The damning National Audit Office report on the M25 widening scheme is the latest sign that PFI might be nearing the end of the road. But what are the alternatives?
The last seven days have not been kind to PFI. On Friday, the latest National Audit Office report into the procurement of a major PFI project arrived - coming down hard on the £3.4bn M25 road-widening scheme being undertaken by Skanska, Balfour Beatty and Atkins. This followed news on Wednesday that the £450m Royal Liverpool University hospital PFI was to be further delayed by a legal challenge from a member of the public over value for money, and preceded Monday’s news that the Homes and Communities Agency was withdrawing funding from all £1.9bn of PFI housing programmes not in procurement. And this was all before the latest revisions to the way PFI projects work, which were due out at the end of the week.
Chancellor George Osborne has made no secret of the fact the knives are out for PFI, which has been the channel for £56bn of construction spending since it was first used by John Major in 1992.
The paradox is that the government has committed itself, through the Comprehensive Spending Review, to a £200bn infrastructure programme, of which 80% has to be privately funded. Which leads many in the industry to wonder if news of the death of PFI may have been exaggerated.
But doubters may underestimate the determination in some parts of government to tackle one of the long-standing criticism of the procurement method - that it fails to give value for money.
One thing that is certain is there is a hard time ahead for PFI. The changes announced in the spending review, which abolished the PFI credits system, mean the policy will finally have to prove itself on a level playing field with all other procurement methods.
So, as each department works through the scale of the cuts, and with another major policy overhaul is expected in the spring, what are the drivers for rejecting PFI? And what are the options for replacing it?
PFI: The case against
Value for money and risk
The argument over value for money has always been fraught, with proponents keen to stress the improved project management benefits supposed to arise from PFI schemes - claiming PFI projects are more likely to come in on time and on budget. And PFI allows government to spread the up-front cost over a much longer timeframe. But with the review of the M25 showing that 7.5% - £80m - of the capital cost was spent on consultants, that view is increasingly taking a battering. Last year the National Audit Office criticised the government’s assessment of value for money, saying projects often failed to justify assumptions that they were more economic.
PFI requires the private sector to borrow the money, so cash will never be as cheap to raise as if the government took on the debt. For the public sector, PFI was always partly about paying to outsource the construction risk of big projects, but increasingly questions have been asked about how successful that has been. The M25 study shows that an extra cost of £660m was incurred, because the deal was done during the credit crunch and the banks were taking a risk-averse view. But the construction wasn’t really any more risky at that stage. Graham Kean, head of public at EC Harris, says: “If you’re not managing the risk properly, then the public sector is paying money for nothing. That’s the area we could get efficiency.”
One of the principal attractions of PFI to successive governments - both here and abroad - has been its ability to finance billions of pounds worth of development without registering on the public sector balance sheet. Of the £56bn of construction schemes so far, only a quarter is government debt, with the remaining £43bn officially off the government’s books.
In addition, the government’s system of PFI credits meant that government subsidies for PFI schemes did not register as individual departmental expenditure, doubling up this incentive. But it looks like all this will change. After the banks’ exposure to off-balance sheet property deals almost brought them down in the credit crunch, the idea of our government doing the same suddenly became much less appealing. In future, it will not have the deck stacked in its favour.
The biggest concern, in an age of austerity, is how a policy reduces your future options. PFI works by tying the public sector into long-term service agreements that ultimately pay off the up-front construction cost of the scheme. This means that it’s hard cheese if political priorities change and you decide you want to cut a service. Hence the £65bn bill for hospitals for the next 30 years, whether we need them or not - and the brand new University College hospital in Coventry reportedly considering closing beds in order to meet its first £54m PFI payment.
Just as the government is looking to cut spending, it finds itself contractually tied to huge expenditure for decades. Alex Jan, associate director at Arup, says: “Rightly or wrongly, the Treasury has realised there’s a risk you’re mortgaging the future, and tying yourself into potentially huge annual payments. And if you’re looking for efficiencies, it reduces flexibility.”
So where now?
James Stewart, chief executive of the Treasury unit Infrastructure UK, says PFI will definitely be part of the future procurement mix. However, it will no longer have sacred cow status, and will be reformed to take account of the critics - particularly in the issue of risk transfer.
How this is done is now being crunched by the Treasury boffins, in advance of next year’s announcement. EC Harris’ Kean says: “It’ll have a different shape, and maybe a different name, but the principle will remain the same.”
One thing that may happen is that funding will be more complex, with many sources used on any one scheme, making it part PFI, part public sector, and part a variety of other routes.
Likelihood rating: 4/5
Regulatory Asset Base
One alternative being looked at and, according to Infrastructure UK’s Stewart, being particularly considered for the waste and roads sectors, is what is known as the Regulatory Asset Base model. It already works in a number of markets - energy, water and social housing being prime examples - and works by raising money from a private, income-generating asset. The regulation comes in to ensure that risks are kept to a minimum, to enable financing to be as cheap as possible.
So in social housing, banks lend to housing associations at very cheap rates with the assurance that the economic regulator (now the Tenant Services Authority) will ensure none go bust. It can be controversial - whereas PFI is part-privatisation, this is nearly full privatisation. And it only works where there is an income stream, implying roads would have to be toll-bearing. A Treasury study on this is due to report in spring.
Likelihood rating : 3/5
Green Investment Bank
Osborne set aside £1bn for the investment bank in the spending review, and said this should be supplemented with money from the sale of mature infrastructure assets. This cash will be used to pay for the highest risk, most experimental parts of infrastructure projects. The idea is that the high-risk capital will unlock projects with huge potential value, as private operators are willing to finance the risk of other stages at much more reasonable rates. More detail is expected in the spring.
Likelihood rating: 3/5
Tax Increment Financing and Local government
The coalition has said it will allow councils to borrow against future increases in business rates resulting from successful developments in their areas. Transport for London thinks that this can be used to pay for the extension of the Northern line to Battersea and Nine Elms, and hundreds of other local authorities are working up big regeneration plans on similar lines.
An announcement on this has been wound up with a wider review of local government finance, with the government so far refusing to say whether it will allow unlimited borrowing or cap councils’ ambitions. Many questions remain.
Likelihood rating: 2.5/5