Letter and memorandum by the Foreign and
You wrote to us on 15 July requesting evidence
to assist the House of Lords Economic Affairs Committee to conduct
an inquiry on "Private Finance Projects and off-balance sheet
The FCO has two PFI projects, FCO Telephone
network (FTN) and the Berlin Embassy. Only the latter is included
on the FCO Balance Sheet.
In practice, the FTN contract has more in common
with standard managed service contracts. It is considered that
the equipment brought into use under the contract is not an asset
of the FCO, and the balance of risks and rewards of ownership
are borne by the PFI operator. Replacement contract options are
under review as the current contract expires in May 2010.
Our Embassy in Berlin has been the FCO's only
PFI contract for provision of buildings and related services.
The contract came into force in June 2000 for a period of 30 years,
with the option to extend for a further 30 years.
We have provided answers to the questions the
Committee asked in the attached document and made it clear whether
the answers refer to Berlin or FTN.
17 September 2009
1. (a) How should the cost and benefits
of Private Finance projects be assessed?
The Costs should be relatively easy to assess
as the Net Present Value (NPV) of any agreed set of unitary charges
on asset usage. However, primary, secondary or other contract
terms can complicate the calculation. In the FCO, we have concentrated
on the primary period. Any ongoing service costs should be variable
in nature and considered on an annual basis. Benefits present
greater difficulty, inasmuch as many may be subjective, anecdotal
and unquantifiable. However appropriate templates could be developed.
An alternative approach might be to use normal
Green Book appraisal techniques, comparing the PFI proposal with
a traditionally funded comparitor, which could be leased, owned
(b) What discount rate should be used
in comparing Private Finance with conventional public procurement?
The normal method is to discount cash flows
using the interest rate implicit in the contract. This will include
the risk element to the contractor. Comparison with the (lower)
Treasury risk-free rate would indicate the risk premium locked
into the contract. A market benchmark interest rate would allow
comparison to both the proposed PFI contract implicit rate and
the Treasury risk-free rate.
(c) Are current procurement procedures
Given the FCO's limited PFI projects we do not
have an opinion on current procurement practices. The FCO has
not explored further PFI procurement of Embassy buildings, other
than Berlin, because we believe traditional funding has offered
better long term value for money, and has been adequate to meet
our needs for new buildings.
(d) Is enough information disclosed
on Private Finance projects fully to assess whether the taxpayer
is getting value-for-money?
HMT have a PFI reporting unit which collects
data annually. This appears reasonably comprehensive and seems
aimed very much at VFM issues.
2. How does the performance (eg, cost, delivery
dates and service quality) of schools, hospitals, prisons, roads
and other projects operated under private finance compare to those
which were traditionally procured?
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:
the original NPV of the contract exceeded the property valuation
by a factor of four and we were obliged to incur a very substantial
impairment on commissioning. As the long-term liability of the
contract is reflected in Euros, we have also suffered greatly
over the last two years as sterling has depreciated markedly against
For FTN we have not compared the performance
of this Contract with other "traditionally procured"
arrangements; mainly because there are few with a similar scope.
3. Is there significant risk transfer to
the private sector or is it more apparent than real?
In the Berlin PFI contract, there was significant
risk transfer to the private sector. The delivery of the new building
and its subsequent maintenance has been handled entirely by the
private sector partner.
For FTN, given the way the contract was set
up at the outset, the balance of risk and rewards of ownership
were borne by the PFI operator.
4. How effective and costly has it been to
monitor the private sector providers' performance and quality
of service in Private Finance projects in comparison with traditional
The monitoring of the provider's actual performance
in Berlin is thorough and comprehensive and includes formal quarterly
review meetings of all contract partners. However, with traditional
procurement, we would be looking to a less rigorous and costly
arrangement, allowing more budget flexibility.
For FTN monitoring of performance and quality
of service has been no more expensive or different from traditionally
5. (a) When the basis of a Private Finance
contract needs to be altered post procurement because of changing
client needsfor example, a bigger jail is required due
to a larger than expected prison populationhas this proved
problematic compared to projects under traditional procurement?
Berlin's PFI allows either party to propose
changes throughout the life of the contract. Changes proposed
by the building owner"Operator changes"are
paid for by the owner. "FCO changes" are proposed and
paid for by the FCO. In practical terms, changes proposed by the
FCO are less problematic than under traditional procurement since
there is no requirement for the Embassy to tender on each individual
(b) What has been the experience of
PFI projects that have reverted to the public sector?
The FCO has no experience of a PFI project
that has reverted to the public sector.
6. (a) How should future payments by
the Government under existing Private Finance contracts be recorded
in public sector accounts?
The guidance provided under International Financial
Reporting Standards and summarised in the Financial Reporting
Manual is relatively clear and logical.
(b) Is risk transfer an appropriate
(c) Should all such liabilities be
included in the national debt? Or should they be accounted for
separately from government debt?
Capital contracts are long-term HMG liabilities
and it would seem logical to include them in national debt. It
would also be logical to allot them a separate category within
(d) How much does the public sector
accounting treatment of capital and revenue aspects of projects
This does matter. For the FCO, PFI contracts
represent a significant charge on our accounts. Whether a project
is classified as capital or revenue affects the budgetary/Parliamentary
scoring: capital projects are recognised at value/NPV at commissioning.
For the Berlin Embassy the PFI represents a
balance sheet liability of approximately £40m representing
the net present value of future payments. The value of the building
is included as a fixed asset at approximately £11 million.
The lease is held in Euros, and therefore these balances are affected
by movements in the exchange rate from year to year. In the last
FY, the annual charge for interest and service charges amounted
to some £5.2 million. For FTN, the current annual charge
amounts to approximately £30 million.
7. Would public sector investment in the
last decade have been lower without Private Finance? If so, by
We don't believe that the FCO can answer this
question in its general sense. We specifically would not have
had sufficient capital funding to build the Berlin Embassy without
8. How much impact has the financial crisis
had on launching new Private Finance projects? Is the crisis likely
to have a permanent effect on the Private Finance market?
We have had no new PFI projects planned so there
has been no affect for the FCO.
9. (a) Are there realistic alternative
roles for private finance than the current PFI type private finance
Private finance operates in traditional estate
procurement when property assets are leased. This approach usually
gives value for money, although often less good than freehold
ownership. The development of PFI into PPP would indicate that
there is room for imaginative ideas in this area. However, too
much diversity in the finance model might be viewed as the sort
of thing that brought about the credit crunch. The framework should
be readily understandable.
From the FCO's standpoint, the availability
of a buy-out clause (or at least first refusal on contract disposal)
would be useful, not least to avoid the possible association with
(b) Should the UK be aiming for more
diversity in private finance models?
With diversity comes complexity. Any additional
complexities would need to be offset by PFI contracts demonstrating
better value for money in the contract delivery.
(c) Would a national infrastructure
bank (such as the proposed Dodd-Hagel NIB in the US) add any value
in the UK?
The national infrastructure bank would be an
interesting development and could enhance the public sector's
(d) Should the public sector have a
more hands-on role in financing and/or delivery?
A more hands on financial approach would result
under a national infrastructure bank, and a centre of PFI financing
and delivery expertise would be welcome.
10. (a) Is there an optimal mix between
conventional public procurement and Private Finance for public
The existing traditional avenues finance activity
from the private sector carrying out specific public sector projects.
It should also be remembered that the original introduction of
PFI was seen as something of a financial work around to allow
circumnavigation of annual capital controls. The proper application
of accounting rules has now corrected this and the whole market
has now matured and developed. The exact level of private sector
involvement will probably vary from project to project. At the
end of the day, value for money should have the dominant role
once risks and benefit options have been evaluated.
(b) What is the long run role of private
finance in the delivery of infrastructure both in the UK and globally?
As far as the FCO estate goes, many assets required
to deliver FCO responsibilities can be procured by leasing as
well as purchasing/building/owning, but PFI (in the sense of the
private sector supplying serviced assets and often providing services
to the public on behalf of the FCO as well) seems unlikely to
be a cost effective for the provision of FCO services.