PFI on trial

The fact that the Treasury is currently trying to close a deal to reconfigure and increase capacity at its Whitehall head office could be seen as an unfortunate twist of fate. Why? The negotiations are with its existing PFI consortium, Exchequer Partnerships - so just when politicians are baying for the blood of the 20-year old procurement method, what should come along but a prime example of why it can be inflexible and expensive.

Exchequer Partnerships - made up of Lend Lease’s PFI arm Catalyst Lend Lease and a fund run by Barclays Bank - signed a £170m, 35-year PFI in May 2000 to refurbish and look after the buildings. But now the Treasury wants to house more people there, and Exchequer is understood to be negotiating variations to the deal.

The wrangling comes at exactly the wrong time for the construction industry, as a Treasury announcement on the future of the controversial procurement method is due possibly as early as next month. For critics, the Whitehall situation shows exactly why PFI isn’t working for the public sector: it ties the government in to long-term liabilities to pay private firms, without enough flexibility to adapt to the changing requirements of the public estate.

PFI is accused from many sides. Despite the £60bn of schools, hospitals and assorted public buildings that may never have existed without it, and the constraints on public spending that make private finance even more important, the Treasury select committee said that procurement of PFI projects, including the £244m Royal Liverpool hospital, should be put on hold while the value for money is assessed independently. Tory MP Jesse Norman, backed by 80 other MPs from all political parties, has called for construction firms to give back a percentage of the PFI profits they have made over the past 20 years. And most recently, health secretary Andrew Lansley launched a tirade against it, saying that PFI schemes were endangering the finances of 22 NHS trusts.

The evidence is stacking up, and the political pressure is building on the government to do something about it soon. And with 61 PFI schemes now in procurement, with a value of £7bn, this isn’t small beer for the construction industry. So with the chancellor expected to report next month, what will his verdict be? And, if he finds it guilty, how catastrophic will his sentence be for contractors?

The prosecution

Cost

The principle allegation is that PFI costs more than traditional procurement. This is difficult to deny: at the moment, the government can borrow at just over 4%, whereas PFI consortiums pay much higher interest, of anything between 7-10% return a year, depending on who you believe. Over 20-35 years, this adds up to an awful lot. An analysis by the Treasury select committee found that this could mean one PFI project - the Royal Liverpool - will cost £175m more than the £246m it would cost the government to procure it directly. That’s a premium of 70%.

This situation has been vastly exacerbated by the credit crunch - with private sector interest rates much closer to government loan rates before the 2008 financial crisis. James Wardlaw from Goldman Sachs told the Treasury committee that PFI deals signed now are locking in the higher cost of capital for the forseeable future.

Bias

Furthermore, critics say PFI has only been allowed because the rules of the game have been rigged in its favour: any spending on PFI schemes hasn’t previously come off government departments’ total budgets, meaning they’re effectively “free” for individual departments. What’s more, the government’s liability for future PFI payments, which totals more than £210bn, is not fully counted in the headline public sector debt.

The way PFI’s value for money case has been assessed by Whitehall mandarins also includes an optimism bias that assumes conventionally procured projects will see budget overruns of 20% compared with PFI, and healthy corporation tax returns from the PFI consortiums, despite the fact 90 of the 700 UK PFIs are based overseas and don’t pay corporation tax to the Treasury. The Public Accounts Committee found that: “Tax revenue is being lost through the use of offshore arrangements by PFI investors and the effect has not been adequately assessed.”

These concerns are compounded for critics by the fact that most PFI consortiums give away little information about their deals, citing commercial confidentiality. This has led to calls from MPs for deals to be subject to Freedom of Information requests. Andrew Munro, an associate in the PPP team at consultant Davis Langdon and a supporter of PFI, admits the maths has not been transparent: “It’s not clear how figures are arrived at, which has meant it can look like they have been plucked out of the air to justify the PFI route.”

The Treasury select committee itself concluded: “The value for money appraisal system is biased to favour PFI. There is an incentive for both HM Treasury and public bodies to present PFI as the best value for money option.”

Profit

The evidence of the way PFI has benefited the private sector can be seen, say critics, in the windfall profits consortiums have made re-financing PFI projects once the construction phase has been completed. Evidence to the Commons Public Accounts Committee shows profits from refinancing or sale average 50%. In some sectors, the returns have been even higher, with health PFIs averaging 66% and defence PFIs a shocking 134% average profit. Carillion has made the most, raking in a profit of £114m on its 24 projects
(a 40% margin), but all the major PFI contractors, including Lend Lease, Kier, Costain and Balfour Beatty have made big money from selling their stakes.

Liability

The problem, say the accusers, is not just the cost, it is also the inflexibility of PFI deals. Sources suggest that incoming coalition ministers and Treasury officials have been frightened by the long-term liability implied by the government’s 700 existing PFI contracts, at a time when public spending is so tight, and the Treasury office PFI scheme is a good example of PFI’s inflexibility.

Traditional PFI deals seem to be unable to react easily to the changing needs of the public sector without incurring further expense. The Cabinet Office has so far managed to claw back £1.5bn from existing contracts, but the difficulties in doing so are huge. David Mathieson, director of public sector at Turner & Townsend, says: “PFI providers have proved themselves to be quite commercial in their attitude to PFI contracts, in using variation clauses for changes. It means the public sector can end up over-paying for services, particularly if its requirements change. PFI providers have shown themselves to have limited flexibility.”

Red tape

The last major bugbear is the transaction costs of PFI projects - the sheer volume of legal and technical consultants required to make a PFI contract stick. An assessment of the M25 widening, done through PFI, found that up to £1.1bn could have been saved had it been procured conventionally. Part of this was an estimated £80m spent on consultants, 7.5% of the capital value of the motorway upgrade.

Treasury guidance for departments using PFI admits that “significant transaction costs” are likely to be incurred, far greater than traditional procurement.

The defence

Getting things done

If there is one very big argument in favour of PFI it is the fact that it has allowed the construction of infrastructure and buildings over the last 20 years that would otherwise have had no hope of being built. PFI critics lament the fact that liabilities for future payments are not put on the public balance sheet, but this is also one of the system’s key strengths. Under internationally accepted accounting principles, PFI liabilities do not have to be included on the national accounts where risk has been deemed to be transferred. Therefore buildings can be procured at a time - such as now - when public borrowing is severely constrained.

This reality was tacitly admitted by education secretary Michael Gove when he chose PFI for a new £2bn round of school building in July. PFI may cost you a premium, but it gives you the ability to invest in either economic or social infrastructure even when you don’t have direct funding available. The premium is the price you pay for that benefit.

James Stewart, global chair of infrastructure at KPMG, and former head of the government’s Infrastructure UK unit, says: “It’s fine to compare PFI against conventional procurement, but that assumes that the funding for conventional procurement is available. We’re in a situation where we have to invest in infrastructure, and we need to work out the best way within the fiscal constraints.”

Efficiency

The second most common argument in favour of PFI is that it delivers: that projects are more likely to come in on cost and on time than under traditional procurement. This assumption is based in part on surveys by the National Audit Office in 2003 and 2009, which found that most PFI schemes do come in on time and budget, and it has been so widely accepted that it was built into the Treasury’s value for money justification. Including this so-called “optimism bias” in the financial appraisal has been criticised, but the general experience that PFI projects are more likely to build to programme has not been challenged.

Either way, under PFI the public sector is shielded from the costs of time and budget overruns by the PFI vehicle. Stewart again: “There are countries we work in where the governments have got the cash to invest up front but they’re still asking whether they should use PFI. It’s because they don’t trust the public sector managers to effectively project manage big schemes. It’s a major benefit.”

Protecting buildings

The defence against the accusation of inflexibility is that the inability to cut maintenance spend is part of the point of the contracts. PFI effectively prevents the current government from doing what every previous one has done when spending gets tight: cut back on upkeep. This means that the value of existing investments in buildings is maintained, whereas in previous recessions it has been jeopardised. Jeremy Barker, director of corporate finance at KPMG, says: “Isn’t it going to be fantastic that 30 years after these hospitals are built they’ll still be working well, because PFI means they’ll be maintained?”

The higher transaction costs associated with PFI are, supporters say, because the method of procurement forces the client properly to plan and design the scheme before going ahead with it. Doing this has been a constant call from reviews of construction procurement from Egan onwards. This forced thinking ahead saves the need for variations later in the process that can add time and cost to traditionally procured buildings.

Chief construction adviser Paul Morrell has said the discipline of PFI has led to the whole-life cost of buildings truly to be considered during procurement for the first time. His report into low-carbon construction highlighted this issue, and he has since called for PFI-style arrangements, over shorter time periods than the traditional 25-year deals, to be adopted. Morrell says: “As a consequence of PFI, there are now contractors who have started to understand that value is created on drawing boards not on building sites.”

The verdicts

Graham Kean, head of public, EC Harris

NOT GUILTY

PFI as a concept has delivered where the conventional approach to investment in public sector assets was failing. That doesn’t mean that it is a more efficient route, it just means that it addressed the prevailing problem of the day, which was the lack of capital to fund much-needed schemes, and an explicit transfer of risk to those who are best placed to manage it. 
The benefits of PFI include bringing forward investment; getting schemes delivered to budget; transferring risk around both delivery and management; and providing a catalyst for innovation through competition. Of these benefits it is the degree of risk transfer that is often overlooked, and this does not seem to be factored in in today’s commentary on affordability.
Current critics seem to be focusing on cost and flexibility. This is not a failing of PFI per se, more a symptom of the conditions that were imposed by clients and their advisers at the point the schemes were procured. Having got through the costly and risky phases of procurement and construction, do the critics now expect “gains” to be shared after the event? If that were the case, then the approach to risk, pain and gain share should have been discussed more openly at the outset.

If we are to improve by learning from experience we should break down the procurement process and look carefully at where every penny of every pound spent finally ends up. I am sure that this would highlight areas where we can improve.

However, to lay all the blame at PFI alone would be too simplistic. The prosecution needs to widen the net to get to the bottom of the challenge and seek further investigation beginning at the procurement stages.

Ann Minogue, partner, Ashurst*

GUILTY

The shiny new buildings in the NHS and for our government offices and schools replacing the run down Victorian relics being used in 1997 are testament to the success of PFI. But if they could have been delivered without the mark-ups of 70% attached to the Royal Liverpool, we could have had so many more.

PFI may have avoided the procurement debacles of the Scottish parliament, but what a shame these could not have been avoided without the tax payer being locked into inflexible 25/30-year deals that will cost a small fortune to re-negotiate. And it does seem wrong that the government covenant strength is now providing reliable long-term income streams for overseas investors who do not pay UK tax.

There will always be some projects for which PFI is the appropriate funding route but it is not, and never has been, a procurement route. Surely the time has come to address head on government procurement failings and embed in government procurement practices the best features of PFI? Paul Morrell has flagged up the focus on whole-life costing and the fact that value is created on drawing boards, not on building sites, so proper time must be allowed for design stages of the project. Other lessons might include ensuring original budgets include proper contingencies - hopefully not at the level of 20%. And while the government, like the private sector, needs to have the flexibility to defer anything but essential expenditure in hard times, proper budgeting for essential maintenance can be achieved without PFI. What is the point of well-maintained obsolete buildings?

The government should dust down Sir Peter Levene’s report in 1995 on construction procurement and start finally to implement some of its recommendations. Wouldn’t it be wonderful for the industry and for the tax payer if the government procured with the efficiency of the best of the repeat clients in the private sector?

*Ann Minogue is writing in a personal capacity

Jonathan Hook, global engineering and construction leader at PwC

NOT GUILTY

Ironically, while we chastise ourselves here in the UK over PFI’s apparent failures, countries all over the world are looking to replicate what is perceived internationally as a great success story.

The criticism of private sector companies for making perceived excessive profits from the sale of PFI investments is particularly wide of the mark for me - people are quick to forget who takes the bidding, design and construction risk, and who provides the finance and proves the operating model. In that context the returns have been fair.

PFI in the UK should continue, but it undoubtedly needs a rebranding to restore its image. I think we are likely to see a variation of the model consistent with the government’s localism agenda. It may involve initiatives such as tax increment financing and local asset backed vehicles, and also perhaps the emergence of local bonds to encourage investment and community participation. Ideally we might also see a real partnership of private and public sector with both locked into the whole life success of a project. I don’t think any of us mind too much what it is called or exactly how it is configured - the key message is that many major capital programmes just won’t get done without private sector risk sharing and finance. Without those programmes it is difficult to see how the country can grow out of deficit.

The Building verdict – and the sentence

The current speculation is that the judgment will be handed down, probably by chancellor George Osborne, some time in November. Politicians are likely to brand PFI guilty of having wasted public funds, and undoubtedly there will be some playing to the gallery here. However, the real victory or defeat will be found in the nature of the sentence, which, sources suggest, may be deferred.

The sentence
When it comes, many are optimistic the sentence will be a new formula that won’t throw away all of the benefits of the original model. Richard Howson, chief operating officer at Carillion, says: “We’re encouraged by Michael Gove’s announcement that he’s investing £2bn in schools PFI. We’re optimistic it’ll be a mechanism we can use.”

But given all the political rhetoric, it is very likely we will see a name change. This may be good news for PFI - after all, a name change, such as has been done in Scotland, where the new contracts are called Non-Profit Distribution (NPD) rather than PFI, but the deals are largely similar, seems to have had some success in reducing controversy.

The key difference with the Scottish NPD contracts, though, is also one that may be picked up in England and Wales - that profits above a certain point are shared between the PFI consortium and the public sector. Bidders compete, in part, on the basis of how much profit they can return to the public sector.

Davis Langdon’s Andrew Munro says: “It does seem to have completely succeeded in politically detoxifying the brand - as soon as the politicians can say ‘we’re sharing profits’. But the contract documents are the same, otherwise the deals are the same.”

Because of the current poor market, says Munro, the prospect of sharing super profits has not deterred potential PFI bidders.

Whatever changes are introduced are also likely to address the issues of flexibility and transaction costs. Stephen Ratcliffe, director of the UK Contractors Group, says: “It’ll have to be slicker and be cheaper, and be more standardised. It’ll evolve.”

There is also likely to be a greater focus on the reality of the transfer of risks - the public sector could get PFI cheaper by ensuring it’s not paying for the transfer of risks that weren’t ever genuinely transferred anyway.

A more fundamental problem, though, is likely to remain: however PFI adapts, there will be less of it in future. In general, it is less well adapted to provide the kind of economic infrastructure - railways, bridges, power stations - the government is focusing on. For the £200bn of new infrastructure needed by the government, PFI’s share in any form is going to be pretty small beer.