What is the value for money case for and against using the private finance initiative to fund social infrastructure?

For what is essentially a dry accounting and procurement issue, discussions around the private finance initiative (PFI) have long inspired a surprisingly fierce – almost religious – fervour. Supporters and critics alike are passionate in defence of their own revealed truth about the controversial method of financing and procuring public projects.

Since 2018, however, this is a debate that, in England at least, has been largely silent, given that the nay-sayers effectively won the argument. The Treasury cancelled the successor scheme to PFI, with then chancellor Philip Hammond declaring PF2 “inflexible and overly complex”.

But, with the chancellor Rachel Reeves understood to be looking again at how the government can bring in private finance to help fund its social and economic infrastructure plans, it is now an argument that looks ready to fire up all over again. Given this, it seems sensible to ask whether returning to this form of project delivery, used on more than 700 UK projects to date, would be a good idea.

PFI differs from traditional public sector build projects because it sees the public sector engage a private consortium to finance, design, build, operate and maintain a public asset over a 25-year period – with the private sector’s costs paid back through an annual “unitary charge” once the scheme is completed.

>> Also read: How do we fund the future? How Building’s new initiative will look at options for financing public projects

While PFI allows schemes to go ahead, the cost of private companies borrowing the money to invest in projects is higher than the cost of borrowing from the public balance sheet. But, despite this, the National Audit Office in 2011 and the Public Accounts Committee again in 2018 found that, over a quarter of a decade on from the inception of the model, the Treasury had made no full value for money assessment of the use of PFI compared to traditional forms of procurement.

Fortunately, Building is on hand to summarise the arguments. As Reeves weighs up the pros and cons of a new, limited version of privately financing infrastructure ahead of the launch of the 10-year infrastructure strategy in June, here is our cost-benefit analysis of the track record.

The costs

1. Cost comparison

The biggest argument against PFI is that it is simply inherently more expensive than traditional publicly-procured construction because of the higher costs of private borrowing. Even if one ignores all the other potential differences between publicly and privately-financed construction, actually determining exactly how the borrowing costs of equivalent projects compare is not as easy as you might think, however.

Until 2012, the Treasury assessed the value for money of the borrowing costs of PFI against a metric it called the “social time discount rate”, which it said reflected the benefit of the ability to deliver projects earlier under PFI, rather than postpone them until government cash was available. The reality of this was that any project with borrowing costs of less than 6.09% automatically scored more highly than public projects – despite the fact that public borrowing costs have generally been much lower than that.

The National Audit Office in 2013 said it disagreed with the Treasury’s method of assessing financial value, and that the real comparison should be between the cost of private borrowing against the real cost of public borrowing. MPs on the public accounts committee in 2018 said this private cost could be as much as 3.75 percentage points higher than public borrowing – a difference with an enormous impact over the life of a PFI. For example, according to a 2018 NAO report, the total interest cost incurred on a £100m loan over 30 years rises from £34m to £118m at 2% and 6% interest respectively.

The same report estimated that the cost of schools built under PF2 were “around 40% higher than the costs of a project financed by government borrowing”, and that other similar studies had found costs to be 70% higher.

Studies have also highlighted that PFI schemes do not return as much as they should to the taxman, with nearly three-quarters of PFI special purpose vehicles located offshore for tax purposes, with projects also subject to fees such as large set-up, legal and insurance costs that public projects do not have to bear.

Mark Hellowell, senior lecturer in global health policy at the University of Edinburgh, and a former advisor to the public accounts committee on PFI, says it is possible to construct an argument that there are benefits to bringing in private sector investors in order to benefit from the rigour and challenge they bring – and paying the extra cost for that. Ultimately, however, he says: “I don’t think it’s very compelling compared to the price paid. The real private sector discipline in PFI comes in the construction fixed price – but you don’t need a 25-year contract for that.” 

2. Lack of flexibility

Another big issue cited with PFI contracts is the ongoing liability they create for the public sector bodies paying for them, with little flexibility to adapt to changing requirements. With unitary charges commonly running for 25 years from the date of a PFI asset opening, the cost of PFI assets is blamed for tying up a significant proportion of the revenue budgets of public bodies such as NHS trusts and education authorities.

The latest government data shows that, despite a £60bn asset value for the PFI projects built so far, there remains £123bn in outstanding payments towards those same projects to be made by the public sector, running into the 2050s. The 2018 PAC report on the subject bemoaned the fact that the government, it said, was “not doing enough” to address the impact of “inherently inflexible” PFI schemes on local budgets.

Contracts designed to ensure the private consortium delivers specific outputs at the same time make the public sector unable to escape the contracts in almost all circumstances. In one of the worst examples of this, the PAC highlighted the case of the £24m Parklands School in Liverpool, built under PFI and then subsequently closed. Due to the contract, the council remains committed to paying charges totalling £47m towards the empty school into the 2030s.

There have also been concerns that this inflexibility has left the public sector without recourse in cases, particularly in early PFI projects such as the notorious Norfolk and Norwich Hospital PFI, where risks have turned out to be overstated and projects have made super-profits in the operational phase.

Salman Ahmad, a lecturer in accounting at Aston Business School, says: “In the UK, PFI project management was centrally prescribed by the Treasury. This added inflexibility to the contractual control regimes and hence the public sector was not able to respond in a timely or appropriate way in line with broader value-for-money objectives.”

3. Cart before the horse

PFI was originally set up by the Conservative chancellor Norman Lamont in 1992 explicitly as a method to keep government borrowing off the public books. While the justification for PFI evolved under New Labour, critics say the fact that it has traditionally benefited from an “off balance sheet” designation, has meant that PFI has ended up being used even where it is not necessarily the best outcome.

Similarly, the PFI credits made available to individual departments and government agencies effectively meant that money was available to departments for PFI projects which simply would not be forthcoming for traditionally procured schemes – effectively forcing public clients down this route. Nick Gray, chief operating officer for the UK & Europe at consultant Currie & Brown, actually a supporter of PFI, admits that “the driver – the main dynamic – was to get spending off the balance sheet”.

This is a problem, says Edinburgh University’s Hellowell, because the public sector stops making the best decisions it can regarding public cash due to the need to satisfy and attract private partners. He says: “Historically it was the only game in town.

“What happened in the UK, and we’ve seen it around the world, is that you only get investments delivered that make sense for public private partnerships, not the ones that make the most sense for the delivery of services.

“You’re letting your procurement route decide your project.”

4. Benefits not delivered

Even ardent supporters of PFI accept that borrowing costs are higher for PFI than for public schemes. But many would argue that this is more than made up for by a range of benefits (see below for detail), such as more reliable build out, risk transfer, the consideration of whole-life costings and the required ongoing investment over 25 years to maintain buildings to a good standard.

However, critics say that the reality is that many of these benefits are not delivered. Evidence of this comes from the current experience with PFI “handback”, where projects that were among the first PFI schemes to be built are now being handed back to their public clients.

A recent report commissioned by the government on the issue found that there were “increased disputes and deteriorating relationships” between public bodies and PFI companies due disagreements over whether buildings are in the state they should be in at the end of the PFI contract. Craig Elder, partner at law firm Browne Jacobson, says the disputes undermine claims about the benefits of PFI “to a very high degree” and “erodes notions of the benefit of certainty about allocation of risk and responsibility at the end of the contract”.

In addition, there are a number of individual projects that have been identified as problematic, from the Norfolk and Norwich Hospital PFI which was branded the “unacceptable face of capitalism” for the scale of super-profit made from a re-financing, to the M25 widening PFI, which cost an extra £660m due to procurement delays.

Notably, the inquiry into two PFI hospital projects initially undertaken by contractor Carillion before its collapse, found that the cost of the two schemes doubled after a series of build problems stemming, at the Royal Liverpool at least, from poor design. The report said it was not clear why the problems occurred, given that “PFI arrangements are meant to lead to better design and performance by transferring the risk to the most appropriate party”.

The benefits

1. Projects delivered

Critics say the fact that the borrowing undertaken for PFI schemes does not register on the public sector balance sheet means that investment decisions are skewed (see Cart before the horse above).

But for many supporters, this factor cannot be ignored as a crucial benefit – because it means projects can be funded which otherwise would stand no chance. In the real world, it is claimed, where governments have genuine constraints on spending, the choice often has not been between PFI and a mythical public sector-funded scheme – but between building something or nothing.

Simon Rawlinson, head of strategic research and insight at consultant Arcadis, says: “The value question has to be considered against the counterfactual that projects might not have been delivered without PFI funding.”

Currie & Brown’s Nick Gray says: “The point is, if the government doesn’t want to borrow, then money at gilt rates isn’t available. So the question of whether PFI is more expensive is academic. It can be the only way to do things.”

In the case of UK PFI, that means over 700 separate projects – schools, hospitals, roads, prisons – have been delivered that arguably might not exist today if the financing route had not been available, with a capital value of £60bn.

In other words, any assessment must factor in the wider costs to society and the economy of not building some important new piece of infrastructure, particularly if it is social infrastructure such as a school or hospital, where the main benefit is in allowing the delivery of public service. Phil Harris, managing director of investments at Galliford Try, says: “Value for money should consider how well the building has been able to serve its intended purpose over its life, not just the cost of the building itself. Buildings are by their very nature a means to an end.”

In a sense, this is what the Treasury’s much-criticised “social time discount rate” was an attempt to do.

The former boss of PPP quango Infrastructure UK James Stewart, who is now chair of consultant Agilia Infrastructure Partners, says it is a “big problem” that value for money criticisms of PFI generally don’t address the fact that the alternative to PFI is nothing being built at all.

Another significant aspect of the financial model is the “buy now, pay later” element of it. While traditional build requires you to pay your contractor as they build the project out, under PFI, the public sector doesn’t spend a penny until the building is occupied – thereby easing cashflow and bringing forward delivery timescales.

Stewart says: “The [Treasury] green book analysis has always assumed that the alternative is possible and ignored the value created by bringing forward the delivery and benefits of a project.”

2. Better build

PFI’s supporters also point to evidence suggesting that privately financed projects are more likely to be delivered to time and to budget than traditionally procured construction. While the evidence on this is not, perhaps, conclusive, it is consistent.

Trade body the Association of Infrastructure Investors in Public Private Partnerships (AIIP) claims that PFI schemes are three times more likely to be built to budget, albeit that claim is based on comparing data taken from separate studies, one in 1999 and one in 2002, which will have used different methodologies.

However, a single study by the NAO in 2009, which aimed to answer this exact question by surveying 150 PFI and 50 traditionally procured projects, did indeed find that PFI schemes were more likely be built without delay and to cost – albeit not significantly so. The study found that 69% of PFI schemes were on time, next to 63% of public projects, with 65% coming in at price, compared to 54% under traditional procurement.

These top line numbers may also understate the benefits of PFI, as the survey also found that in nearly all cases, the cost overruns in PFI projects were due to specification changes made by the client, rather than build problems. It also found that project teams valued the nature of the incentives in the PFI contract due to the emphasis on clear output specifications and deferment of payment until completion, with 53% of project teams giving very good quality ratings to completed projects.

Currie & Brown’s Gray says: “PFI contracts contained eye-watering penalties for contracting failures in terms of liquidated damages. So, you just don’t really find any evidence of cost overruns.”

Amar Qureshi, co-founder of Agilia Infrastructure Partners, says: “The fact that in the PFI model full revenue only commenced on acceptance of the asset by the public sector was a very powerful incentive to get the project built.”

3. Consideration of whole life costs

If PFI critics bemoan the long-term financial liability created by the unitary charges on these projects, supporters say this approach has not only kept the buildings in good condition, but ensured they were designed with whole-life costs in mind from the outset.

To the first point, the AIIP says there is a £49bn long-term maintenance backlog in the public estate, an issue having a profound effect in schools and hospitals across the country – a level of dilapidation PFI buildings have escaped. A spokesperson says: “Surveys of PFI projects found high levels of satisfaction in maintenance, and the NAO found the contractually agreed standards resulted in higher maintenance spending in PFI hospitals. On this front, the ‘inflexibility’ can be considered a strength.”

Further to this, Gray says the financial incentives in the operating company made it prioritise long-term value rather than just short-term cost. “This meant they looked at getting the right balance between capital spend and whole-life value.”

Supporters also say that the use of PFI forced a genuine appraisal of the long-term costs taken on when deciding to commission a new public building – something otherwise just not done in the public sector. Tim Stone, chair of Nuclear Risk Insurers and former non-exec board member at the European Investment Bank, says: “One of the things PFI does, when properly constructed, is force an honest assessment of the cost of doing something over the long run.

“But one of the things PFI has been hampered by is the public sector’s assessment of the counterfactual – there’s virtually no remotely reliable data about what the true cost of an asset built and maintained publicly over its lifetime would be.”

As Galliford’s Harris says: “Often the comparisons are apples and pears: people compare the total unitary charge over 30 years [of PFI] – which includes interest and FM – with the simple capex [capital expenditure] cost of the equivalent asset.”

Verdict

Given the high costs of PFI, it is not hard to see why the government moved away from using it in a time of public spending austerity during the 2010s, especially given the relatively cheap availability of government borrowing.

However, debates for and against this method of financing infrastructure have been more characterised by heat than light, and an honest appraisal of the method, factoring in all the benefits as well as the downsides, has been long overdue.

While the arguments over value for money may be more finely balanced than they at first appear, it seems clear that the prospects for additional spending on a major infrastructure programme look grim without some consideration of private finance.