in whether a consortium wins a bid. Cost
and duration of construction may receive more attention. During
tendering, clients often cannot spend time with all the bidders
to collaborate on potential innovative ideas. When any innovative
ideas are finally costed, they may be too expensive and be abandoned.
Moreover, the intention of private finance is to allocate risk
to the contractor. That can encourage contractors to play safe
with tried and tested methods to lessen the risk of something
going wrong and being penalised with reduced payments (NAO pp 90-91).
126. PFPs have led to some innovation although
few witnesses described this as a key reason for using private
finance. It is for public sector clients to request more innovation
from contractors when negotiating private finance contracts, if
that is what they are seeking.
127. Private finance projects can lead to innovations
in workforce practices. But this can be unpopular as it risks
less favourable terms and conditions for staff who, as a result
of PFPs, move from being employed by the public sector to private
contractors. HM Treasury guidance states: "The value for
money that PFI can deliver should not be achieved at the expense
of staff terms and conditions" (NAO p 92). TUPE (Transfer
of Undertakings (Protection of Employment)) regulations aim to
maintain the terms and conditions of staff transferred from the
public to private sector.
128. Ms Jaffe argued staff terms and conditions
sometimes change with those on low wages faring "much worse
under PFI/PPPs than more skilled workers" (Q 563). On
the other hand, the National Audit Office, while conceding little
analysis existed in this area, said a survey of 43 PFI schemes
showed pay for the least skilled was "marginally worse".
Those with skilled and management roles were paid more in the
private sector (p 92). The Centre for Public Service Partnerships
at Birmingham University plans to study such workforce issues
and their impact on services: "The industry has evidence
to suggest that transferred employees have a wider range of responsibilities,
better training, and better prospects for their future. However,
there is also much contrary evidence" (p 290).
129. Unison also opposed the potential for the
creation of what it described as a two-tier workforce, where transferred
staff's conditions are protected while new staff subsequently
hired are often brought in on less favourable terms and conditions.
Ms Jaffe said: "So you can have people working alongside
each other on exactly the same contracts but with totally different
annual leave or sick leave or pension arrangements." She
suggested that this affected staff morale and led to poorer quality
of service (Q 563).
130. Public sector employees transferred to the
private sector during the course of a PFP are protected by TUPE
(Transfer of Undertakings (Protection of Employment)) regulations
and employees recruited directly are protected by general employment
law. Pay and conditions of the two categories of employees may
well differ, at least at the outset. Where average labour costs
subsequently fall, in a PFP transferred from the public sector,
such cost savings may simply indicate that the pay and conditions
of the employees previously in the public sector exceeded the
131. During the course of a private finance project
contract, if a public body wants to close or change the use of
part of a building (e.g. shut a hospital wing due to the local
population size declining) under the terms of the contract it
usually has to pay charges to the contractor.
132. Critics argue it is impossible to predict
the type and quantity of future demand for public services. For
example, the demands of a hospital will be different in 20 years
given new and improved treatments and changes to the demographics
of the local population. With a private finance contract requiring
charges for adapting to these factors over time public authorities
may be deterred from making the necessary changes.
133. Sir Peter Dixon cited the case of putting
in day care facilities after the hospital had been built. These
facilities had not been provided for in the original design due
to a planning error before he took up his post. Rectifying this
was "very expensive" because under the private finance
contract the hospital was stuck with the one provider and could
not get quotes from alternative contractors. "We had no ability
to challenge the capital costs of our provider and of course they
did it to suit them and we just had to cough up" (QQ 317-319).
134. Sir Peter Dixon believed that further big
changes will be needed over the life of the hospital: "Inflexibility
is an issue and there is no doubt that in 30 years time when this
project comes to an end there will have been several reincarnations
of the buildings" (Q 319).
135. But proponents of private finance argued
that many of the costs involved in amending PFP contracts also
arise under traditional procurement. Dr Stone said: "The
vast majority of the costs of changes also exist in traditional
procurement but are easier to hide where there is not a contract
to renegotiate. The additional cost is a trade-off for transferring
the risks for the long term condition of the infrastructure"
(p 3). Under traditional procurement if, for example, the
wing of a hospital was no longer needed, the costs of building
it would have already been paid. Under PFPs not all the construction
costs would have been paid for until the end of the 25-30 year
contract. Partnerships UK noted that: "All sunk costs are
inflexible and in that sense conventional procurement is as inflexible
as PFI insofar as an asset no longer required still needs to be
paid for" (p 188).
136. Others argued that the long-term nature
of the contract and the associated costs helped ensure clearer
specification of PFPs. Mr Allen said: "One of the principal
causes of cost overruns on public procurements is the procuring
authority changing its specification repeatedly. So the fact that
within a PFI contract there are constraints on the public authority
doing that, that has been one of the reasons why you have seen
fewer cost overruns once the contracts have been let" (Q 378).
137. The PFP route can, however, lead to inflexibility
at a high level of public policy decision making. Sir Peter Dixon
said that not only did PFP contracts lead to inflexibility at
the level of the individual hospital but that they also restricted
changes to the broader health care system. If a hospital had to
close in London, it was less likely to be a PFP one because of
the charges involved. So the allocation of medical care within
a given budget would not be driven by health needs alone: "Whatever
else happens in reorganising services in central London my hospital
has to stay there because it has a £43 million a year
payment to a private provider. You can shut another hospital which
does not have that and sell off the land, but you cannot do it
with mine" (Q 324). The Institution of Civil Engineers
feared the "lack of flexibility is a factor leading to a
lack of resilience and flexibility in our infrastructure networks"
138. Inflexibility has been a feature of private
finance contracts, although it has also been a key factor in forcing
the public sector to plan ahead. But flexibility is negotiable,
at least to some extent. Public authorities should determine how
much flexibility they want, the means of achieving it in the terms
of the contract and what they are prepared to pay for it; then
139. One route to greater flexibility in PFPs
might be by adopting some of the features, such as provision for
periodic review of prices, of the model applied to regulated utilities,
which in Professor Glaister's view had "... worked spectacularly
well" (Q 384). We recommend that the Government should
explore the feasibility of importing into PFP contract terms selected
features of regulatory review models for utilities.
BID COSTS AND COMPLEXITY
140. Private finance contracts are complicated
as they bundle together the provision of capital, construction
and services. This means fewer companieseven coming together
in consortiamay be able to bid for such contracts, thus
limiting competition (Dr James Cuthbert and Ms Margaret
Cuthbert, pp 295-296).
141. This complexity can also make preparing
bids a costly exercise, deterring competition. Furthermore, the
Centre for Public Service Partnerships reported: "There has
been an insistence on very detailed drawings and specifications
from all competitors, even in the earliest stages of the bidding
process" (p 290). In addition, the long and drawn out
nature of the process increases the transaction costs of the bid.
Few firms may be able to devote enough man-hours to such tender
processes. The complexity and high bid costs may be influencing
the number of players in the construction sector, driving firms
to merge to enable them to compete for large complicated contracts
(Institution of Civil Engineers p 311).
142. Contractors may be put off by the complexity
of the project rather than by bidding costs. Sir John Bourn said:
"The worst projects were the ones that were so complicated
to do, so in a way if you were not getting any bidders you really
needed to ask yourselves whether it is a sensible thing to try
to do it this way, is this one of the projects that would be better
to do conventionally?" (Q 357).
143. Competition was also limited during periods
when lots of contracts were tendered and firms simply could not
bid for everything. Sir John Bourn said: "In the early days
you could not actually find anyone to compete in the short
term for all the work that was available." He added: "As
time went on that was resolved to a degree" (Q 357).
144. The impact of the credit crunch on competition
in private finance projects has been unclear. Sir John Bourn
said: "The credit crunchthrough its limitation of
access to funds, making them more expensive, lending money for
a shorter periodhas tended to reduce competition"
(Q 357). But the slowdown in construction generally due to
the downturn may have freed up more contractors to bid for private
finance work. Mr Rylatt said: "In the current construction
environment there is not a lot of conventional work around, for
obvious economic reasons. The market is very, very much a buyer's
market at the moment and is not a seller's market" (Q 185).
145. High bidding expenses risk reducing competition
for private finance projects which, in turn, could increase costs
to the taxpayer. The Government should examine possible mechanisms
for encouraging competition, such as returning an element of bid
What projects are suitable for
LONG-TERM STABLE PROJECTS
146. A significant part of the benefit of private
finance projects comes from the whole life approach to contracts
that last for 25-30 years. Since amendments incur charges, projects
requiring relatively few changes are better suited to this type
of procurement. If the nature of the requirement cannot be well
identified at the outset then it will be difficult to write successful
long-term contracts. So road projects, for example, seem particularly
suitable for private finance procurement. Similarly, new schools
can be well specified in advance and are thought to be more successful
than refurbishment where there are more unknowns outside the contractor's
control (Mr T Martin Blaiklock p 285, Mr Buxton
Q 112). Sir Peter Dixon pointed out that the more unpredictable
a refurbishment scheme, the more difficult it was to have a fixed
price and to manage that risk appropriately (Q 316).
147. IT projects were widely viewed by witnesses
as unsuitable because they are difficult to specify and define
at the outset. The pace of technological change means that requirements
frequently change as well (Dr Stone Q 25, Centre for
Public Service Partnerships p 287, Mr Humpherson Q 232).
Councillor Richard Kemp, Local Government Association, said of
IT projects: "By the time you have actually gone through
the process the specification will have moved on" (Q 94).
148. Nevertheless, problems with IT projects
are not confined to those undertaken via private finance. Sir
John Bourn believed that under certain conditions IT projects
could be appropriate for private finance: "If you set about
it in a sensible way, were not too ambitious, knew what you were
doing, had trained people, consulted those who would actually
have to operate the projects then you could make a success of
it. I think all the difficulties have led the Treasury to think
for the present timeI would not quarrel with this for the
time beingthat you would not attempt to use PFI for IT
projects but I think the time could come when you could do that
again" (Q 361).
149. Private finance has been widely used in
the NHS. But Mr Blaiklock argued that hospitals were not suited
to the long-term, relatively stable ideal needed for PFP contracts
"as the way patients are treated continuously evolves, requiring
different public service assets, as technology advances"
(p 285). However, Lord Crisp, formerly Permanent Secretary
at the Department of Health, argued that for private finance across
the NHS, "the positives outweigh the negatives" (Q 206).
SIZE AND COMPLEXITY
150. Some projects are deemed too big for private
finance as they would require the contractors to take on more
risk than they would be prepared to. Crossrail was viewed as one
such project. Mr Allen said: "You would struggle to
find sufficient equity in a consortium vehicle to back that kind
I think one of the lessons might be that the London
Underground PPP contracts were too large to structure efficiently"
151. However, private finance can be used for
part of Crossrail. Ms Mingay said: "On these very large
projects you often have projects within projectsthat there
are elements where private finance can be incorporated into the
deal. Again in Crossrail it is the rolling stock and the construction
of the Canary Wharf Station being done by the private sector,
where the rest is being done publicly" (Q 543).
152. The projects most suitable for private finance
are those where the requirements can be clearly specified at the
outset and which are of a size that consortia of private sector
companies can take on their balance sheets.
EXTENDING THE REACH OF PRIVATE FINANCE
153. Private finance could be used in more areas
than hitherto, particularly in the provision of services. Mr Metter
said: "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." He added: "Equally
with the schools, there is no reason why some of the teaching
could not go into the PFI project" (Q 482).
154. Mr Adrian Ewer, chief executive of John
Laing, said: "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" (Q 482).
155. The CBI argued for 'payment by results'
that would transfer at least some risk to the private sector for
the quality of service provided. Susan Anderson, director of public
services at the CBI, said: "If we are looking, for example,
at education what we should be measuring it on is the quality
of the education that is delivered in that school, not just whether
you have a wonderfully designed building" (Q 186).
156. Not all demand-related risk can be transferred
at a reasonable price. Mr Metter said: "In the very
early days of PFI they suggested that we should take the risk
for the number of prisoners they put into the prison when we had
absolutely no control over how many prisoners they were going
to send to the prison. They realised very quickly that to make
the private sector take that risk was just going to be very expensive
for them" (Metter Q 469).
157. The private sector is clearly not best suited
to bear all the risks in all forms of private finance project.
Experience has shown, however, that bundling certain services
with construction in PFPs has delivered benefits, including the
transfer of risk from the public to the private sector. We believe
there is scope to transfer more demand or output-related risks.
For example, with a prison such risks could be partly transferred
by rewarding contractors for lower re-offending rates. In education,
more risk transfer might be possible in the provision of teaching
services; independent schools already take on all such risks.
There is similar scope for the transfer of demand and output-related
risks in relation to medical services.
158. We recommend that the Government should
examine what additional risks now borne by the public sector can
sensibly be transferred to the private sector, acknowledge the
lesson of experience that the risks of exceptionally complex,
large projects are not suitable for transfer to the private sector,
and produce comprehensive revised policy guidelines.
16 National Audit Office (2003) PFI: Construction performance,
Summary, Page 3. Back
'How common and how large are cost overruns in transport infrastructure
projects?', Bent Flyvbjerg, Mette K. Skamris Holm and Soren L.
Buhl, Transport Reviews, 2003, volume 23. Back
National Audit Office (2009) Performance of PFI Construction,
Pages 7-8. Back