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

Letter and memorandum by the Foreign and Commonwealth Office

  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 debt".

  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 or both.

 (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 satisfactory?

  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 the Euro.

  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 procurement?

  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 procured Contracts.

5.  (a)   When the basis of a Private Finance contract needs to be altered post procurement because of changing client needs—for example, a bigger jail is required due to a larger than expected prison population—has 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 change order.

 (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 test?


 (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 national debt.

 (d)   How much does the public sector accounting treatment of capital and revenue aspects of projects matter?

  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 how much?

  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 PFI.

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 models?

  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 unwelcome parties.

 (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 bargaining position.

 (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 sector investment?

  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.

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