Government funding for new infrastructure and buildings is projected to decline from 3.1% of national income this year to just 1.25% in 2013-14, and it is set to remain at that level at least until the end of that decade. At the same time, the collapse in the financial markets has pushed the cost of the main alternative to capital funding by government – private finance – to an unprecedentedly high level.
There is now widespread concern that the rate of capital expenditure in the UK will be inadequate for a very long period, hampering growth and damaging public services. Encouragingly, however, this has led to a flood of creative ideas from the country’s public policy think tanks and academics.
No fewer than four substantial reports on capital financing have been published within the last three months - and many of these, it appears, are already having a real influence on decision-makers.
Taking first the most recent, Capital Contingencies, from the New Local Government Network (NLGN). This focuses on the importance of giving councils new freedoms to raise money through issuing bonds. The think tank also wants authorities to “rapidly explore” their potential for applying financial reserves more intelligently – using pooled resources to aid infrastructure investment.
This chimes with recent proposals by the Local Government Association to use pooled council pension funds for investment in PFI schemes, thereby helping to address the shortfall in liquidity. The move looks likely to make council funds major players in the Building Schools for the Future programme.
Policies like this, which rely on new methods of debt-funding for investment, can reduce the problem of insufficient capital. But they can only do so by placing an additional burden on revenue. And revenue – money for staff and supplies, basically, as opposed to money for buildings and equipment - is also set to be heavily constrained in the coming years, of course.
To be fair, the NLGN has obviously thought about this. Its report calls openly for an increase in user charges – for example, bringing in a workplace parking levy - to help pay for new capital spending. And indeed, there seems to be no doubt among councils that increased revenue generation from service users is inevitable. Whether such modest increases in fees from service users could do much to ease the burden on resources generated by new investment is open to question, however.
A report by the Centre for Public Service Partnerships at Birmingham University, Capital Futures, focuses attention on driving efficiencies in the use of capital through greater collaboration. Public managers have characterised the nature of joint working between local agencies on capital resources as being tactical rather than strategic, and the Centre believes this can change. It wants to widen the Total Place programme to include capital assets and expenditure. This would make for more efficient capital planning, and funds would be generated through asset sales.
It also calls for more leasing from the private sector, and the use of private facilities – for example, co-locating walk-in health centres or police information points in supermarkets or shopping malls. While few could disagree with the need for greater collaboration between public bodies, the juxtaposition of the proposal for increased asset sales and leasing will raise eyebrows.
Getting rid of public buildings to rent newer, costlier private ones should be seen for what it is: a way of reducing short-term budgetary constraints by damaging the longer-term cost-effectiveness of services. This, of course, may be attractive to public managers, but future taxpayers may not thank us for indulging them.
The Centre’s report does, however, contain a concrete financing proposal which is likely to generate a lot of discussion in the coming months: Tax Increment Financing, or Tif. This is a means of using anticipated future increases in tax receipts to finance current projects, where those projects are expected to generate stronger growth and therefore more revenue. The mechanism is popular among municipalities in the US, where it is estimated that there are around 900 Tifs.
The US version of the model is to establish a special district in an area in which an authority wants to develop roads, schools, or businesses. The property values and tax revenues for the district are calculated and the authority issues bonds that are repaid through increases in tax revenue generated by the capital investment – in effect, buying tomorrow what we consumer today. The model is currently being considered by Newcastle City Council, which wants to build a new university research centre.
However, the system is not without its critics. In particular, there are likely to be objections to the idea that increased tax revenues will go to bond investors rather than strengthening the finances and service capacity of authorities.
Of the four reports published recently, Delivering a 21st Century Infrastructure for Britain, published by the right-leaning Policy Exchange, is probably the most intellectually sophisticated. It comes in two main sections: the first, by the distinguished economist Dieter Helm, lays out the case for an expansion of the utilities regulation to include other areas of infrastructure; the second, by banker James Wardlaw, calls for a new UK infrastructure financing facility.
Helm’s work starts from a proposition that, given the size of government debt, as much investment as possible should be undertaken off the balance sheet and financed by the private sector. On the other hand, he believes that the PFI, as currently constituted, has cost too much due to the excessive rate of return. He argues that private investment can be provided at a cost that is much closer to the government borrowing rate through expanding the 'Regulated Asset Base' (RAB) that exists in the utilities sector.
Companies within the RAB have a lower cost of capital than other businesses because they operate within a framework in which the returns to shareholders are protected by regulators. In other words, the equity risk in the RAB for the company is zero – it has been transferred to customers or taxpayers, who are forced to pay for the returns that have been agreed by regulators.
By expanding this framework to include a much wider area of the economy (the decarbonisation programme, high-speed rail, road transport and much of the PFI programme are specifically identified), Helm suggests the cost of capital on privately financed projects could be massively reduced.
Interestingly, the idea of expending the RAB seems to have high level support among decision-makers. Speaking at an industry conference recently, James Stewart, chief executive of Partnerships UK – the PFI/PPP agency – said such a move could help to take the heat out of the debate on the cost of private finance.
'In the utilities sector and the regulated markets, no-one really talks about the utilities companies making lots of money because everyone takes comfort from the independent regulator,' he said. 'It interests me personally...the extent to which we can introduce regulation into these markets to give a better framework and to take heat out of the system.'
In other words, there exists within the PFI/PPP industry a feeling that the regulation of private sector returns may be beneficial for its long-term survival – perhaps reflecting a belief that the extraordinarily high rates now being charged in the market could finally slay the golden goose.
At the same conference, Richard Abadie, former head of PFI policy at the Treasury and now a Partner at PricewaterhouseCoopers, asked why the government was not regulating returns: 'If the government are concerned about the cost of finance, and how it is performing, let us regulate it. Let us not throw the whole system out the door.'
Section 2 of the Policy Exchange report lends further support to this analysis. It is essentially a series of proposals designed to deal with the impact of the financial crisis on the availability and cost of senior debt for PFI schemes. James Wardlaw, an adviser to the Investment Banking Division of Goldman Sachs, notes (somewhat euphemistically), that 'judgements about the value for money of private sector versus public sector gilts-based financing have become more difficult'.
That is, it has become more difficult to ensure that comparisons between PFI on public procurement find in favour of the former.
He goes on: 'Essentially, the key question for a procuring authority is what are we getting for the incremental cost of financing over and above the cost of government borrowing through gilts? This was a much easier question to answer when the differential was 60 basis points per annum [i.e. 0.6% above the cost of long-term gilts] than when it is 250 basis points or higher.'
Importantly, Wardlaw expresses his doubt that the financing market will return to moderate pricing. 'It is tempting to think that the issues are temporary...But there is a stronger case to be made that these issues are structural and that we will not revert to the heady days of abundant liquidity which encouraged the headlong pursuit of incremental yields irrespective of risk.
'Against this backdrop, we must reflect on the adequacy of the existing institutional set-up in this country to deliver the financing of infrastructure that we need and the role that the Government should play.'
His proposition is that some kind of central infrastructure bank, probably involving Partnerships UK, the new Infrastructure UK, the Treasury’s Infrastructure Financing Unit and the Public Works Loan Board, should be established. The prize, he suggests, is 'an institution which facilitates the introduction of private sector capital without crowding it out, finances itself with a government guarantee, aims to break even with any dividends reinvested, and whose liabilities do not score in the National Accounts but whose activities are defined by national priorities.'
This last element may be the most difficult to achieve – the provision of a state guarantee would normally imply some impact on the national statistics. But it will be interesting to see what the Pre-Budget Report has to say about Infrastructure UK, the planned investment body, about this issue.
The final report, Power to Build, is by Reform Scotland and is specifically aimed at policy-makers north of the border. It is hard not to see the report as a piece of policy advice for the Scottish Conservatives, who have struggled to achieve any coherence on the issue of capital investment in recent years.
The Tory bias of the report makes for some (for PFI experts) amusingly partisan and inaccurate points. 'The PFI/PPP system was introduced to the UK in 1992 to harness private sector innovation and bargaining skills in public sector projects,' it notes. 'It was later also used to remove debt from the public sector balance sheet.” In other words, what started out as an honest attempt to improve performance under the Conservatives was hijacked by Labour and turned into little more than a balance sheet scam.
(This little piece of revisionism - Kenneth Clarke and others were actually quite straightforward about the balance sheet advantages of PFI - appears quite frequently in Tory circles at the moment).
Nonetheless, the report actually has some quite sensible points to make. It suggests that the debt component of the PFI structure ought to be replaced by public finance (through direct borrowing, bond issues or Tif). But there would continue to be private sector involvement through a management company, which would deliver 10% of the capital expenditure required through the provision of equity. What this would do, in effect, is place the activities of the Treasury Infrastructure Financing Unit, which exists to lend government money to PFI schemes, on a permanent footing, and at favourable rates.
The idea appears to be to utilise the alleged benefits of private finance in terms of on-time and to-budget delivery (benefits which, in fact, only exist if you take as your baseline the point at which contracts are signed) while securing the benefits of government rates of borrowing. There are problems with the specifics here (for example, the report suggests that the Scottish Futures Trust should decide who gets the tender to manage and commit equity to projects, which would violate EU procurement law) but overall the idea appears defensible.
It may even have the support of parts of the PFI/PPP industry. For example, Andy Friend, a non-executive director of PUK and former chief executive of construction group John Laing, told a conference recently that the government’s obsession with using PFI as a means of keeping debt down, as opposed to trying to find the best overall structure, had damaged efficiency:
'The resulting distortions of common sense risk distribution...led quite unnecessarily to private sector funding costs being factored in across entire capital structures – where a combination of private and public financing would have been both more serviceable and cheaper.'
Herein lies the rub, however. With the government focused on trying to cut the level of public debt, the treatment of private finance on the national accounts remains a key issue - perhaps the key issue. By using government capital, or by issuing guarantees, the 'fiscal advantage' of private financing is likely to be eroded.
There is, of course, a reason for this: the provision of public capital or public guarantees imply that risk is taken on by the public sector – risk that would be transferred under regular PFI arrangements. But it is interesting that none of these thinkers – most of whom lean towards the right and are certainly pro-private sector – think that there is any advantage to transferring this risk, given the cost of doing so.
Mark Hellowell is a research fellow at Edinburgh University
