Q21 Lord Forsyth of Drumlean: It is much lower interest rates.
Dr Stone: It is the margin, you are absolutely right. It is what benefit you get for that margin. In my view, you have to look at the overall cost of the deals and this is why the comparison between the conventional and PFI is so important. What matters is not whether that brick is more expensive than that brick or that piece of interest is more expensive than that piece of interest but what does the service overall cost throughout its life. The PFI deals overall cost less than the conventional according to the NAO otherwise they would not have been done. For me, that is the test. If one element is more expensive but by putting that expense in you are managing the risk better and the cost of the risk is going down then there is a trade here and what I would be very careful about is that separating any one element of the thing destroys the system.
Q22 Lord Forsyth of Drumlean: Having waded through quite a lot of the evidence that we have had, the suggestion is that PFI deals end up certainly being more likely to be delivered on time and on budget but they are more expensive. You are arguing they are more expensive overall. You are arguing a value for money case. You are saying for your bucks you get more bang, is that right?
Dr Stone: First of all, I am not quite sure where the measurement of more expensive comes from. If you look at the present value of the whole life cost of things, they are cheaper firstly. In some cases, indeed, the capital spend may be greatly more expensive. If we take the M40, for example, which was one of the early deals, on that particular route the bidders were asked to take responsibility for 25 years of operation. I will check it is 25 and not 23, but we will assume 25. One of them said, "Actually, if we build this road with porous asphalt it will work better, it will be a low maintenance cost and there are some great side-effects in terms of lower skid resistance and better environmental noise absorption". They spent more money on that but they saved money on the maintenance and in terms of the overall PV it was cheaper. That was a very good deal and that came out of creativity from the private sector in responding to, "Please be responsible for 25 years". The material itself was developed by the Transport Research Laboratory developed by the government but we never used it because it was too expensive to lay in the first place, but over time it is a good deal.
Q23 Lord Forsyth of Drumlean: I think the question you were expecting to be asked was whether we could improve the procurement measures for PFI projects and what changes could be made, but as I am listening to you I am thinking are you not actually just saying the benefits, which you cannot quantify, are about identifying flaws in the public procurement process. We all know, or at least I think I know, that government departments look at the Treasury if they have got a particular project, they know that the Treasury are going to try and trim it back so they will put in a proposal which may not be the absolute outside possibility of what will go wrong, so is it any surprise that a lot of public sector projects, once they are approved by the Treasury, turn out to cost more. They always were going to cost more and we all know that the Treasury has periods when there is retrenchment or whatever which interrupts projects and delays them, departments change priorities, but that does not mean you have to go out and borrow money very expensively in the market in order to have a more innovative, creative procurement policy. Would it not be smarter to have smarter public procurement rather than go the whole hog of PFI? Dr Stone: What matters is what works, I absolutely agree. I do not care how it is done, what I care about is that the public service that is being requested by Parliament is delivered the best way it possibly can be. I would love to see public procurement improved to the point where it is oodles better but I shall be very old and very withered by the time that happens because the incentives in the system make it extremely difficult. Some elements of procurement have undoubtedly improved a bit but the system within which the public sector operates actually militates against those sorts of behaviour. My point about risk management is you actually have to deal with the fundamental context of employment of public officials and that is really quite difficult. If you look at the debates around public sector pay, I have had a recent example of fighting a battle to get the nuclear safety inspectors paid a decent wage so we can recruit enough of them to deal with the future of nuclear in this country. Fighting public sector pay is a serious battle. While that issue maintains, producing the right solution in the public sector is really hard. If we can fix it, it would be wonderful. PFI as a process is about a series of elements together. If the government, for example, were to put the money into these deals, which it could do, what it effectively does is it assumes credit responsibility for making sure that feedback will happen, that when performance starts to drop the lending part of government acts like the credit department of a bank and forces behaviour back again. That is not going to happen. Having that sort of skill within government, I cannot imagine it ever happening. If we could that would be great and if you can find a way of changing public procurement so that it is as effective in the long run and is as accountable in the long run, bearing in mind as I said earlier there is no equity in government to which you can attract the failures of projects, it is quite hard to drive the behaviour. If I can give a very quick little example just to think about, and the economists amongst you will immediately spot the flaws in this but it is an interesting analogy. All the PFI deals that are done transfer some of the risks to the private sector. All those deals have ended up somewhere in banking terms at the bottom end of the investment grades, triple-B, triple-B plus. If you transferred all the risk they would be junk. That is what the government has in normal procurement. I fully accept that the capital structures are different but what it says is something along the lines of, "The risk that is borne by government conventionally is far greater than people recognise. We don't account for it, we don't manage it and we don't adapt our systems to recognise that".
Q24 Lord MacGregor of Pulham Market: I would just like to come back to the point about the scale of the number of projects in any given year and the point about off-balance sheet financing because you referred to public debt. Some critics would say that one of the ways of getting round the level of control over public debt in one year or another, and of course we are very much in that situation at the moment, is to put as many projects as possible into the PFI sector where in the past it has been accounted for differently in the national accounts, and thus you get this sudden rush of schemes which ultimately we will all have to pay for and there may be retrenchment in due course because of that. That was the point I was trying to get on off-balance sheet financing. I fully accept a lot of the points you make about the benefits of the process but if it is allowed to go too far I wonder if you would still feel there is a risk there and, therefore, the accounting is quite important.
Dr Stone: With respect, I think the issue is with the accounting for the conventional in the first place completely. As I said, the minute you make that decision you are committed for 50, 60, 70 years depending on what the asset is. Unless and until we have public accounts that actually recognise having built that school that these are the cash costs today, these are the cash costs over time and somebody is responsible for those you will not manage it and you will not actually deal with it properly. That is what this is about. In my view, as they currently stand public accounts are not fit for purpose as a tool to manage infrastructure. It is not about today. Today is almost an irrelevance in the life of a school, a road or a sewerage system, it is about how do you manage these things over the long-term and what is the measure. The public debt is almost irrelevant, what matters is the public obligation to deliver those services. What do we have to do to keep this road going? In the accounts of the Department for Transport I would want to see for every road in the country somewhere a line that says, "This is what you have to do and in any year when somebody says you are not going to do the maintenance this year because we have not got the money" and it goes three years forward and goes up by 50% because of dilapidations and so on, that somebody is accountable for that. We do not have that mechanism at all. The debate that comes from accounting is a complete distortion in my view, you are not measuring the right thing.
Q25 Lord MacGregor of Pulham Market: Can I ask you if you believe that private finance is more applicable in some public services than in others?
Dr Stone: It absolutely is. First of all, as I said, the PFI process is a pilot project and it works pretty well for those deals that can be very well-defined and are relatively stable. By "relatively" I include the hospitals where you might build an extra ward because of changes in healthcare policy a couple of years into the deal. That works fine. It works very well for things like pilot training in simulators and so on. It is a disaster for IT projects, and the reason it is a disaster is that most IT projects are not fully specified until the day you shut them down. One of the issues for me in this is we have a mechanism which is a good starting point for projects that are well-defined, but we do not yet have anything which works for services that change materially over time. One of the things that we will face when we come down this route is there is an assumption that the cost of changing your mind is zero, and it is not. Over time I think we also have to start to ask questions about-again I will use IT as an example-the assumption, and my Lord Chairman may object to this one, that IT services have to be best in class at any point in time. The IT service is there to deliver a deal, to deliver an outcome, to deliver tax returns or passports or whatever. If it does the job, it does the job, full stop. The more we can start to get people to think about why we are doing it in the first place, what are the outcomes we are trying to deliver, we stand a better chance of dealing with the need for change. The need for change comes from a change perhaps in legislation or safety regulation and so on and there is a cost to that, and that is fine. If we can make it transparent and build it in that is good, but we need to think very carefully about how to manage those changes and at the moment PFI does not give you much of a base for that.
Q26 Chairman: Some observers think that the current PFI model has had its day and that better versions should be developed. Do you think it would be beneficial to introduce additional models and, if so, what form might they take?
Dr Stone: I think it is absolutely essential. As I said, the current form suits projects with very stable long-term needs. The two examples I would point the Committee to are the Military Flying Training Services deal that the MoD has done where in effect what they have done is they have appointed somebody to deliver trained flight deck crew but they have no interest in the aircraft, the simulators, the universities or anything else that goes into that; they are simply focusing on the outcomes. That is an interesting example. Earlier engagement of the deliverer is something that has to be looked at very carefully. We have had very little real experimentation-I am not sure I should use that word-very little development of the process. A few years ago Treasury looked at a model which they referred to as the project delivery organisation and there has been very little development of these ideas. I think it is absolutely vital and somebody somewhere, whether it is Treasury or another department, should be driving this today.
Q27 Lord Moonie: Dr Stone, is the UK approach in deciding between private finance and traditional public delivery reflected elsewhere in the world? Are there better approaches in other countries?
Dr Stone: I think the UK approach is helpfully pragmatic, sensible and easier to operate and we focus on value for money which is a simplistic definition because, as I said earlier, it does not include the benefits of the services but is a consistent starting point. I do not think the boundary conditions are well thought through so, for example, when we come to do hospitals whether or not pathology is included or not can transform the way an outpatient unit works, as UCL have done with a very clever pathology service built in. We put artificial boundaries around some of these deals and I do not think the choice of what is in or out is necessarily always terribly pragmatic and rational. There are other countries, for example Australia, which are much more hidebound by the process, much more focused on the mechanistic process than even we are. There are others, like France for example, where the introduction of competitive dialogue has been taken on a much more practical basis. Competitive dialogue here has made life more complex, it has not delivered the clarity that was intended because in my view much of the implementation has been about the mechanism and not about the outcomes that that particular part of the procurement process was designed to add. The EIB, from whom I think you will be hearing after me,-
Q28 Baroness Kingsmill: I am sorry to interrupt you, but I am not sure I understand what competitive dialogue is.
Dr Stone: It is European procurement law and it is one of the processes that you go through in running a competition. In essence, once you have got into the shortlist of bidders you do two things: you first of all have a debate with each of the bidders in private about their solution and then you talk about the contractual basis on which they would then implement that. It is intended to drive out more clarity about the solutions early on. It is something that came out of Brussels as a bright idea and has been implemented differently by different jurisdictions. As is too often the case, we have turned it into a machine and less into "What are we trying to make happen". EIB have produced a group, the EPEC team, and they are looking at the sharing of benefits and knowledge within the 27Member States. Are there better approaches in other countries? The New Zealanders are (a) partly responsible for some of the early thinking, but (b) now thinking quite hard about how to make the process better. I think we do need to learn from other countries and we need to be more willing to look at the way that they deliver those outcomes. I think we have done a pretty good job but we have got a long way to go.
Q29 Lord Eatwell: The recent financial turmoil has caused a whole series of funding models to be called into question. Is there also a significant reappraisal of the funding model that has been used in PFI contracts or is there any other broader impact of what we have learned over the last two years?
Dr Stone: That is very interesting. I do not think we have anything like the right solution to financing deals. I think we had an interesting first response. What the crisis has done is to make a number of the banks think very hard about how best to allocate their capital and as Basel II is replaced by whatever capital adequacy rules we come up with to produce stability I think we will see some further changes. It has established a small number of key banks which are now committed to the UK market. The margin, ie the price of risk, has gone from a frankly too low level to probably a much too high level, and it is coming down again so there will be some degree of stability returning over the next 12-18 months. The issue for me is that we are still missing the big trick. We started to have the involvement of pension funds and institutions principally through the use of monolines to manage the risk. There is a wonderful symmetry between infrastructure in general and the long-term consequences of that and the needs of pension funds. It has been very interesting to watch the differences in different countries. For example, in the US most of these institutions have strong credit teams themselves so they can assess opportunities without any help. Here most of those institutions do not have strong credit teams and have either conventionally invested in things where somebody else has given a seal of good housekeeping on the credit quality or a monoline has insured it for them.
Q30 Lord Eatwell: If I could just understand this.
Most of the risk is taken by monolines?
Dr Stone: On the deals that have involved institutions, the monolines have interposed themselves.