Poor prognosis for the PFI? By Noel Plumridge

16 Feb 06
The Private Finance Initiative has never been a free lunch for the NHS. Now even the Treasury seems to be losing its appetite for large PFI hospital schemes. Noel Plumridge explains why

17 February 2006

The Private Finance Initiative has never been a free lunch for the NHS. Now even the Treasury seems to be losing its appetite for large PFI hospital schemes. Noel Plumridge explains why

The government's apparent U-turn over the Private Finance Initiative in the NHS, reversing years of unstinting support, has stunned many people. The most public expression of the new attitude was Health Secretary Patricia Hewitt's decision in December to review the affordability of the £1.2bn scheme for the Royal London and St Bartholomew's hospitals. Commercial terms had already been agreed with partner Skanska, and the trust stands in good financial health. At the time of writing, the future of the Barts redevelopment still hangs in the balance, although the trust might have to make substantial payments if the scheme fails to go ahead.

So what has changed? The PFI has had its critics since its inception in the John Major years. Sceptics then viewed it as convenient accounting smoke and mirrors to reduce public spending and satisfy the European Union's 'convergence' criteria for monetary union. The political Left has consistently opposed it as a route to the privatisation of public services; few claim to understand it fully, few love it. The late journalist Paul Foot famously described it as 'an enormous transfer of power in Britain from public, elected authorities to private, unelected corporations'.

Now, over a decade later, it seems that both the Treasury and the accounting profession are also having serious doubts. The National Audit Office report on the refinancing of the Norfolk & Norwich University Hospital, published in June 2005, rang alarm bells when it identified windfall profits of £73m made by banks and property developers, and along the way highlighted the growing secondary market in PFI hospital shares.

And now the Department of Health's recently issued NHS operating framework for 2006/07 – while affirming that 'the NHS will remain the largest single user of PFI in government, with a programme valued at an estimated £7bn–£9bn' – makes it clear that business cases for PFI schemes must now be 'assessed in the light of the reform programme' and that boards must 'consider longer-term affordability carefully'. As Mark Hellowell observed in Public Finance last week, this represents a cut in planned PFI spending of up to 40%.

If the rhetoric surrounding the PFI has often focused on building works and private sector project management skills, the economic substance has lain in a transfer of hospital support functions to the private sector. But with the English NHS now increasingly working on a market model, and with a viable and growing private hospital sector providing some 10% of NHS-funded elective surgery, the Treasury appears to be no longer willing to support the long-term costs of the PFI approach.

The accounting profession has also caught the new mood. Some trace the Department of Health's new realism to a starkly worded public interest report on the Queen Elizabeth Hospital NHS Trust in Woolwich, southeast London, issued in December by its auditors, PricewaterhouseCoopers. The trust moved to its current location in 2001 as part of an innovative large PFI scheme. Its deficit, projected at £19.7m in 2005/06, had already received considerable local publicity. Instead of blaming board members and urging the trust to tighten its corporate belt, PwC found 'underlying relative efficiency' at Woolwich, and observed that it was the high level of fixed costs arising from the trust's PFI scheme that made reducing costs 'particularly difficult'.

PwC then made two crucial points, which together have possibly pricked the PFI bubble. The first is the initiative's inflexibility within an NHS market that now demands the precise opposite. The fixed amount payable to the PFI partner 'is approximately £15m per year, increasing annually with inflation', the report notes. 'This amount is fixed under the contract and cannot be reduced, even if activity levels fall significantly.' Yet the Queen Elizabeth Hospital, like other suburban general hospitals and especially those around London, is increasingly vulnerable to competition and choice within the emerging NHS market, including competition from two nearby PFI-funded hospitals in Dartford and Bromley.

Under payment by results, a flexible cost base is vital. Income is insecure. However, a large PFI scheme, with its fixed costs, will inevitably focus all attempts to achieve savings on to the remainder of the trust's cost base and, increasingly, its clinical staff.

PwC's second point concerns affordability. Since 2001, it observes, 'the trust achieved its breakeven duty only through significant amounts of financial support'. However, 'central financial support provided to the trust in earlier years of the scheme… is currently being phased out, thereby exacerbating the trust's financial difficulties.' In other words, the Woolwich PFI scheme was only ever affordable with a subsidy, and that subsidy is now steadily shrinking: from £3.1m in 2002/03 to £1.1m in 2005/06.

Affordability concerns are not confined to the Woolwich hospital. The PFI has never been a free lunch for the NHS. The internal rate of return on a scheme – that is, the level of return to equity investors – has typically been around 12%–15%, according to Michael Ware, corporate finance partner at BDO Stoy Hayward. At Norfolk & Norwich, the actual rate has been estimated at 60%. Yet the rate of return on capital implied within the NHS's financial model is a mere 3.5%.

How, then, to find efficiency gains to cover the typical 10% or so difference between a PFI consortium's charges and what the NHS can afford? If, in the longer term, the ambition of government is to make savings through improved labour utilisation on support services and through tightening access to the NHS pension scheme and related entitlements, its ability to do so in the short term is constrained by the Transfer of Undertakings regulations and by public pledges on maintaining conditions of service. This places the financial burden back with NHS trusts, where it commonly becomes an additional claim on already ambitious savings plans – and has led to the PFI being associated in the public mind with hospital closures and bed cuts.

The payment by results funding system highlights the affordability dilemma. A funding regime based on average cost makes new premises financially unattractive, as the trust has no ability to charge higher prices to recover its extra costs. Moreover, the 2006/07 operating framework limits the tariff uplift to an average of 1.5%. An efficiency requirement of 2.5% is, in effect, top-sliced by the DoH. For trusts already in deficit, and tied into PFI contracts extending beyond the career spans of most of their board members, financial balance begins to seem ever more remote.

Meanwhile, it has gradually become less and less feasible to justify the off-balance sheet accounting treatment that made the PFI so attractive to government in the 1990s. The accounting standards net has been steadily closing. An accounting policy change, introducing fuller implementation of Financial Reporting Standard 11: Impairment of fixed assets and goodwill, has already made large capital schemes less attractive. FRS 11 requires that certain reductions in asset values are charged to the income and expenditure account in the year they are incurred. Large building schemes, which typically involve the demolition of existing assets, often therefore generate a sizeable impairment during the site clearance period. This policy change had a material effect on the 2004/05 NHS accounts.

Then, last September, as the Office for National Statistics announced its own intention to treat further categories of PFI debts as public sector national debt, the International Accountancy Standards Board prepared rules that would finally bring off-balance sheet spending firmly within the government's accounts. The IASB maintains that if an asset is subject to government control, and will eventually revert to public ownership, it should appear on the state's balance sheet. Public Finance at that time assessed the value of off-balance sheet PFI in the NHS as £4.93bn – almost entirely in the form of contracts for hospital buildings.

Questions about the future need for big hospitals have also prompted a change of view. With politically sensitive access targets largely met – the NHS has recently announced the end of the six-month wait in England – and a growing acceptance that the service already has enough capacity if it can only be used efficiently, the case for major investment in large hospitals becomes harder to justify.

The publication of the health care white paper last month makes it clear that the direction of health policy, for the foreseeable future, lies in primary care, community hospitals and polyclinics rather than in money-hungry large acute hospitals. The trend is common across western Europe.

Faced with this change of strategic direction, PFI-laden hospital trusts are finding their inflexibility a near-fatal drawback. Like armoured knights on heavy horses, they are in serious danger of sinking into the mud.

Yet a future based on polyclinics will also require capital investment, and the NHS's current preferred model for primary care investment, the Local Improvement Finance Trust (Lift), mirrors both the complexity of the PFI and its long-term commitments to private partners.

Around 60 new Lift-funded primary care schemes are already due to open this year. Yet, ironically, a hurried implementation of payment by results, using a relatively unsophisticated tariff structure, has been closing numerous community hospitals. There is a big difference, of course, between a traditional English cottage hospital and a twenty-first century polyclinic on the German model. But they share the relatively high costs of dispersed as opposed to centralised provision. If community hospitals are no longer viable, can we afford the polyclinic model?

Meanwhile, if the big PFI hospital scheme has had its day, its legacy will be with us for many years to come. We now have the buildings, and the debts. At local level it can seem pretty unfair. David Milner, finance director of South East London Strategic Health Authority, says he is 'very pleased to see, in the operating framework for 2006/07, that the department is shortly to issue practical guidance on applying the experience of previous procurement – because southeast London, having early PFI schemes, is paying a price that's not fully reflected in the payment by results regime'.

The pressing question is who should pay the creditors of trusts such as the Queen Elizabeth Hospital in Woolwich. Should the debt be borne centrally, acknowledging that boards were taking part – not always willingly – in a financial experiment that has been less than fully successful? Or should the local trust, and its local community, carry the can for generations to come?

Noel Plumridge is an independent health care consultant and author of CIPFA's Payment by results: new financial flows in the NHS in England


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