In 1999 a report on PFI projects was commissioned by a Treasury Task Force from Arthur Andersen, the consultancy company (Andersen et al, 2000). The report was commissioned to examine VFM aspects of the PFI projects which had started operations and for which the delivery of services had begun. The study was carried out by the Arthur Andersen company assisted by two professors from Enterprise LSE (London School of Economics).
The Andersen report, produced in 2000, looked at the capital (construction) costs of a number of projects although, as the report pointed out, "…the overriding point is that PFI value for money assessments are made by looking at all the costs of the projects" (Andersen 2000, 10 - my emphasis). But of course, given the newness of the projects, their focus only on capital costs is understandable.
In its report, Andersen had put forward a generally pro-PFI argument. It admitted that the private sector's financing cost was higher than that of the public sector, but stated that this was likely to be a small additional cost compared to the total. For the public sector Andersen assumed an interest (or discount) rate of 6% pa. This was 1.5% above what it assumed to be the long-term rate of 4.5% pa. on gilts (Andersen 2000, 5)13. The private sector cost of capital was assumed by Andersen to be 10% pa including inflation or about 7.5% pa in real terms (Andersen 2000, 10).
Andersen then tried to see how much greater the cost of finance would be using private sector finance. The project assumptions that Andersen used were a capital cost of £100 million with non-clinical operating costs (in base year or real terms) of £10 million a year over 25 years. From such a model, Andersen's report stated that the interest costs would be 26% of the total if financed directly by the public sector and 29% if financed under a PFI. Thus the extra interest cost would be, according to them, only about 3% of total costs. Unfortunately Andersen's figures were not set out in detail in their report. I do this in Table 4.1 below.
| Table 4.1; the Andersen model; a comparison between the capital costs to the public sector of PFI with a PSC; | |||||||||||||||||||||||
| using the Andersen assumptions of a real cost of capital for the private sector of 7.5% pa | |||||||||||||||||||||||
| and of 6% pa for the public sector; and using a discount rate of 6%pa | |||||||||||||||||||||||
| Public sector comparator (PSC)........ | PFI example……… | ||||||||||||||||||||||
| Capital & | Operating | Capital cost……… | Capital cost | ||||||||||||||||||||
| Year | operating | PV factors | cost (PVs | Repayments | Capital | Interest | PVs at 6%pa | Repayment | Capital | Interest | PVs at 6%pa | ||||||||||||
| cost | at | at 6%pa | at 6% pa | balance | at 6%pa | repyt | interest | at 7.5% pa | balance | at 7.5%pa | repyt | interest | |||||||||||
| (£mn) | 6%pa | (£mn) | (£mn) | (£mn) | (£mn) | (£mn) | (£mn) | (£mn) | (£mn) | (£mn) | (£mn) | (£mn) | |||||||||||
| 0 | 100 | 1 | 100 | ||||||||||||||||||||
| 1 | 10 | 0.94 | 9.4 | 1.8 | 98.2 | 6 | 1.7 | 5.7 | 1.47 | 98.53 | 7.5 | 1.4 | 7.1 | ||||||||||
| 2 | 10 | 0.89 | 8.9 | 1.9 | 96.2 | 5.9 | 1.7 | 5.2 | 1.58 | 96.95 | 7.39 | 1.4 | 6.6 | ||||||||||
| 3 | 10 | 0.84 | 8.4 | 2 | 94.2 | 5.8 | 1.7 | 4.8 | 1.7 | 95.25 | 7.27 | 1.4 | 6.1 | ||||||||||
| 4 | 10 | 0.79 | 7.9 | 2.2 | 92 | 5.7 | 1.7 | 4.5 | 1.83 | 93.42 | 7.14 | 1.4 | 5.7 | ||||||||||
| 5 | 10 | 0.75 | 7.5 | 2.3 | 89.7 | 5.5 | 1.7 | 4.1 | 1.96 | 91.46 | 7.01 | 1.5 | 5.2 | ||||||||||
| 6 | 10 | 0.7 | 7 | 2.4 | 87.3 | 5.4 | 1.7 | 3.8 | 2.11 | 89.34 | 6.86 | 1.5 | 4.8 | ||||||||||
| 7 | 10 | 0.67 | 6.7 | 2.6 | 84.7 | 5.2 | 1.7 | 3.5 | 2.27 | 87.07 | 6.7 | 1.5 | 4.5 | ||||||||||
| 8 | 10 | 0.63 | 6.3 | 2.7 | 82 | 5.1 | 1.7 | 3.2 | 2.44 | 84.63 | 6.53 | 1.5 | 4.1 | ||||||||||
| 9 | 10 | 0.59 | 5.9 | 2.9 | 79.1 | 4.9 | 1.7 | 2.9 | 2.62 | 82.01 | 6.35 | 1.6 | 3.8 | ||||||||||
| 10 | 10 | 0.56 | 5.6 | 3.1 | 76 | 4.7 | 1.7 | 2.6 | 2.82 | 79.19 | 6.15 | 1.6 | 3.4 | ||||||||||
| 11 | 10 | 0.53 | 5.3 | 3.3 | 72.7 | 4.6 | 1.7 | 2.4 | 3.03 | 76.16 | 5.94 | 1.6 | 3.1 | ||||||||||
| 12 | 10 | 0.5 | 5 | 3.5 | 69.3 | 4.4 | 1.7 | 2.2 | 3.26 | 72.9 | 5.71 | 1.6 | 2.8 | ||||||||||
| 13 | 10 | 0.47 | 4.7 | 3.7 | 65.6 | 4.2 | 1.7 | 1.9 | 3.5 | 69.4 | 5.47 | 1.6 | 2.6 | ||||||||||
| 14 | 10 | 0.44 | 4.4 | 3.9 | 61.7 | 3.9 | 1.7 | 1.7 | 3.77 | 65.63 | 5.2 | 1.7 | 2.3 | ||||||||||
| 15 | 10 | 0.42 | 4.2 | 4.1 | 57.6 | 3.7 | 1.7 | 1.5 | 4.05 | 61.58 | 4.92 | 1.7 | 2.1 | ||||||||||
| 16 | 10 | 0.39 | 3.9 | 4.4 | 53.2 | 3.5 | 1.7 | 1.4 | 4.35 | 57.23 | 4.62 | 1.7 | 1.8 | ||||||||||
| 17 | 10 | 0.37 | 3.7 | 4.6 | 48.6 | 3.2 | 1.7 | 1.2 | 4.68 | 52.55 | 4.29 | 1.7 | 1.6 | ||||||||||
| 18 | 10 | 0.35 | 3.5 | 4.9 | 43.7 | 2.9 | 1.7 | 1 | 5.03 | 47.52 | 3.94 | 1.8 | 1.4 | ||||||||||
| 19 | 10 | 0.33 | 3.3 | 5.2 | 38.5 | 2.6 | 1.7 | 0.9 | 5.41 | 42.11 | 3.56 | 1.8 | 1.2 | ||||||||||
| 20 | 10 | 0.31 | 3.1 | 5.5 | 33 | 2.3 | 1.7 | 0.7 | 5.81 | 36.3 | 3.16 | 1.8 | 1 | ||||||||||
| 21 | 10 | 0.29 | 2.9 | 5.8 | 27.1 | 2 | 1.7 | 0.6 | 6.25 | 30.05 | 2.72 | 1.8 | 0.8 | ||||||||||
| 22 | 10 | 0.28 | 2.8 | 6.2 | 20.9 | 1.6 | 1.7 | 0.5 | 6.72 | 23.33 | 2.25 | 1.9 | 0.6 | ||||||||||
| 23 | 10 | 0.26 | 2.6 | 6.6 | 14.3 | 1.3 | 1.7 | 0.3 | 7.22 | 16.11 | 1.75 | 1.9 | 0.5 | ||||||||||
| 24 | 10 | 0.25 | 2.5 | 7 | 7.4 | 0.9 | 1.7 | 0.2 | 7.76 | 8.35 | 1.21 | 1.9 | 0.3 | ||||||||||
| 25 | 10 | 0.23 | 2.3 | 7.4 | 0 | 0.4 | 1.7 | 0.1 | 8.34 | 0 | 0.63 | 1.9 | 0.1 | ||||||||||
| Totals | 227.8 | 43 | 57 | 41.3 | 73.4 | ||||||||||||||||||
| Present values of costs at 6% pa | |||||||||||||||||||||||
| --- Repayment of capital | 43 | 41.3 | |||||||||||||||||||||
| --- Interest on capital | 57 | 73.4 | |||||||||||||||||||||
| --- Total capital cost | 100 | 114.7 | |||||||||||||||||||||
| --- Operating cost | 127.8 | 127.8 | |||||||||||||||||||||
| --- Total cost | 227.8 | 242.5 | |||||||||||||||||||||
| Interest cost as % of total | 25 | 30 | |||||||||||||||||||||
| Capital cost as percentage | 44 | 47 | |||||||||||||||||||||
| The public sector comparator | |||||||||||||||||||||||
| The capital cost is £100mn. At a 6% rate of interest, the capital recovery factor over 25 years | |||||||||||||||||||||||
| is 0.078227. Therefore the annual capital cost is £100 mn * 0.078227 = £7.8227 mn and the annual repayments of capital | |||||||||||||||||||||||
| and the interest costs sum to £7.8 mn (allowing for rounding) | |||||||||||||||||||||||
| The PFI alternative | |||||||||||||||||||||||
| At a 7.5% pa interest rate, the capital recovery factor over 25 years is 0.08971. Therefore the annual | |||||||||||||||||||||||
| capital cost is 0.08971 *£100 mn = £8.971 mn and the annual repayments of capital and the interest costs sum | |||||||||||||||||||||||
| to £8.97 mn allowing for rounding | |||||||||||||||||||||||
From this table, it is clear that the difference in interest costs (as a percentage of the total) would be 30% minus 25% = 5% of total costs, not the 3% figure as given in the Andersen report. As I say, I cannot reconcile my figures with Andersen's because the detailed figures are not given in their report. The Andersen report stated that the additional financing cost associated with PFI is small, but it is worth pointing out that, using their example, I estimate the total capital costs (interest and capital repayments) for public finance to be £100 million compared to £114.7 million for the PFI, a difference of £14.7 million or almost 15% of the public finance cost. On these assumptions, this (15%) is the amount which has to be saved on construction alone by the allegedly greater efficiency of the private sector.
13 The addition of 1.5% pa, according to Andersen, was to reflect the macroeconomic constraints on borrowing (see Andersen 2000, 5). In fact this is incorrect. The addition, according to Mott McDonald, "…….included an allowance … to reflect the impact of risks in public sector procurement" (Mott McDonald 2002, 5). As Gaffney et al have pointed out, since the 6% is above the risk-free rate for government borrowing, then some element of risk is already impacted into the discount rate and therefore using 6% pa and then adding on an allowance of risk is double-counting and favours the pro-PFI argument (see Gaffney et al 1999)