Saving private finance, by Mark Hellowell

6 Apr 06
Rumours of the PFI's death have been greatly exaggerated. With its lengthy inflexible contracts and high annual costs, its days were looking numbered in an era of choice. But then Gordon Brown came to the rescue. Mark Hellowell reports

07 April 2006

Rumours of the PFI's death have been greatly exaggerated. With its lengthy inflexible contracts and high annual costs, its days were looking numbered in an era of choice. But then Gordon Brown came to the rescue. Mark Hellowell reports

It can't have been easy. For several months, Gordon Brown kept his Private Finance Initiative expansion plans to himself, even as commentators predicted that the policy's days were numbered. But on Budget day, the chancellor finally played his hand, revealing a programme of 200 schemes worth a massive £26bn.

At least, that was the story that Treasury aides spun the night before and the one the newspapers eagerly bought and splashed on their front pages. In reality, this announcement was like most spin: partly true, but wholly misleading.

The £26bn figure is a fair estimate of the value of PFI projects that will be signed off before 2010. The amount of investment due from schemes that have recently been signed, and those that are near to being signed, is about £21bn. Add to that the investment associated with some of the large transport and defence projects and you gain another £5bn or so.

But this is not, as the spin suggested, a change of policy. There has been no decision to expand significantly one of Brown's favourite policies. What has happened is that some of the larger projects have selected their 'preferred bidders' – and it is at this stage that the schemes show up on the government's spending forecasts. Thus, the forecast in this Budget is just under twice what it was last year.

That aside, the chancellor did provide a significant statement of support for the PFI in the Budget. The document, PFI: strengthening long-term partnerships, contains a series of new policy announcements, bringing this now aged policy back into the modern world.

The central message is that, whatever reforms emanate from the prime minister and the departments over which he exerts his control, the Treasury's very own PFI will be the only means of investment. Thus, PFI contracts are to be made much more flexible to fit in with the Blairite model of public service delivery, in which choice and competition are the central pillars.

Recent events show that this is crucial to the long-term future of the initiative. While the 25%–40% cut in the hospital-building programme was partly about the shift from acute care to 'community' care, it was also a recognition that expensive and intractable PFI contracts create difficulties in the new market context.

It is perfectly clear that NHS trusts pay more for PFI hospitals than others. This is an issue however trusts are financed, as they receive little formal support from the Department of Health. But under the former 'block contract' regime, there was scope for informal support for PFI costs through the process of negotiation. Under the payment by results hospital funding system, that option disappears because trust income will be based on the average costs of each treatment. Since the PFI leaves trusts with an above-average cost base, the scope for financial difficulties down the line is plain.

Added to this, the Patient Choice agenda creates uncertainty for trusts contemplating large procurements, since many will lose services to competing hospitals and independent sector providers as patients 'vote with their feet'. In this context, the flexibility of the procurement mechanism is an essential precondition of such a large-scale investment as hospital building.

Similar concerns can be raised about the huge spending programme in education, Building Schools for the Future. Under this initiative, all secondary schools and many primary schools will be rebuilt or refurbished through long-term public-private partnerships. At least half of the funding will come through the PFI. Although there is no PBR-style funding mechanism here, choice is similarly at the core of the government's approach to reform, and this causes a tension.

There is a high-level question about whether the BSF, which targets poorer areas and struggling schools, makes any sense in the context of what Blair calls 'a system of independent, self-governing state schools'. Targeting poorer schools – ie, those that the logic of choice tells us will improve or die – seems old hat.

That fundamental difficulty aside, the PFI makes the job of local education authorities harder because the companies concerned will expect to be paid for their school, regardless of whether it is open or closed. Already this has happened where populations have unexpectedly declined: the Belfast Education and Library Board, for instance, is paying an annual unitary charge of more than £350,000 for a school that is reported to be less than half full.

And, under the market model, local education authorities will have to open and close schools and expand them or downsize them. The inflexible nature of the PFI makes this much more difficult.

Liverpool City Council has been making this point to Partnerships for Schools, the government-backed agency that oversees the BSF programme, in recent months. The council has made it clear that it will not be using the PFI for its £320m schools programme. The model, it says, is simply too inflexible in the context of the education white paper.

In response, PfS is playing hardball. The Treasury's position is that large capital projects should be delivered through the PFI, and PfS is part-owned by the Treasury through its Partnerships UK parent. Not surprisingly, the agency is not minded to endorse Liverpool's proposal and, since it holds the money on which the local plans are based, that is important.

Officially, PfS is considering a compromise, and a decision is 'imminent', according to the council. But PfS will certainly not want to generate uncertainty across the programme by sanctioning derogation from the established process – and, in doing so, tacitly accepting that there is a problem.

In the meantime, the programme is stuttering. The theory underpinning this strategic, long-term programme was that private firms would bid cheaply for initial BSF waves on the basis that they would receive more work further down the line. However, there is no absolute guarantee of future work, and the industry has come to doubt the realisation of BSF's ambitions in the new climate.

The progress of the programme has disappointed many on both sides of the public-private divide. By now, it should be delivering £1.2bn of private finance into England's secondary schools, along with around £1bn of public capital for smaller schemes, according to the original plan outlined in 2004.

But all the uncertainty over broader policy has taken its toll. The Budget papers show that there is £1.8bn of PFI money in the pipeline, but all the schemes that contribute to this figure have yet to be advertised to the market. Just £491m will be delivered through the PFI this year – and 100% of this comes from the pre-BSF private finance schemes. As with health, the education programme is falling behind.

In this context, the Treasury's new document will be seen by the industry as a welcome, if belated, intervention. The changes described are unlikely to fill too many column inches, but added together they constitute a serious attempt at reform.

Probably the most eye-catching change is cutting down contract lengths. This sounds like a simple method of dealing with the PFI's overly long tenures, but it might be difficult to implement.

Shorter contract times imply a higher annual PFI charge in proportion to the amount of private finance in schemes, limiting what the public sector can afford. The result is that contracting authorities will be more conservative in sizing their PFI projects – perhaps moving forward with their investment plans in smaller phases. Already there are signs that health care schemes are going down this route.

Another big change involves catering, cleaning and security services. Evidence from Partnerships UK has shown that the quality of these services has suffered under the PFI. From now on, transferring these services through the PFI contract will be approved by central government only in exceptional circumstances.

It is interesting to speculate what would have happened if this had happened some years ago. Criticism of the PFI has been led by the public sector trade unions because of their desire to protect staff employed in these so-called 'soft' services from worse conditions in the private sector. If the unions do not repeat their call for an end to the policy at Labour's annual conference this year, this will be why.

Less immediately arresting, but probably more important, are the changes to the financial structure. Officials have concluded that bond financing, the standard way of financing hospital deals, might need to be regulated in future. Thus, they will take a dim view of 'over-indexation' in future deals, suggesting that plans submitted on the basis of index-linked bonds will not gain automatic approval.

Where projects are bond-financed, the Treasury will be asking for a 'modified spend clause', referring to a hedging technique, a little trick the PFI world borrowed from corporate finance. This will allow bond holders to be compensated when a bond is paid back before maturity, as would happen if the authority wanted to end the deal.

This changes the rules of the PFI game quite significantly. It will give public sector procurers greater flexibility to ditch PFI contracts when they feel they need to – for example, where hospitals or schools are no longer needed. Past experience, however, shows that the private sector might have something to say about this in the forthcoming consultations.

Taken in the round, how significant are the new changes, and what effect will they have on flexibility? Well, shorter contract times will certainly ease concerns about generation-long straitjackets. But this might not be affordable.

The absence of services contracts will give authorities more flexibility in dealing with new priorities, and responding to the public's priorities. But soft services were always a bit of an afterthought in the PFI, and adapting them is much less costly than adapting a building.

The new flexibility to change contracts where large-scale changes are necessary, or where buildings as a whole must be mothballed, is probably the most significant contribution to flexibility. But the extent of this flexibility will be constrained by the European Union procurement directives. And how the move will play with the market is anyone's guess.

The chancellor had little choice but to amend his cherished PFI policy: the big programmes in health and education had to be put on a more stable footing. By the time Brown takes charge of the reform agenda, as we understand he eventually will, we will know if his attempt to rescue the PFI has been successful.

Mark Hellowell is a research fellow in public-private partnerships at the University of Edinburgh


Did you enjoy this article?