In its examination of financing costs for Scottish schools PPPs, Audit Scotland (2002), found overall rates of return on private finance in the range of 8-10% a year, some 2.5% to 4% higher than a public authority would pay if it had borrowed money on its own account. Similarly, in a study of the first 12 PPP hospital projects in England, Shaoul et al (2008) found private finance costs of about 8% - well in excess of the 4.5% available on public finance in the relevant period. Financing costs matter in a PPP, just as they do in projects funded through direct borrowing, as they are part of a project's costs and to a large extent determine the level of the annual payments that the public authority must fund. The Freedom of Information Act has enabled independent scrutiny of PPP 'financial models', documents which contain estimates of a project's profitability. Cuthbert and Cuthbert (2008) looked at the cost of two completed hospital schemes in Scotland, the Edinburgh Royal Infirmary and Hairmyres, and compared this with an estimate of what these projects would have cost had public finance been used. To do this, they compared for each scheme the net present value (NPV)12 of returns to investors with the amount of private capital raised to finance the construction work.
On the Edinburgh Royal Infirmary scheme, they found the cash value of the returns on private capital (excluding payments for operations, maintenance and service provision) was £760 million. This was then discounted at 5% - the rate of interest that would have been paid by these hospitals on public finance at the time their contracts were signed - to give the figure £416 million, more than twice (2.04) the £181 million of capital raised by the private sector to build the hospital. The same analysis was applied to the £68 million Hairmyres scheme, generating a similar ratio (1.97). Although they are estimates, these ratios provide an indicator of the cost of these facilities to the NHS, relative to what the cost would have been, had the required finance been accessed through direct borrowing. The authors concluded that PPP is a "one hospital for the price of two policy" (p.5).
The Treasury argues that the higher cost of private finance is simply a function of the risk of investment being explicitly priced (HM Treasury 2003). On this analysis, when government finance is used for a project, the risks associated with the investment are the same as in a PPP, but any additional costs (e.g. due to time and cost overruns in construction, or problems in operation) are passed on to current and future taxpayers. In contrast, in a PPP, these project risks are borne by private investors, rather than taxpayers, and are priced according to standard methodologies.
The claim that the cost of private finance is simply the cost of public finance, plus a "risk premium", is therefore fundamental to the micro-economic case for PPP. If the cost of private finance is the same as public finance after allowing for risk, and the private sector is able to manage this risk and deliver projects more cheaply, then the total cost of a PPP could be lower than a public project.
However, the available evidence suggests that this is not the case. Research commissioned by the Office of Government Commerce (OGC), and carried out by the accounting and management consultancy PricewaterhouseCoopers (2002), shows that private finance costs are significantly higher than is predicted by the Treasury's claim. PwC analysed 64 PPPs that were signed between 1995 and 2001, comparing for each project the projected rate of return on capital with a benchmark designed to reflect the return that should be expected on the scheme, given its costs and risks.
The study found that projected rates of return exceeded the benchmarks by an average of 2.4%.13 While this may appear to be a narrow margin, it represents a substantial amount of money over the life of a contract of 25 to 30 years or more. What PwC calls "excess returns" of as little as 1% could lead to an increase in overall costs to the public sector of 10% over the term of a 30 year contract.
The credit crunch is increasing the cost of private capital relative to public funding (Hellowell 2008). Investors in public projects have been hit by the shortfall in bank liquidity in much the same way as homebuyers and businesses, with finance now being rationed and credit margins increasing. The impact of this is two-fold. First, bond finance, hitherto much the cheapest form of senior debt finance for PPPs, is no longer available. This is because the US 'monoline' insurers, such as Ambac and MBIA, lost their triple-A credit rating in the wake of the US sub-prime crisis. These institutions played a key role in the commercial bond market, guaranteeing repayments to bondholders in return for a fee, reducing overall financing costs, in particular for many larger PPP projects.
Second, in the bank finance market, now the only source of senior debt for PPP investors, liquidity has reduced dramatically since July 2007 and, where credit is available, the cost is very high. This is partly because the banks' own cost of capital has increased due to the fact that banks are no longer willing to provide credit except at high interest rates. In addition, the shortfall in liquidity has reduced competition in the senior debt market. Rather than lending individually, banks are now lending as cartels, or "clubs", and as a consequence of this, credit margins (the interest rates above the banks' own costs) have doubled in the last year. Pre-credit crunch, credit margins on simple accommodation schemes like schools and hospitals were between 60-80 basis points (0.6-0.8%) above the bank's own cost of capital. This has now increased to 100-150 basis points (PricewaterhouseCoopers 2008).
It is significant that the UK government's own evidence base suggests there are "excess returns" to investors. This is a particular cause for concern given that private finance costs are now increasing to historically high levels. This implies that, to be value for money, the private sector must be so much more efficient than the public sector that it can more than offset its higher cost of finance through being more able and better incentivised to manage risk. In principle, it is possible that this is the case, but there is clearly a high burden of proof given the evidence of excessive profitability. As we see below, no valid evidence has been provided by the government is support of its assertions.
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12 Based on a discount rate of 5% - the National Loan Board rate at the time these projects reached financial close.
13 According to the National Audit Office (2007), the level of competition is low in the PPP market, and declining. Between 2004 and 2006, only 67% of PPP projects received three or more bidders. One third of projects attracted only two bidders at the point at which detailed bids were submitted.