Treasury sets PFI terms in concrete, by Mark Hellowell

26 Jan 11
Draft guidance on PFI contracts, published today, shows the Treasury wants to leave things pretty much as they are. The PFI industry must be pleasantly surprised by the cautiousness of these proposals.

In this time of austerity in state spending, almost all areas of the public sector are under pressure to cut costs and strip out waste. But for investors in the new schools, hospitals, prisons, transport infrastructure and defence equipment provided under the private finance initiative, there has been little need for concern.

The terms of these contracts - of which there have been about 700 since 1992, worth a combined £250 billion or thereabouts - are cast in concrete. The annual fees paid by central and local government bodies are fixed and linked to inflation, and they will continue to provide a very good return for PFI investors for 30 years or more.

Now, in draft guidance on making savings in existing PFI contracts, published today, the Treasury has confirmed that it wants to leave things pretty much as they are. The options it identifies for cutting the costs of PFI deals for public authorities are, in relation to what could be achieved, pretty modest.

Most of the options involve trying to ensure that authorities do no more than implement the contract that they originally signed – trying to get contractors to do what the said they would do, and imposing penalties where service quality falls below par (in other words, making sure that the risk that authorities are paying a high premium for is actually transferred).

The guidance recommends to authorities that they improve the use of their estate and actively seek ways to get rid of bits of it that they no longer need (presumably due to cuts in services). A new code of conduct will be introduced that will ask PFI contractors to 'engage constructively' with attempts to make savings along these lines.

Thus, the guidance is focused on reducing the scope of services or the rigour of performance standards, rather than hitting investors in the pocket.

The PFI industry must be pleasantly surprised by the cautiousness of these proposals. Pressure on the government to ensure that PFI investors 'take a hair-cut'on their profit margins has been growing of late, just as it has for other parts of the industry that work with the public sector.

Last week, the Commons’ Public Accounts Committee said that, despite carrying out dozens of inquiries and interrogating hundreds of ministers, civil servants and industry practitioners, it had found 'no clear and explicit justification' for the use of PFI. And it criticised government for failing to secure better terms from investors.

Jesse Norman, a Conservative MP, has set up a cross-party campaign for what he has called a 'PFI rebate', which is supported by more than 60 other MPs. The group’s goal is to get PFI contractors to hand back at least £500 million. This may sound a lot – but looks achievable given the value of the contracts (about £120 billion in present value terms).

A report by the consultants McKinsey has advised the Department of Health that a reduction of just 0.03% in the financing charges on contracts signed by NHS Trusts in England would lead to savings of up to £200 million. Extending this from the NHS to the wider public sector would put that figure closer to £1 billion.

But these solutions are meagre compared to what could be achieved if the government chose to use its buying power more forcefully. There are, in my view, two key areas to explore – and if either of them were to be implemented, the savings could be much higher than either Norman or McKinsey have suggested.

The first is to ensure that maintenance spending is subject to regular reviews, and that contractors are forced to identify opportunities for sharing any gain with their public sector 'partners'. Maintenance is perhaps the key function performed by PFI contractors once buildings are completed, and is provided on a monopoly basis throughout the whole period of the contract.

It has emerged that, on many deals, projections of maintenance expenditure made at the time that contracts were signed was overly prudent. In turn, this has meant that the annual charges being paid by public authorities are at a much higher level than is necessary to reimburse PFI providers for their costs.

This surplus cash ends up in investors’ pockets - and there is, as yet, no mechanism for the public sector to claw any of it back.

As the National Audit Office recently made clear, that needs to change – and it is difficult to see how companies interested in doing future business with government (along with those banks that are either owned by the taxpayer, or underwritten by it) could resist the pressure for long.

The second and potentially much more productive option is to lower the rate of return provided to investors – particularly those who provide so-called 'risk capital', or equity.

In my recent research, I’ve looked at the projected equity returns on 10 large NHS PFI schemes, assessing these with the so-called Benefit Cost Ratio method - a standard measure of return among financial practitioners.

The Benefit Cost Ratio compares the present value of the cash-flows to be received by investors against the present value of their original investment, using a discount rate set according to the investor’s cost of capital – i.e. the rate of return targeted by investors on alternative investments in the capital market with the same risk profile.

The results are astonishing. In many schemes, the present value of the cash flows to be earned by investors is five or six times greater than the present value of their investments. If the investors were earning only a ‘normal’ rate of return – the kind we see in the market for investments subject to the same amount of risk - the two sets of figures would be the same.

The degree of excess return on PFI equity investments is, in other words, huge. By asking equity investors to take a lower charge, calibrated to provide investors with a return that is closer to, or the same as, the market norm, the government could save billions.

Against these more substantial options for saving money, the Treasury’s latest guidance note looks like mere tinkering.

Mark Hellowell is a lecturer in health systems and public policy at Edinburgh University. His research on projected returns to PFI investors will appear shortly in Financial Accountability and Management

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