Ministers are putting their faith in a new, improved version of the Private Finance Initiative. But financing costs are likely to increase in the short term and alternative options are still few and far between
Alongside the Autumn Statement, the Treasury published the outcome of its year-long review of the Private Finance Initiative, a programme that George Osborne described in his speech as ‘discredited’. The overarching goal of the review was to come up with a new investment model – which ministers are calling PF2 – that is less expensive than traditional PFI.
So will PF2 achieve lower prices than its predecessor? After reading the documents released today, I’d say no.
The most eye-catching change is that public cash is to be used as equity in projects, alongside private sector risk capital. This will allow the government to share with the private sector some of the returns on equity, and is clearly a response to influential critics such as the Public Accounts Committee, who allege that PFI leads to excessive profits.
This, of course, is the aspect of the announcement that the media will focus on but I suspect there is less to it than meets the eye. If, as seems likely, we are talking about the public sector providing a relatively small proportion of the overall amount of equity in the project company, an excessive return to investors will still mean an extra expense for the authorities involved – and the wider public sector.
More important is the decision to increase the amount of private sector equity relative to debt. In the past, PFI investments have been a very highly geared, with debt to equity ratios of about 90/10 normal. Ultimately, the level of gearing is determined by the market, not the state, so we will see how the industry responds.
But the Treasury has sent out a strong signal that it believes gearing of 75/25 is more appropriate. It hopes a lower level of gearing will get risk-averse investors like pension funds to take an interest in lending to new-build infrastructure projects.
This is crucially important because, as the document makes very clear, bank lending is no longer a sustainable source of debt capital for PFI – sorry PF2 – schemes. In the wake of the financial crisis and in anticipation of much stricter international capital adequacy regulations, banks are unwilling and unable to lend for the long term, and the high interest rates they charge when they are able to do so are ultimately passed on to authorities.
So the banks are now, as a matter of policy, out of the picture – and lower gearing is seen by officials as the way to get the institutional investors to lend.
But what will this do to the financing costs? In the short term, these will almost certainly increase. On an average project, the interest rate on debt is now around 7% (much higher than pre-crisis, when the Labour government was doing most of its investing), while the normal rate of return expected on equity is 15%.
With gearing of 90/10, this implies a Weighted Average Cost of Capital (WACC) of 7.8%. Changing the gearing to 75/25 implies a higher WACC, of 9%. In the longer term, both sets of expected returns should be reduced to take into account the lower level of risk, but it is likely to take the market some time to get comfortable with this new scenario.
In public, pension funds are adamant that, even if they do get involved (after years of government arms twisting), they have no intention of providing lower-cost funds.
There are other important elements of the review that will require further analysis as things proceed. There are moves to accelerate the procurement process by withdrawing approval for projects that are not signed within 18 months of being tendered.
This responds to the very real problem of protracted procurement timetables, leading to high transaction costs for all parties and significant barriers to market entry. But it is a risky approach – and could undermine a public authority’s bargaining position quite significantly as negotiations approach the deadline.
There is also confirmation that ‘soft facilities management services’ – things like catering and cleaning – will not be part of PF2 deals. In fact, this has been standard practice for some time. This should make deals more flexible – especially if authorities want to cut costs – but it will also significantly weaken the union voice in this area of policy debate, which is something ministers and official will welcome.
There are some limited steps towards greater transparency – most of them positive but overblown. There is already quite a good level of financial information freely downloadable from the Treasury website. And then there is, inevitably, some highly questionable and politically inspired drivel.
I’m extremely sceptical about the Treasury’s claim to have found £1.5bn savings on existing deals. Little evidence is provided in the document. Even if the figure is right (a remote possibility given the uncertainties involved and the political incentive for optimism bias) this probably equates to about 0.5% of the outstanding nominal liability. Finally, the Treasury’s claim that the budgetary incentive to pursue PFI has been eradicated is completely absurd.
PF2 is to be piloted on a forthcoming programme of new schools (worth about £1.75bn), some defence accommodation of unknown cost and a £400m hospital scheme in Birmingham. For these projects, no alternative capital financing option is available and PF2 continues to be the only game in town. How’s that for a budgetary incentive?
