Is PFI on the critical list? By Mark Hellowell

28 Aug 08
The huge number of gleaming new hospitals are a testament to the success of the Private Finance Initiative. But can the policy survive now that it is no longer the only game in town? Mark Hellowell reports

29 August 2008

The huge number of gleaming new hospitals are a testament to the success of the Private Finance Initiative. But can the policy survive now that it is no longer the only game in town? Mark Hellowell reports

New Labour's millennial NHS Plan promised to build 100 new hospitals in England by 2010, largely through the Private Finance Initiative. Government figures suggest this target will be met, but then the programme will come to an abrupt end as funding is diverted from the acute sector to primary and community care.

Since 1997, 92 new health care facilities have opened their doors. A further 35 are in construction, most of which will be completed by the end of the decade. The PFI, accurately described as the 'only game in town' by NHS managers, accounts for more than 90% of the £11.5bn of capital invested in these projects.

After decades of capital neglect, the hike in NHS investment was widely welcomed. But the overwhelming dominance of the PFI in hospital-rebuilding has been attacked by Labour's Left-wing, trade unions and many academics. There has also been widespread public concern about the policy's economic rationale and the impact it has had on health care capacity.

For years, New Labour's political commitment to the PFI was strong enough to face down this criticism and the hostile media coverage that sprang from it. But a number of factors have combined to make the initiative less attractive to NHS trusts, the Department of Health, the Treasury and even the prime minister. The results of this new reality have been brutal . In July 2004, John Reid, then health secretary, announced plans for a new wave of 15 hospital schemes, worth £4.4bn – all but one of them to proceed under the PFI. These plans have now been radically pared down, with the total capital value slashed to £2.85bn – a real-terms cut of around 50% (see Table 1).

Only one of the schemes, the redevelopment of the renowned Great Ormond Street Hospital for Children, has reached construction stage. And it can be no coincidence that this £225m project is the only one earmarked to go ahead under public procurement. Three other trusts have managed get their projects advertised to the private sector.

For the majority, capital values have been slashed by hundreds of millions of pounds. A £1bn scheme for hospital services in Merseyside, for example, has been downsized to £500m, and its components split into three separate schemes. Plans for new hospitals in Birmingham and in Hillingdon in north London have also been cut in half.

Two projects, for Leeds Maternity services and Southall Hospital (original combined capital cost £304m), have been abandoned altogether. Many others are likely to follow.

There is no doubt that the policy of moving outpatient services, diagnostics and routine surgery from hospital to primary care settings has had an impact on demand for the PFI. Also crucial is the growing awareness across the policy-making hierarchy that the PFI is not a 'free good'. On the contrary, it generates high fixed costs and fits in poorly with the wider health care reform agenda.

The key factor has been the payment by results hospital funding system. Under PbR, a hospital's income is based on the volume of patients it treats, rather than the needs of the population it serves. This method, introduced in stages from 2005, provides resources to trusts in the form of a national tariff for each treatment carried out, which is set to equal the average cost of that treatment across the NHS.

When putting together business cases for new investment projects, trust managers have to estimate what levels of activity they are likely to be delivering in future decades. That is difficult, bordering on impossible, in a context where income levels will fluctuate according to patient choices, and where primary care commissioners are expected to buy care from a range of public and private providers.

A more fundamental problem is that the PFI creates extra costs for trusts, and PbR tariffs are not designed to reflect this. Those with large PFI schemes therefore run a higher risk of running into deficit than those with less expensive estates. In 2005/06, half of trusts with major PFI projects were in deficit, many seriously, compared with fewer than a quarter of trusts overall (see Table 2).

A look at the income/capital cost ratio for each trust shows why. For the 18 trusts with major PFI schemes in operation in 2005/06, capital costs were 4.3% higher than the amount funded under the tariff. And because PFI costs are fixed under largely intractable contracts, the impact of the shortfall inevitably hits the remainder of a trust's cost base – and that means quality of care can be threatened.

These higher costs are caused by two factors. First, irrespective of how you finance them, new buildings will cost more than old ones: capital costs on a new facility will be higher than that on an older, depreciated asset. Second, as an increasing body of evidence shows, the cost of finance on PFI schemes is higher than for publicly financed schemes, and these costs are borne by trusts.

In 2002, PricewaterhouseCoopers carried out a study on PFI financing costs for the Office of Government Commerce. This found that the average rate of return on all capital employed by the private sector (ie, equity capital from investors and debt from banks and the capital markets) is 7%. For buildings owned by the NHS, in contrast, the cost of capital is just 3.5%.

It could be argued that under the PFI, the private sector is bearing construction risk, and therefore has an incentive to keep capital investment costs under control. However, it is highly unlikely that the efficiencies it could bring to bear would be of sufficient magnitude to offset such a major difference in financing costs.

In addition, while more up-to-date information is hard to get hold of, there are good reasons to assume that the cost of capital is increasing for private operators as a result of the credit crunch. The cost of money has increased significantly over the past 12 months, as have the margins expected by banks and providers of bonds.

While NHS managers have good reason to regard the PFI with a critical eye, Whitehall's enthusiasm might also be on the wane. The primary advantage of the initiative from a department's point of view is that upfront capital costs do not score against annual accounts. However, the ability to keep private finance off balance sheet could be eliminated when the UK moves to International Financial Reporting Standards in 2009/10.

Under the new regime, PFI contracts will be accounted for according to Ifric 12, issued by the International Financial Reporting Interpretations Committee. The committee reviews accounting issues that have arisen from the reporting standards and issues authoritative guidance on them, known as 'interpretations'. The interpretations are approved by the International Accounting Standards Board and have the same authority as accounting standards. Ifric 12 makes it clear that PFI investments will not score on the private sector's balance sheet, and the Treasury has accepted that this means they must score against the capital budgets of public authorities.

According to recent statements by the Office for National Statistics, this will increase the amount of PFI investment recorded in the national accounts. The addition of more than £30bn in capital liabilities could force the government to break its sustainable investment rule, which places a 40% ceiling on the ratio of public debt to gross domestic product. It would also, at a stroke, eliminate one of the main advantages of the PFI from the point of view of the Treasury.

While the move to IFRS will address accounting anomalies, one perverse outcome is that NHS trusts with PFI projects will have to pay twice for the use of their facilities – one charge to their private partner

(already higher than average NHS costs, as explained above), and one to the government in the shape of the capital charge, set at 3.5% of the value of their entire estate.

This is basically an administrative anomaly, and might be addressed in the autumn Pre-Budget Report, but the current confusion is undoubtedly contributing to a sense among NHS trusts that proceeding with the PFI is just not worth the candle.

Meanwhile, it remains to be seen whether the government as a whole continues to be interested in using the PFI in the absence of any of its accounting advantages. For successive governments, the PFI has had a political as well as a practical significance. New Labour's endorsement of what had been a Conservative policy was important in the wake of its 1995 rewriting of Clause 4, the part of its constitution that committed the party to 'common ownership of the means of production'.

And there is still a strong feeling at the top of New Labour that its relationship with the private sector must be nurtured. DeAnne Julius's Public Services Industry Review report, commissioned by the Department for Business, Enterprise and Regulatory Reform and published on July 10, stressed the importance of business involvement in the public sector in terms of national GDP. It also highlighted the potential for British public services firms to take their expertise overseas.

Berr Secretary John Hutton's decision to commission the review was a clear attempt to further the Blairite project of increasing private involvement in public services. The CBI business lobby was quick to welcome the document, calling on ministers to 'ensure that every part of the government machine is geared to selling our expertise and allowing the public-private partnership market to flourish'.

What is less clear is how important the PFI is to this process. The government's use of the private sector in health care is so much greater in scale and scope than could have been imagined just a few years ago. With independent sector firms, from the US and around the world, now taking on health service commissioning and delivery, the PFI no longer has the iconic status it once had.

The PSI review identified primary and community care as areas of huge potential growth for business. But it is not clear exactly what role the PFI, or variants of it such as NHS Local Improvement Finance Trusts, will play in this.

Under Lift, which has been used in primary care since 2001, new public-private businesses are established to manage capital investment programmes within health localities. There are currently 48 Lift companies, covering about half of England's population, and these have provided more than £1.4m worth of investment in primary care facilities. Around 40% of England's Primary Care Trusts are now involved in the Lift programme, and the remaining 60% are to be invited to do so from 2009.

In principle, the Lift vehicle might be expected to deliver the lion's share of the hundreds of new polyclinics that are an important part of Health Secretary Alan Johnson's current reforms. And, indeed, it seems likely that, where Lift companies are in place, they will play some sort of role in the provision of new facilities.

But more generally, the role for privately financed investment in NHS stock seems less relevant now that the private sector is playing an ever-increasing role in the actual delivery of care. The natural outcome of further privatisation and marketisation of health care is private companies bringing their own capital to bear in providing buildings – and being remunerated through service payments, as happens under the independent sector treatment centre programme.

A few years ago, the PFI's usefulness to the government went beyond a mere accountancy fiddle. Its aggressive promotion by a New Labour government sent a signal to the City and industry that the party was on its side.

Now, with the policy discredited within the NHS, and the possibility that PFI capital costs are about to show up on DoH and national accounts, its continued use in health care, and indeed in the wider public sector, is now in doubt.

Mark Hellowell is research fellow at the Centre for International Public Health Policy at the University of Edinburgh


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