Memorandum by Mr T Martin Blaiklock, Consultant,
Infrastructure and Energy Project Finance
INTRODUCTION
The Economic Affairs Committee has requested
comment with respect to PFI-type transactions and the associated
balance sheet issues arising therein.
I have been a consultant, banker and practitioner
in infrastructure and energy project finance,—PFI, PPP and
the like,—for the last 30 years, with both UK and international
experience of investment, commercial and development banking operations
in this field. I also regularly give seminars and training courses
on this topic.
How should the cost and benefits of Private Finance
be assessed?
1.1 The main quantitative, and generally
accepted, method for the comparison of PFI proposals with conventional
procurement entails:
(a) the preparation of a Public Sector Comparator
("PSC"),—the cost of undertaking a conventional,
Government-funded project over the same life cycle as a PFI option,
and
(b) comparing the PSC against the expected PFI
costs over the same time period (eg usually 25-30 years for a
PFI Concession).
1.2 The main criterion of comparison is
the Present Value of both options. This creates two problems:
— what discount rate to use? (see below)
and;
— the costs for the PFI option will be
guesses as, when the comparison is first undertaken, PFI bids
will not yet have been prepared.
1.3 Overall, PSC analysis is a useful decision-making
tool for Government for deciding between the PFI and conventional
options. However, it has limited utility in evaluating decision-making
post-the event. Once the decision has been taken to employ one
option or the other, the decision is generally irretrievable.
What discount rate should be used?
1.4 Classic investment theory dictates that
the discount rate to be used should represent the cost of capital
to the investor or, in the case of PFI, Government sponsor for
finance for a similar period, eg UK 30 year gilts.
1.5 When using such discount rate, the underlying
costs in the PSC analysis should also include allowances for inflation,
tax and the cost of finance or money. After all, inflation and
tax exist come what may. The cost of money will be a margin above
the rate of inflation.
1.6 However, the UK Government is the only
Government I have come across which does not follow this principle.
1.7 The UK Government, as evidenced by the
Green Book, undertake their analyses in "real" terms,
excluding inflation and the cost of money, as opposed to "nominal"
terms, which include these items. As a result, there is an inherent
inconsistency in the analytical approach to PFI by HM Treasury.
Treasury lives in a "real" world, whereas PFI concessionaires
live and price their deals in the actual, or "nominal",
world.
1.8 The consequences of this approach are
that:
— in times of high inflation,—which
have arisen within the last 30 years, the common time horizon
for PFI concessions—ignoring inflation can result in under-budgeting
by Government departments for the future payments they will have
to make under a PFI concession; and
— it is difficult to identify what the
"real" discount rate should be.
1.9 Between 1991 and 2003 Treasury imposed,
via the Green Book, a discount rate of 6% "real", which,
assuming that inflation was 2-3%, is equivalent to a "nominal"
rate of 8-9%.
Over this period, however, the cost of 30-year
gilts for HM Government was 5-6% on average, ie 2.5-3% pa lower.
Hence, by HM Treasury insisting on public authorities
using a 6% "real" discount rate, Government was imposing
a higher discount rate than normal investment analysis theory
and principles would dictate.
1.10 This has had three consequences:
— the PFI option is much like a credit
card for governments. It allows payments, which otherwise would
normally be due to be paid today, to be paid at some future date.
Hence, a higher discount rate favours the PFI option compared
to the PSC;
Thus, by using a higher-than-expected discount
rate during the years 1991-2003, HM Government was unduly favouring
the use of the PFI option;
— imposing a discount rate 2.5-3% higher
than one might normally expect translates into a differential
favouring the PFI option of 35-40% in Present Value terms when
taken over a 30 year project life cycle;
Hence, it was no surprise that the PFI option,
in most cases, always looked cheaper than the conventional option
in the PSC analysis; and
— by using a too-high a discount rate,
the PFI option, when chosen, can result in under-budgeting by
PFI sponsor departments, viz the current problems faced
by many NHS Trusts, who have undertaken PFI projects.
1.11 In 2003, HM Treasury introduced a new
Green Book, which dictated that the (real) discount rate to be
used was now to be 3.5%. The discount rate was termed the "social
time preference" rate, terminology which means more to economists
than bankers and commercial executives. Its justification is enwrapped
in Byzantine econometric theory, and allows HM Treasury to justify
whatever rate they want.
If one adds inflation of 2.5-3% to the 3.5%
discount rate, then one arrives at 5.5-6% "nominal",
which fairly closely has reflected the cost of 30 year gilts for
HM Government in recent years. Good. The "new" post-2003
discount rate, albeit quoted in "real", as opposed to
"nominal", terms, more closely reflected reality.
1.12 However, to cover their tracks (for
the errors 1991-2003), HM Treasury introduced another concept
which none other of the 60-70 countries in the World who are implementing
PFI/PPP schemes has adopted, that is "Optimism Bias".
This is an automatic multiple which HM Treasury applies to public
sector project cost estimates, the multiple dependent on the complexity
of the project. The concept is totally empirical and has little
theoretical or practical justification.
1.13 Hence, excluding Optimism Bias, the
PSC analyses undertaken since 2003 probably more closely reflect
reality than hitherto, albeit that the process adopted (ie "real"
v "nominal") is still fundamentally flawed.
Are current procurement procedures satisfactory?
1.14 Public service procurement procedures
are regulated by EU Directives. On the other hand PFI projects
takes twice as long and are twice as costly to prepare and implement
than for conventional procurement. As a result, PFI is not suitable
for projects which need to be implemented immediately.
1.15 Secondly, EU Procurement rules are
somewhat inflexible, which dictates against some of the issues
arising in PFI concessions. Also, there is no room for adopting
procedures, eg the "Swiss Challenge", which can take
into account more effectively innovative proposals put forward
by the private sector.
Is enough information publicly disclosed on PFI
transactions?
1.16 In short, no. The UK is unique in providing
very little information to justify their decisions and actions!
For PFI, during the bid process, some confidentiality may be called
for, but not after concession award.
How does the performance (cost, delivery and service
quality) of PFI schools, etc, compare to those traditionally procured?
1.17 Comparison of capital costs between
conventional and PFI projects can be misleading. The private sector
PFI concessionaire will build a project with assets "fit-for-purpose"
and maintain those assets such that they can achieve the required
performance under the PFI concession accordingly.
The public sector, however, with a tradition
of poor maintenance regimes, will often build over-engineered
and costly projects to allow for poor maintenance.
1.18 The key criterion for comparison should
be: is the service provided by the PFI concessionaire comparable
to that which might otherwise be provided by the public sector?
This is often difficult to assess, and is more a subjective than
objective exercise.
Is there significant risk transfer to the private
sector or is it more apparent than real?
1.19 This question is almost impossible
to answer. Risk transfer does arise under PFI transactions, but
"risk" is a subjective judgement. "Risk" can
be identified, evaluated and the impacts assessed under different
scenarios, but the public and private sectors will always disagree
as to how much risk is actually transferred.
1.20 Secondly, there are different types
of risk: eg technical, commercial, financial, legal; environmental;
etc. Further, some of these risks are interdependent, eg a delay
can cause a cost-over-run, and a cost-over-run can cause a delay.
So "double counting" can arise.
1.21 Given that PFI (and PPP) is a financial
concepts, the key risk is financial or money-related. Hence, the
risk to be evaluated in a PFI "transfer of risk" assessment
should be "financial". Unfortunately, such an evaluation
often gets lost in the misunderstanding of what PFI is all about.
1.22 Overall, not as much risk is transferred
under PFI as one might expect. Any judgement on this issue, however,
has to rely upon detailed knowledge of the underlying financial
arrangements and contractual responsibilities under the PFI Concession,
details of which invariably do not fall in the public domain (see
para 1.16 above)
How effective and costly has it been to monitor
the private sector providers' performance and quality of service
in PFI projects in comparison with traditional procurement?
1.23 No comment, except that it is noteworthy
that, in the few PSC-type analyses which have fallen into the
public domain, little, or no, account was taken by Government
agencies for monitoring costs.
PFI CONTRACT CHANGES
AND TERMINATIONS
1.24 If a PFI concession contract needs
to be re-negotiated, usually due to a change in the service specification
or technological advance, then the PFI concessionaire will always
be at an advantage.
Hence, PFI concessions are best suited to project
types and sectors where the underlying output performance will
not change over the 30 years of a PFI concession, eg a school
building, roads, or a prison. Hospitals, in my view, are not suitable,
as the way patients are treated continuously evolves, requiring
different public service assets, as technology advances.
1.25 Not many PFI deals have been terminated.
The most important case has been Metronet (see NAO Report, HC
512 2008-09). However, this NAO Report underestimates the true
cost to the taxpayer of the Metronet collapse, as it identifies
costs before tax, whereas an after tax assessment is more consistent.
PFI concessionaire companies can write off any PFI losses against
profits from other activities, thereby precluding the Exchequer
from collecting taxes which otherwise would be payable.
ACCOUNTING FOR
PFI TRANSACTIONS
1.26 There is international confusion on
this topic. The accounting definitions for what should be "on"
and "off" balance sheet (eg the identification and reporting
of contingent liabilities) are also confusing.
1.27 The underlying criterion adopted by
many countries is the Eurostat Directive of Feb 2004, under which,
if the completion and either the demand or availability risk is
passed to the private sector, then the transaction can be deemed
as "off" balance sheet for the host government.
1.28 However, the flaw in this Directive
is that it requires an assessment of commercial or physical risk
transfer for what is, in reality, a financial risk. PFI is a funding
mechanism, no more, no less. It therefore requires a financial
assessment (see also para 1.21).
The judgement, therefore, as to whether a particular
PFI transaction is "on" or "off" balance sheet
should be based on where the financial risks lie.
1.29 It is also important to remember that,
as a PFI concession proceeds, the financial risk will change,
eg from the construction to the operations period.
1.30 Overall, governments should at least:
(a) record in National Accounts the potential
(contingent) liability of any PFI-type transaction entered into;
and
(b) provide a weighting, or probability, for
such liability arising.
[Note: in the same context, governments
should be asked to identify and weight potential contingent liabilities
for entities such as Network Rail and state-owned agencies or
companies, which are not classified as "PFI" or "PPP"].
Would public sector investment in the last decade
have been lower without PFI? If so, by how much?
1.31 In short, probably. The Government
have used PFI (and PPP) as a credit card and probably overspent
like the rest of us!
1.32 Nevertheless, the use of PFI has not
resulted in greater competition in the UK contracting industry
or created any new UK-owned and domiciled contractors, rather
the opposite has arisen.
1.33 Hence, the value of PFI/PPP to the
UK economy as a whole is questionable. Many current PFI concessions,
eg GCHQ, M6 Tollroad, and indeed privatised, UK public service
utilities too, eg BAA, Thames Water, 90% of our major ports, etc,
are non-UK owned, often with the UK "special-purpose"
companies paying minimal corporation and capital gains tax. The
use of shareholder loans—often at 15-20% interest—to
shield tax liabilities has added to the reservations of the value
of some of these PFI structures to the UK Exchequer and economy.
What is the impact of the current financial crisis
on the PFI market?
1.34 The impact has been:
— there are now fewer lenders in the PFI
market, and debt usually represents about 80% of the funding required
for PFI transactions;
— the amount any one bank is prepared to
lend is 25-50% of what it was two to three years ago;
— loan maturities are now much shorter,
with a reduction from 15-25 years or more, to 10-15 years now;
and
— the cost (ie margins) for such loans
has doubled or more. Margins have increased from, say, 100 "basis
points" to 2-250 "basis points" [Note: 100 "basis
points" equals 1%, over LIBOR].
The UK PFI sector is not alone in facing these
constraints.
Are there realistic alternative roles for private
finance than the current PFI-type finance models?
1.35 70 years ago, when faced with similar
problems as the UK economy, the US Federal Government introduced
tax-free "industrial revenue bonds" to fund new infrastructure
developments. Such instruments were attractive as investments
for private, long-term investors such as pension funds, life insurance
companies and rich savers.
Since then (1930), nearly all US/North American
infrastructure investment has been successfully funded this way.
Commercial banks have taken "a back seat" in this scenario.
While such bonds contain an element of government
subsidy (ie a tax break), they attract a new source of capital,
encourage saving and impose a stricter financial regime on borrowers.
Further, any Incremental revenues that such investments accrue
can be hypothecated, ie dedicated to support project cash-flows
and debt service.
[Note: such bonds were precisely what Bob Kiley
proposed for funding the London Underground five years ago, but
which HM Treasury rejected!]
1.36 Many transport PFI's generate enhanced
property values contiguous with the project. Schemes should be
developed to encourage the measurement, capture and use of such
benefits to fund the underlying infrastructure.
1.37 There is a need for a review of the
role of Private Equity in UK public service and infrastructure
projects. Abuses have occurred!
[NB. The Treasury Committee's Review of Private
Equity in July 2007 omitted this topic.]
1.38 There is also a need to review the
role and activities of Partnerships UK, a PPP advisory company
or "quango", housed in the Treasury Building, and which
enjoys a monopoly of advice to public authorities and municipalities.
Is there an optimal mix for conventional and PFI-type
investment in public services?
1.39 In short, no. PFI-type expenditure
should be constrained by the extent to which contingent liabilities
may be created (ie how much the credit card is to be used by Government).
Currently, it is understood that UK Government PFI-type expenditure
represents around 15% of the Government's annual investment in
public service assets.
1.40 Some countries, eg Brazil, have introduced
constraints in their use of PFI structures by relating expenditure
to Annual GDP. It is also known that the IMF is concerned by such
issues, but to date have failed to produce any guidelines.
1.41 Overall, many of the problems associated
with PFI/PPP transactions also encompass expenditures undertaken
by state-owned enterprises, which many governments have kept "off
balance sheet" for years, eg Network Rail, Electricite de
France, the German Landesbanks, etc. It is expected, however,
that many governments, including UK Government, will be most reluctant
to expose the liabilities for the finances of all the state agencies
under their jurisdiction!
CONCLUSION
PFI (& PPP) is a useful funding mechanism
for public service and infrastructure projects, just as a credit
card is for personal expenditures. The key is to know when to
use it, for what, and for how much. There is "no free lunch"
as they say.
10 August 2009
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