The Economic Affairs Committee has requested comment with respect to PFI-type transactions and the associated balance sheet issues arising therein.
I have been a consultant, banker and practitioner in infrastructure and energy project finance,-PFI, PPP and the like,-for the last 30 years, with both UK and international experience of investment, commercial and development banking operations in this field. I also regularly give seminars and training courses on this topic.
How should the cost and benefits of Private Finance be assessed?
1.1 The main quantitative, and generally accepted, method for the comparison of PFI proposals with conventional procurement entails:
(a) the preparation of a Public Sector Comparator ("PSC"),-the cost of undertaking a conventional, Government-funded project over the same life cycle as a PFI option, and
(b) comparing the PSC against the expected PFI costs over the same time period (eg usually 25-30 years for a PFI Concession).
1.2 The main criterion of comparison is the Present Value of both options. This creates two problems:
- what discount rate to use? (see below) and;
- the costs for the PFI option will be guesses as, when the comparison is first undertaken, PFI bids will not yet have been prepared.
1.3 Overall, PSC analysis is a useful decision-making tool for Government for deciding between the PFI and conventional options. However, it has limited utility in evaluating decision-making post-the event. Once the decision has been taken to employ one option or the other, the decision is generally irretrievable.
What discount rate should be used?
1.4 Classic investment theory dictates that the discount rate to be used should represent the cost of capital to the investor or, in the case of PFI, Government sponsor for finance for a similar period, eg UK 30 year gilts.
1.5 When using such discount rate, the underlying costs in the PSC analysis should also include allowances for inflation, tax and the cost of finance or money. After all, inflation and tax exist come what may. The cost of money will be a margin above the rate of inflation.
1.6 However, the UK Government is the only Government I have come across which does not follow this principle.
1.7 The UK Government, as evidenced by the Green Book, undertake their analyses in "real" terms, excluding inflation and the cost of money, as opposed to "nominal" terms, which include these items. As a result, there is an inherent inconsistency in the analytical approach to PFI by HM Treasury. Treasury lives in a "real" world, whereas PFI concessionaires live and price their deals in the actual, or "nominal", world.
1.8 The consequences of this approach are that:
- in times of high inflation,-which have arisen within the last 30 years, the common time horizon for PFI concessions-ignoring inflation can result in under-budgeting by Government departments for the future payments they will have to make under a PFI concession; and
- it is difficult to identify what the "real" discount rate should be.
1.9 Between 1991 and 2003 Treasury imposed, via the Green Book, a discount rate of 6% "real", which, assuming that inflation was 2-3%, is equivalent to a "nominal" rate of 8-9%.
Over this period, however, the cost of 30-year gilts for HM Government was 5-6% on average, ie 2.5-3% pa lower.
Hence, by HM Treasury insisting on public authorities using a 6% "real" discount rate, Government was imposing a higher discount rate than normal investment analysis theory and principles would dictate.
1.10 This has had three consequences:
- the PFI option is much like a credit card for governments. It allows payments, which otherwise would normally be due to be paid today, to be paid at some future date. Hence, a higher discount rate favours the PFI option compared to the PSC;
Thus, by using a higher-than-expected discount rate during the years 1991-2003, HM Government was unduly favouring the use of the PFI option;
- imposing a discount rate 2.5-3% higher than one might normally expect translates into a differential favouring the PFI option of 35-40% in Present Value terms when taken over a 30 year project life cycle;
Hence, it was no surprise that the PFI option, in most cases, always looked cheaper than the conventional option in the PSC analysis; and
- by using a too-high a discount rate, the PFI option, when chosen, can result in under-budgeting by PFI sponsor departments, viz the current problems faced by many NHS Trusts, who have undertaken PFI projects.
1.11 In 2003, HM Treasury introduced a new Green Book, which dictated that the (real) discount rate to be used was now to be 3.5%. The discount rate was termed the "social time preference" rate, terminology which means more to economists than bankers and commercial executives. Its justification is enwrapped in Byzantine econometric theory, and allows HM Treasury to justify whatever rate they want.
If one adds inflation of 2.5-3% to the 3.5% discount rate, then one arrives at 5.5-6% "nominal", which fairly closely has reflected the cost of 30 year gilts for HM Government in recent years. Good. The "new" post-2003 discount rate, albeit quoted in "real", as opposed to "nominal", terms, more closely reflected reality.
1.12 However, to cover their tracks (for the errors 1991-2003), HM Treasury introduced another concept which none other of the 60-70 countries in the World who are implementing PFI/PPP schemes has adopted, that is "Optimism Bias". This is an automatic multiple which HM Treasury applies to public sector project cost estimates, the multiple dependent on the complexity of the project. The concept is totally empirical and has little theoretical or practical justification.
1.13 Hence, excluding Optimism Bias, the PSC analyses undertaken since 2003 probably more closely reflect reality than hitherto, albeit that the process adopted (ie "real" v "nominal") is still fundamentally flawed.
Are current procurement procedures satisfactory?
1.14 Public service procurement procedures are regulated by EU Directives. On the other hand PFI projects takes twice as long and are twice as costly to prepare and implement than for conventional procurement. As a result, PFI is not suitable for projects which need to be implemented immediately.
1.15 Secondly, EU Procurement rules are somewhat inflexible, which dictates against some of the issues arising in PFI concessions. Also, there is no room for adopting procedures, eg the "Swiss Challenge", which can take into account more effectively innovative proposals put forward by the private sector.
Is enough information publicly disclosed on PFI transactions?
1.16 In short, no. The UK is unique in providing very little information to justify their decisions and actions! For PFI, during the bid process, some confidentiality may be called for, but not after concession award.
How does the performance (cost, delivery and service quality) of PFI schools, etc, compare to those traditionally procured?
1.17 Comparison of capital costs between conventional and PFI projects can be misleading. The private sector PFI concessionaire will build a project with assets "fit-for-purpose" and maintain those assets such that they can achieve the required performance under the PFI concession accordingly.
The public sector, however, with a tradition of poor maintenance regimes, will often build over-engineered and costly projects to allow for poor maintenance.
1.18 The key criterion for comparison should be: is the service provided by the PFI concessionaire comparable to that which might otherwise be provided by the public sector? This is often difficult to assess, and is more a subjective than objective exercise.
Is there significant risk transfer to the private sector or is it more apparent than real?
1.19 This question is almost impossible to answer. Risk transfer does arise under PFI transactions, but "risk" is a subjective judgement. "Risk" can be identified, evaluated and the impacts assessed under different scenarios, but the public and private sectors will always disagree as to how much risk is actually transferred.
1.20 Secondly, there are different types of risk: eg technical, commercial, financial, legal; environmental; etc. Further, some of these risks are interdependent, eg a delay can cause a cost-over-run, and a cost-over-run can cause a delay. So "double counting" can arise.
1.21 Given that PFI (and PPP) is a financial concepts, the key risk is financial or money-related. Hence, the risk to be evaluated in a PFI "transfer of risk" assessment should be "financial". Unfortunately, such an evaluation often gets lost in the misunderstanding of what PFI is all about.
1.22 Overall, not as much risk is transferred under PFI as one might expect. Any judgement on this issue, however, has to rely upon detailed knowledge of the underlying financial arrangements and contractual responsibilities under the PFI Concession, details of which invariably do not fall in the public domain (see para 1.16 above)
How effective and costly has it been to monitor the private sector providers' performance and quality of service in PFI projects in comparison with traditional procurement?
1.23 No comment, except that it is noteworthy that, in the few PSC-type analyses which have fallen into the public domain, little, or no, account was taken by Government agencies for monitoring costs.