Memorandum by Dr J R Cuthbert and Mrs
1. This note is our submission in response to
the call for evidence on PFI dated 15th July 2009. We are independent
researchers in the field of the economy and public finances, and
we make this submission as individuals. Before we give our answers
on the specific questions posed by the Committee, this brief section
(a) gives short biographical details; and
(b) sets out the history of our research on PFI,
outlining the main data sources we have examined, and the key
aspects covered in our research.
2. Biographical Details
Jim Cuthbert is a statistician, who has worked
in academia, the civil service and consultancy. As a civil servant,
he worked in the Scottish Office and the Treasury, and was latterly
Scottish Office Chief Statistician.
Margaret Cuthbert is an economist who has spent
her career working in industry, academia and consultancy. Her
main research interests are in public finance and in enterprise.
We have published extensively, particularly
in the areas of public finances and the Scottish economy. Copies
of the papers we have published since 1997 can be found on our
website at www.cuthbert1.pwp.blueyonder.co.uk
3. Outline of Our Research Interest in PFI
Our research interest in PFI started in 1999,
but our research was limited initially by the lack of information
in the public domain. The situation changed radically from 2005,
however, with the advent of the Freedom of Information Acts, (FoI).
Because of FoI, we have been able to assemble what is probably
a unique archive on the operation of PFI, including the detailed
financial projections for eight PFI schemes; the full contracts
for a number of PFI schemes, (including around 10,000 pages of
documentation on the new Royal Infirmary of Edinburgh); and detailed
information on the indexation arrangements for around 35 PFI schemes.
We have carried out extensive research on this
material looking in particular at:
The cost to the public sector of the
provision of the capital element of PFI projects, and the projected
levels of profitability of PFI schemes for the private sector
funders. This research involved developing new analytical techniques
to supplement the commonly used, but unsatisfactory, measures
of net present value and internal rate of return. The research
revealed clear evidence of high costs to the public sector, and
very high projected profits, in several of the PFI schemes examined.
Procedures for ensuring value for money
and affordability of PFI schemes: we have identified failures
in these procedures in several of the schemes we have examined.
The effect of the Treasury's specified
discount rate: prior to 2003, this had the effect of wrongly burdening
the public sector comparator in the value for money comparison
with an additional cost equivalent to the government's capital
The indexation arrangements for adjusting
the unitary charge in the light of inflation: we have identified
flaws in these arrangements in a number of schemes.
The way in which the Office for National
Statistics adjusts the National Accounts in relation to "on-book"
schemes, and the way in which ONS has operated the risk based
test to determine whether schemes should be on or off the books.
We have identified flaws in both of these areas.
Much, but not all, of our research in PFI is
in the public domain, particularly in the form of a number of
papers submitted to the Finance Committee of the Scottish Parliament,
and in the form of a debate conducted with ONS on the on/off treatment
of PFI schemes, conducted in the context of the Scottish Economic
Statistics Consultants' Group. References to relevant papers,
copies of which are on our website, are given at the end of this
4. Question 1 (a): How should the cost and benefits
of PFI schemes be assessed?
The evidence of high costs, and high projected
profits, in several of the PFI schemes we have examined, (see
reference 3), indicates that the existing techniques designed
to ensure value for money and affordability in PFI schemes have
not worked well. However, on a more positive note, our research
also indicates that more careful examination, by the public sector
client, of the kind of financial projections we have been studying,
could in itself reveal many potential problems in prospective
PFI deals. (The projections we have been examining are the financial
projections produced by the operating consortia at the time of
the signing of the PFI contract: these are available to the public
Among the key indicators which we suggest the
public sector side should be looking at are the following:
(a) The financial projections can be used to
split out of the projected stream of unitary charge payments those
costs associated with services (like operations, management, maintenance,
and lifecycle costs), leaving what we have called the non-service
element of the unitary charge: this non-service element essentially
represents the cost to the public sector client of the provision
of the original capital asset. The net present value of this non-service
element can then be calculated, using a discount rate equal to
the current National Loan Fund interest rate. This net present
value indicates how much the public sector client could have borrowed
from the National Loan Fund, for the same cost as the stream of
non-service element payments. If this net present value is high
relative to the cost of the original capital asset, then this
is prima facie evidence that the project may involve excessive
costs to the public sector. For several of the schemes we have
examined, the ratio of NPV to capital was indeed very high, being
close to or greater than two.
(b) The financial projections can also be used
to calculate the projected internal rates of return (IRR) on the
different sources of capital finance: and also, for each different
source, the average outstanding debt on which this return is earned
over the lifetime of the project. For example, in all of the eight
cases we have examined the projected IRR on broad sense equity
(that is, the aggregate of subordinate debt and equity proper)
is 15% or more, and in two cases is over 20%: moreover, these
returns were being earned on an outstanding debt which in five
cases averaged, over the lifetime of the project, more than 200%
of the amount of capital raised. Figures like these are potentially
indicative of excess profits, which the public sector side in
the negotiations should probe.
(c) The financial projections can also be used
to probe for a mismatch between the profile of non-service element
payments, (as projected on the basis of the original inflation
assumptions), and the profile of projected senior debt charges.
A common feature of the financial projections we examined was
that the non-service element payments were basically projected
to increase through the life of the project: while senior debt
charges were projected to decline, and would commonly terminate
completely several years before the end of the project. This left
an increasing wedge between the non-service element and senior
debt charges, which was largely available to be taken as profit.
The existence of a marked mismatch between the profiles of the
non-service element and senior debt charges is therefore another
indicator of potential excess profits, which the public sector
side should probe.
(d) Another aspect which the public sector should
probe is how sensible the arrangements are for adjusting the unitary
charge payments in the light of future variations in inflation
rates away from their initially assumed values. In our wider study
of the business cases and contracts for PFI schemes, we have found
many examples where these arrangements appear highly questionable.
For example, we have found several examples where the whole of
the unitary charge is subject to indexation at whatever the future
rate of inflation will beeven though major elements of
the consortium's costs, (namely, senior and subordinate debt charges),
are pre-determined, and will not increase in line with inflation.
Such inappropriate indexation potentially hands the operating
consortium a large future windfall profit if inflation increases
above its initially assumed levels.
5. Question 1(b): What Discount Rate Should Be
Used in Comparing Private Finance with Conventional Public Procurement?
Since public procurement would involve borrowing
from the National Loan Fund, a fair discount rate for comparison
with the public sector is the current NLF rate. Prior to 2003,
the discount rate which the Treasury specified, of 6% real, had
the effect of burdening the public sector comparator with an additional
cost equal to the government's capital charge, even though, according
to the Treasury guidance, the capital charge should not have come
into the value for money comparison. The effect was to significantly
bias the value for money comparison in favour of the PFI option.
(See reference 5 for analysis showing how the Treasury discount
rate had this effect.)
6. Question 1(b): Are Current Procurement Procedures
A number of aspects of current procedures are
(a) The practice of selecting a preferred bidder,
may, in effect, limit competition: there are indications of significant
cost increases occurring between the selection of the preferred
bidder and the final signing of the contract.
(b) PFI projects are typically large, bundling
together into one contract both the provision of the capital asset,
and services. This bundling is essential if the project is to
be classed as an operating lease, and hence kept "off the
books". There is, however, no doubt that large, bundled,
contracts restrict competition. As evidence of this, witness the
following quotation from a presentation by a major PFI provider,
where it was stated that an advantage of PFI for them was "Tender
costs and complexity reduce competition".
(c) Our examination of PFI contracts indicates
that arrangements used to examine value for money and affordability
are often inadequate. (See in particular reference 4 for a detailed
analysis of a number of problems identified in the case of the
new Royal Infirmary of Edinburgh.) In some cases the assessment
of affordability is given in the business case for only one year:
in some others, affordability is assessed by calculating an aggregate
over the lifetime of the project with negative balances for many
of the early years being "cancelled out" by positive
ones in the later yearseven though this procedure makes
(d) There is a downside to the narrow concentration
on value for money in current procurement procedures. The scale
of PFI is such that it has important effects on the wider economy.
Passing an entire large project, possibly the biggest construction
and services project an area is likely to have for many years,
to a firm based outside that area, can have important adverse
effects. Such effects could impact, for example, on the viability
of local industry, on the depth of the local skills base, and
on the amount of research and development carried out in the area.
Some account should be taken of these wider effects in PFI procurement.
7. Question 1(d): Is enough information disclosed
on private finance projects fully to assess whether the taxpayer
is getting value for money?
(a) Our own research, using Freedom of Information,
has indicated the benefits of the wider information on PFI which
is now starting to become available under FoI: however, FoI itself
is by no means an easy or ideal way of accessing such information.
(b) As noted at 6 (d) above, the broader implications
of PFI for the wider economy are very important. Information should
be made available to enable these implications to be assessed:
for example, on where procurement and research involved in PFI
is actually sourced.
8. Question 3: Is there significant risk transfer
to the private sector or is it more apparent than real?
The very high levels of costs to the public
sector and projected profits observed in some of the PFI schemes
we have examined have implications for the true extent of risk
transfer. If costs and profits are high relative to the levels
of risk transfer conventionally assumed, then meaningful risk
transfer cannot really be said to have taken place. In such circumstances,
instead of meaningful risk transfer, what is really happening
is that the private sector could be said to be having a flutter
at the public sector's expense.
9. Question 5: Are post procurement alteration
We have no first hand evidence on actual re-negotiations.
But our scrutiny of PFI contracts has identified a potentially
significant weakness in the arrangements for re-negotiation. PFI
contracts sometimes specify that, when re-negotiations take place,
the guiding principle should be that the internal rate of return
on equity should be maintained. But the IRR on its own is an inaccurate
indicator of the value of a sequence of returns: the net present
value of a sequence of returns depends both on the IRR and on
the profile of debt outstanding. It would be perfectly feasible
to structure a renegotiation so that the IRR was unaltered, but
the profile of outstanding debt was changed so that the net present
value of the return to the investor was greatly increased. Rules
on renegotiation need to be much more tightly specified to avert
10. Question 6: Treatment of PFI contracts in
The evidence on PFI schemes which we have obtained
under FoI raises two important implications for the way in which
ONS handles PFI schemes in the national accounts.
(a) First of all, there is the question of how
ONS treats existing "on book" PFI schemes in the national
When a PFI scheme is classified as "on
book", ONS makes adjustments to the public sector capital
stock and to the public sector net debt: the same adjustment,
equal to the capital value of the asset involved, is made to both.
However, for the eight PFI schemes whose financial
projections we have analysed, the ratios of the net present value
of the non-service element of the unitary charge to the capital
value of the asset were 2.04, 1.97, 1.97, 1.82, 1.68, 1.60, 1.49
and 1.28. (In calculating the net present values, the payment
streams were discounted at the National Loan Fund interest rate.)
This means that the stream of payments which
the public sector has contracted to pay for the capital asset,
(leaving aside payments for services and lifecycle costs during
the project), has a current value which is in each case much greater
than the value of the capital asset. Given this, ONS's practice
for "on book" schemes of including an amount equal to
the value of the capital asset in the public sector net debt significantly
understates the cost of the actual liability being taken on by
the public sector.
(b) Secondly, there are implications for the
way ONS has operated the existing ESA95 test of whether a scheme
should come on to the books. As argued in paragraph 8 above, the
high levels of projected profits associated with several of the
schemes we have examined means that meaningful risk transfer has
not actually taken place. This invalidates the standard ESA95
test of whether a scheme should be on or off the books, which
is based on risk transfer.
For both these reasons, ONS's current approach
is likely to grossly underestimate the cost of PFI schemes to
the public finances. Too few schemes are "on book":
and for those that are, ONS's addition to net debt understates
the true level of public sector commitment. Note that under proposed
changes to accounting rules, which may bring all schemes "on
book", the second of these problems will still remain. (See
reference 1 and 2 for an account of our debate with ONS on this
It is of vital importance that ONS move towards
more accurate accounting treatment for PFI schemes. It is not
just that the current approach grossly underestimates the true
cost of PFI to the public finances. The misguided desire to classify
PFI schemes as operating leases, (and hence to keep them "off
book"), has fundamentally distorted the way PFI as a whole
has operated: this has led to the very large bundled PFI contracts
which have restricted competition, and which have almost certainly
contributed to excessive costs.
11. Question 7; Would public sector investment
have been lower without PFI?
It is not just the level of investment which
is important, but its nature. We have no direct evidence on whether
levels of investment would have been lower without PFI. But there
is plenty of anecdotal evidence that the nature of investment
would have been different without PFI, with much more refurbishment
as compared to new build. A bias towards new build rather than
refurbishment is potentially a sub-optimal allocation of resources.
12. Question 9: Are there realistic alternatives
It would potentially greatly increase competition,
and hence reduce cost to the public sector, if PFI projects were
to be unbundled into much smaller constituent parts. If PFI schemes
are automatically "on book" in future, then there is
no longer any need to attempt to meet the condition that they
should be capable of being classed as operating leases: and hence
there is no need for such large bundled contracts in the future.
18 September 2009
References: the following six papers give further
details on some of our research on PFI: copies can be accessed
on the website www.cuthbert1.pwp.blueyonder.co.uk, under Theme
(1) Cuthbert, J R: The Need to Review the
ONS Approach to Including PFI Liabilities in the Public Sector
Net Debt: paper SESCG2008/1/1, discussed at Scottish Economic
Statistics Consultants' Group, 9 January 2008.
(2) Cuthbert, J R: A Comment on Martin Kellaway's
response to Paper SESCG 2008/1/1: note dealing with PFI accounting,
discussed at Scottish Economic Statistics Consultants' Group,
7 May 2009. The ONS paper to which this is a response can also
be accessed on our website.
The following four papers were given as evidence
to the Finance Committee of the Scottish Parliament, in connection
with their inquiry into the methods of funding capital investment
projects: the papers are also available on Finance Committee website,
(3) Cuthbert, J R, Cuthbert, M: The Implications
of Evidence Released Through Freedom of Information on the Projected
Returns from the New Royal Infirmary of Edinburgh and Certain
Other PFI Schemes.
(4) Cuthbert, M, Cuthbert, J R.: The Royal
Edinburgh Infirmary: A Case Study on the Workings of the Private
(5) Cuthbert, J R, Cuthbert, M: The Capital
Charge: Problems Arising from the Misapplication of Current Cost
(6) Cuthbert, M, Cuthbert, J R: PFIRefinancing.