1. My evidence. My evidence is given with numbered paragraphs for ease of reference. Details of books and papers are given in the list of references at the end. If required, I would be prepared to give oral answers to the specific sets of questions set out in the Call for Evidence.
2. Cost of capital. My evidence refers to the health sector, especially hospitals, focussing on a detailed case study of the Norfolk and Norwich University Hospital (NNUH). However there must be a presumption that all public sector projects (not only hospitals) which are financed by the private sector will be more expensive than if financed by the public sector. Why? Quite simply because the private sector's cost of capital is very much higher than that of the public sector. The annual cost of capital to the private sector (at 10%) is more than double that of the public sector (at 4.3%) (see Edwards, June 2009, page 29).
3. Higher Private Finance Initiative (PFI) costs. Given these relative costs of capital, a hospital financed by the private sector will be 92% more expensive than one financed by the public sector. To put this another way, the initial construction cost of the privately-financed hospital would have to be about half of the cost of a publicly-financed hospital to compensate for the private sector's higher cost of capital. These figures are based on a realistic model set out in a report commissioned by the Treasury and carried out by Arthur Andersen (the consultancy company). The Andersen model was extended to 39 years (the contract life of the NNUH) (see Edwards, June 2009, 36).
4. Value for money. At present, PFI projects are assessed for "value for money" (vfm) on the basis of cost effectiveness using the discount rate of 3.5% per annum as set out in the Treasury's Green Book (Treasury 2003). The vfm test is not a test which compares the costs and benefits of a project. Thus the vfm comparison has been limited to what Jon Sussex has called productive efficiency and is not concerned with allocative efficiency (mixes of care) (Sussex 2003, 63). As a result, as Sussex and others have claimed, PFI distorts investment priorities in the NHS by concentrating resources on large new acute hospitals and the basic problem of integrating all the elements of health care (preventive as well as curative) remains (see Edwards June 2009, 23,24)
5. With-and-without comparisons. Thus the procedure has been to make with-and-without comparisons-that is comparison of the project with and without the PFI. The unknown in this comparison is the "without", namely the Public Sector Comparator (PSC) with which the PFI cost is compared. Unfortunately the comparison process has been far from transparent and details have rarely been given as to how the PSCs were arrived at. The comparison should be made at the same stage and on the same basis and should cover the full life of the project (see Edwards, June 2009, 39,40). The stage and basis should be set out in detail. In particular the basis on which an allowance for time and cost overruns (what has been called optimism bias) has been applied to the PSC should be set out clearly. This has hardly ever been done.
6. Manipulation of the comparisons. As a result it is hard to avoid the conclusion that the PSC has been manipulated so that the PFI cost comes out at just below that of the PSC. A classic example is given by the vfm test for the NNUH. In the Full Business Case for the hospital carried out in 1996, a cost overrun for the PSC of 34.22% was assumed. Not 34%. Nor 35%. But 34.22%! The comparison was a shambles. As the chair of the Select Committee on Health put it; "In other words, the full business case does not tell us the full business case" (UK Parliament, May 1999, para 20). Thus the vfm comparisons have been fiddled; the procurement procedures have been far from satisfactory; and insufficient information is disclosed to assess whether the taxpayer is getting value for money.
7. The reason for the manipulation? Basically because hospital managers were told that there was no alternative to a new PFI hospital. A new hospital had to be a PFI project or nothing. The PFI project had to be shown to provide vfm and to be cheaper than a PSC. However as Jeremy Colman (as assistant auditor-general) pointed out; "if the answer comes out wrong, you don't get your project. So the answer doesn't come out wrong very often" (quoted in the Guardian of 7 April 2009) (see Edwards June 2009, pages 2 and 46).
8. Why the pressure for PFI? PFI projects have been promoted strongly by Labour Governments since 1997. This is in spite of the Labour party being opposed to PFI before it came to power. The pressure for PFI projects has been because on coming to power in 1997, the Labour Government adopted two fiscal rules, one of which was that the proportion of public debt to GNP should be kept below 40%. Financing public sector investment through PFI was seen as a way of achieving this objective. Of course, the 40% target is now in tatters as a result of an incompetent macro-economic policy. In the meantime, public expenditure is pushed up by the higher costs of PFI projects. But there are…
9. two further problems stemming from PFI. The first is the confusion of responsibilities for maintenance. As a recent Public Accounts Committee report pointed out, even when a PFI company is not itself carrying out a change to a project, it frequently charges a fee for simply acting as a conduit (PAC September 2008, 3). These fees have added on from 2% to 25% to the cost of the change. The second further problem with PFI contracts is the cost of negotiating them. As Jon Sussex has pointed out, the PFI is unpopular with health service managers because of the larger transactions costs that are entailed compared with conventional procurement. Thus at the NNUH, the PFI set-up costs totalled about £32 million, about a fifth of the £159 million base construction cost of the hospital. The set-up costs are not generally included in value for money comparisons. These costs can be reduced by reducing competition and by standardising procedures, but a reduction in competition is likely to lead to an increase in cost tenders while the standardisation has been criticised for its loss of flexibility and innovation.
10. The public loss. As stated in paragraph 2 above, it is highly likely that the cost of privately-financed projects will be considerably greater than that of publicly-financed projects. A good example of this is provided by the NNUH. The hospital was constructed in 1998 at a base cost of £159 million. The rent which will be paid by the NNUH Trust through to the year 2037 (the first break year of the contract) at 1998 prices and discounted at the Treasury's annual discount rate of 3.5%, will total £465 million, just under three times the construction cost (see Edwards June 2009, 59). It is hard to imagine the PSC being anywhere near as high as this, given that the optimism bias on standard public sector projects has averaged less than 13% (see Edwards June 2009, 44). Thus the extra cost (discounted over the full life of the contract and at 1998 prices) associated with the PFI project of the NNUH will be something like £300 million.
11. The private gain. Meanwhile the companies involved with PFI projects make very high profits. For example the share capital of Octagon Healthcare (the company financing the NNUH) was £1,325,000 at the end of 1998. By the end of 2003, the dividends to Octagon's shareholders had totaled £11,000,000. Thus in five years the share capital had been repaid more than eight times over (Edwards, June 2009, 98) with Octagon taking very little risk (see Edwards June 2009, 43). An equally spectacular example of a high rate of profit from PFI projects is provided by Innisfree Limited, a major PFI investor. Between 1998 and 2008 the real annual rate of return to the shareholders of this company (including director's remuneration with the profits) was more than 200%. This compares with an annual average of less than 15% for UK companies (private non-financial corporations) over the same period (Edwards, June 2009, 73)
12. The future? Given the commitment to PFI projects since 1997, the implications for future UK public expenditure are severe. In June 2008, the capital value of PFI projects was given as £57 billion of which only £24 billion was included on the public sector's balance sheet. But the future payments on all PFI projects were reported to be £181 billion, more than three times the capital value. Even when discounted, the future payments are said to £100 billion in present value terms. The latter is said to be arrived at using the "standard discounting methodology" which I take to mean using the Treasury's discount rate of 3.5% per annum. It is worth noting that £100 billion was about 7% of total GDP in 2008 (see Edwards June 2009, 102).
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1 Chris Edwards is a Senior Fellow at the School of International Development, University of East Anglia.