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Digging deeper, by Mark Hellowell

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25 March 2005

The Private Finance Initiative has not gone away – it's just adapted to meet changing times. Mark Hellowell explores the opportunities and pitfalls in the new areas that the programme is expanding into

In the 20 months since the Treasury published its seminal paper on the Private Finance Initiative, Meeting the investment challenge, the programme has undergone some radical changes. In July 2003, its use was withdrawn for small-scale projects and IT. Changes have also been made to the value-for-money appraisal process and the system of central government subsidy to ensure the initiative competes more fairly with publicly funded alternatives.

In the context of the prudential borrowing regime, these changes mean that the PFI will lose out to the public sector more frequently. Yet it would be wrong to see this as the government scaling back its commitment to the programme. The ban on using it for small schemes and IT was always on the cards. Its high start-up costs meant it was never a cost-effective choice for projects under £20m. And, after some high profile failures, such as at the Criminal Records Bureau, it came to be seen by everyone as too inflexible a mechanism for efficient investment in IT.

As for the value-for-money changes, the previous public sector comparator regime had become an embarrassment. The Treasury's realisation that the system had become politically unsupportable came when Jeremy Colman of the National Audit Office described some comparators as 'spurious' calculations based on 'pseudo-scientific mumbo jumbo'.

Where the PFI has lost out then, it is because the Treasury's hand has been forced. The rarely voiced truth is that these past 20 months have seen the scope of the concept greatly expanded.

In one small but important part of the Treasury paper, officials outlined three major new sectors that the PFI would take on: waste, affordable housing and regeneration.

The first of these is the most straightforward. Local authorities in England currently spend about £1.6bn a year on waste management, largely through outsourcing contracts concerned with landfill disposal. Waste management PFI schemes have also been around for some time. Nine deals have so far been reached between authorities and private partners, and a further seven are in procurement.

But the existing programme of schemes has been hindered by delays to planning applications and public concern over health issues. Now the Department for Environment, Food and Rural Affairs is putting pressure on councils to press ahead with planning applications for new waste management facilities, in line with the new emphasis on recycling. The government and local authorities know they have their work cut out if they are to meet European Union targets on recycling.

These require the volume of biodegradable municipal waste sent to landfill to be reduced to 75% of 1995 levels by 2010; 50% by 2013; and 35% by 2020. The government will be liable to pay fines of £180m a year in today's money if it fails to comply.

Accordingly, environment minister Elliot Morley has asked private companies to prepare for a £10bn investment programme in the sector. The acute need for new capital assets, and the ease with which the policy goal of reduced waste can be written into contracts, suggest that the PFI will play a major role in delivering that.

Although the use of private finance in social housing is unlikely to reach this kind of scale, there is still the likelihood of a major programme here. The PFI has already played a limited role in helping the government meet its £19bn decent homes target, with refurbishment projects under way in Manchester, Islington and Reading. But this is only three of the eight 'pathfinder' schemes launched in 1999 and there are signs that the government is losing patience with the others. It withdrew its commitment to fund a project in Camden last month after costs spiralled from £55m to £115m in two years of negotiations with a single bidder.

There is now a consensus that refurbishing council estates through the PFI does not usually provide good value for money.

The private sector was never comfortable taking unquantifiable refurbishment risks on denuded properties built in the 1960s and 1970s. Accordingly, most PFI companies chose not to get involved, and those that did demanded a very high price.

The Office of the Deputy Prime Minister has since swept away regulations preventing the PFI's use for building new homes. This should make negotiations with bidders much simpler, since the risks of demolition and rebuilding are seen as manageable. Most industry players expect a successful programme to emerge.

The July Spending Review saw the chancellor, Gordon Brown, highlight the importance of 'an expanded PFI programme' in housing, and provide funding of £1.2bn over the three years to 2007/08.

In response, the government received 11 bids for funds from local authorities. A majority of these involve the private sector building new social or affordable homes. Ministers are expected to make a decision on which schemes will receive central funding by the end of this month.

But of the three new areas identified by the Treasury, it is regeneration that is seen as the biggest challenge for the government, and the biggest opportunity for the private sector. Regeneration is a rather nebulous term encompassing a range of different concerns, from social exclusion to the shortfall in housing supply and a general requirement for economic renewal. There is a strong sense in Whitehall, and in industry, that the PFI could help deliver regeneration projects faster and more cost effectively than current routes.

Richard Parker, a partner at PricewaterhouseCoopers, says: 'The regeneration sector needs the disciplines engendered by elements of the PFI, like the Gateway Review process. Projects need to be stress-tested for their viability.'

The responsibility to develop a workable model has fallen to Partnerships UK, the quasi-public agency that provides expert advice to the government on public-private partnership matters, and leads some of its most important PPP programmes.

To take on the challenge, PUK has appointed property expert Stephen Dance. He has been working since the autumn of 2003 to try to find a way forward. He says: 'What we are really looking for is a delivery vehicle based on PFI principles, a model where there is a government income stream underpinning the delivery of a holistic regeneration service in a manner that is affordable, value for money and replicable in different areas of the UK.'

Dance is examining the possibility of a PPP delivering a range of social benefits, along with physical development and economic improvement, a contract in which the private sector partner would be paid in part according to its success in delivering these priorities.

But where would the money come from? In all sectors of the PFI developed successfully so far, there has been a single government income stream. Dance says: 'We need to formulate a partnership structure that would bring together different funding streams across a range of government departments.

'The challenge is to develop a replicable delivery mechanism that enables an authority to do that.'

A second issue is which authority would do that. The answer is that it would probably vary depending on the area. Since different authorities have different legal powers to enter into contracts or joint ventures, finding a model that is replicable across the country is a significant challenge.

PUK is currently working with English Partnerships, the Office of the Deputy Prime Minister and the London Development Agency to apply some 'hypothetical solutions' to these problems. He says: 'We are in the process of testing these hypotheses on a number of live situations to see whether or not it is workable and, if it is, whether it is a model that we all feel is capable of being developed in the wider market.'

The model would look something like that proposed for Building Schools for the Future, the £2.2bn-a-year schools investment programme run through the PUK-backed quango, Partnerships for Schools. This body has established a centre of expertise at the Department for Education and Skills and will commit equity into individual delivery vehicles at the local level, making money if these vehicles' projects are successful. These organisations, known as local education partnerships, are still in the development stage. They will be joint ventures between local authorities, Partnerships for Schools and a selected private sector partner, and deliver a range of PFI and conventional projects.

In the case of regeneration, the focus would not just be schools, it would be everything from roads to community centres. The idea is that the delivery vehicle would be established at the local level, and funding would feed in from the various agencies and government departments.

A big advantage of this approach from the government's point of view is the possibility it offers for gaining from the increasing land values generated by the investment. The intention is that this money would help to subsidise the public works projects, lowering the capital costs of new community facilities or infrastructure. The result could be a system that provides a range of public infrastructure and wider development within the scope of a single master plan.

A key question is whether the private sector will want to be involved. Interestingly, it seems that there is a substantial appetite for this kind of project among PFI contractors, despite the evident risks.

Richard Weston, chief executive of construction group Equion, says: 'If a regeneration partnership can allow a range of different buildings to be developed as single PFI contracts, then they could be delivered an awful lot more quickly and a lot more cheaply. The framework of a regeneration partnership could probably shave one or two years off the lead time of relatively small but essential public buildings, and provide valuable wider development.'

The government's real challenge will come when it tries to convince the banks that an infrastructure contract with a development contract tacked on presents acceptable risks.

'The financial markets will need to be persuaded that this is a bankable proposition – and that's where you have to ask yourself “Is it worth doing?”,' says Dance. 'Is there enough appetite there to overcome the complexities and make a real market of it? Because if there isn't, there isn't much point doing it.'

Mark Hellowell is the editor of Public Private Finance

PFmar2005

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