The financial crisis and the Comprehensive Spending Review have put severe pressure on public sector bodies to cut back on spending and to increase efficiency. The way in which the axe will fall on services, however, may be far from even-handed. Some commitments entered into in the days of relative plenty are contractual commitments that will last in some cases for possibly 50 years. Once these contractual commitments are honoured, then the squeeze required on other service areas may be disproportionately severe.
One such body of contractual commitments involves the Private Finance Initiative. In Scotland a number of local authorities made arrangements, in binding contracts, to adjust their unitary charge payments for PFI schools to private sector consortia to allow for future inflation. Many entered into arrangements that will commit them to increases significantly above the rate of inflation in the PFI contributions that they will need to make.
Moreover, the information available indicates that a number of authorities in effect have cut corners in their affordability assessments, making assumptions that were unduly optimistic, or failing to assess fully the availability of funding over the whole life of the PFI contract. This means that many authorities will experience considerable difficulty in meeting their PFI contractual commitments, particularly since central government support to local authorities is likely to be progressively cut in real terms over the foreseeable future.
The consequences, both in terms of an increasing squeeze on other local authority services and in terms of pressure for steep council tax increases, are likely to be severe. Our study covers Scotland, but it is also likely to have relevance in England and Wales where PFI has also been a popular way of providing for new schools.
Our research is based on available information and data (much obtained through Freedom of Information) on the unitary charges that local authorities have contracted to pay, on the support made available for these projects from the Scottish government, and on the methods of indexing the unitary charges to provide for inflation over the long length of the contract life.
In total, we have obtained data for all of the 37 schools projects in Scotland delivered through PFI or its non-profit distributing variant. Note that the annual unitary charge of a PFI schools project covers the ongoing cost of operating and maintaining the schools, the debt service and dividend payments to the financial providers, as well as any tax arising.
In a PFI project, while the ongoing cost of operating and maintaining schools will rise with inflation, that part which covers debt service should in fact fall through time if bank and other loans are used, as the principal is paid back. The Treasury strongly recommend that there should be a matching of the indexation of the unitary charge to the underlying inflation exposure of the contractor’s costs during the service delivery period of the PFI contract, on the assumption that the contractor’s debt-servicing costs are fixed. So, if 40% of the initial unitary charge relates to capital costs and 60% relates to running costs, then that part of the unitary charge which is indexed is only 60%.
The first thing we did was to look at the indexation procedures authorities had actually adopted. In fact, authorities chose one of two main approaches: some authorities indexed a proportion of the initial unitary charge in line with an index such as the RPI, while others indexed the whole unitary charge, but at some percentage of RPI. In 12 of the 37 projects, the whole unitary charge has been indexed at full RPI. This runs counter to the Treasury view that ‘under PFI an RPI escalator typically applies to only part of the unitary charge (not including the element relating to initial capex)’.
Knowledge of an authority’s indexation procedure then allowed us to calculate by how much its own contribution to the unitary charge will have to rise to meet indexed increases in the unitary charge. What we mean by the authority’s own contribution is that bit of the unitary charge it will have to fund out of its own resources – that is, excluding the fixed amount of support which central government provides to each schools’ PFI project.
The data shows that eight authorities had, in effect, committed to increasing their contribution to the unitary charge by over twice the level of inflation in the early years of their PFI projects: ten were committed to increasing their own funded payments by more than 1.5 times the inflation rate: for a further 16, their own contribution would rise by between one and one and a half times the inflation rate, with only three increasing their contribution by less than the inflation rate.
What happens after the initial years of the PFI project depends on the type of indexation to which the authority has agreed. But our analysis shows that it can take many years before the increase in the contribution paid by the local authority out of its own funds, (as opposed to the Scottish government fixed support), falls to near the inflation rate. For example, where it is a percentage of the unitary charge that has been indexed at full RPI, the time it will take to half the gap between the initial increase in the authority’s contribution and the rate of inflation can be over 15 years, assuming inflation continues, (as most local authorities envisaged), at 2.5%.
In summary, most schools PFI projects in Scotland can look forward to above inflation increases in the contributions which the local authorities themselves will have to make towards the unitary charges. And in some cases, particularly in the early years of the project, the increases will be very much more than the rate of inflation.
We then considered whether local authorities adequately showed that the PFI projects were affordable throughout the lifetime of the projects. This is important, because if an authority cuts corners in its initial affordability assessment, then this is likely to make the problems it faces in an era of budget cuts even more severe. Central government guidance makes clear that projects should not proceed if affordability is not fully tested.
Final business cases show a lack of detail, and this in itself is a matter of some concern. But from what detail is available, a number of specific issues and problems can be identified. To give a few examples:
a) In four cases there is a substantial funding gap in the last two to three years of the project life because the project support from the Scottish government will already have run out. In one project, the authority will have to find £130m in nominal terms over the last two and a half years to pay for the project, (equivalent to over £60m in today’s prices). The capital value of the project was £319m.
b) In two cases, the assumptions made by authorities about the proceeds from land sales proved to be unduly optimistic.
c) One authority used a temporary funding source amounting to £3.5m to assist with the unitary charge in the first year, giving no indication of how it would fund this amount in the future.
d) Five authorities planned council tax increases to meet PFI costs. One authority planned an extra 1% on council tax each year between 2006/07 and 2017/18, followed by a further 0.7% in 2018/19, so that by 2018/19, council tax was expected to be 13.5% higher than it would otherwise have been without the PFI project: this higher level would then continue. Given that the Scottish government is now operating a freeze in council tax rises, these councils will have to find other means to meet their PFI funding obligations.
Finally, we looked at the question of whether authorities had considered, in their financial planning, the possibility that inflation might depart materially from the government’s inflation target of 2.5%. In fact, in their final business cases, none of the authorities had looked at the implications of inflation being any more than one percentage point above this target. Given past experience on inflation, and also given that RPI is currently running at close to 5%, this appears astounding.
Overall, the findings in our research paint a worrying picture of the squeeze which is going to be imposed on other areas of local authority service because of PFI contractual commitments, as the financial pressures on local authorities intensify. In particular, if we now hit the combination of relatively high inflation combined with real-terms cuts in the support local authority gets from central government, the problems faced by many local authorities with PFI commitments are likely to be severe.
Margaret Cuthbert and Jim Cuthbert are independent economic researchers at the Public Interest Research Network, University of Strathclyde
