PFI is dead? Long live PFI!

Last month the House of Commons Treasury Committee published its report on the Private Finance Initiative (PFI). The report is critical of PFI in many respects and calls for urgent reforms. Stephen Matthew and Janet Lewis look at its findings.

The ups and downs of PFI

The Treasury Committee report does not purport to be a comprehensive study of PFI – instead, it draws together existing research and evidence. Crucially, it is intended to be relevant for early changes in policy.

At present, PFI officially remains a viable means of delivering investment in infrastructure for the current coalition government (which may be a surprise to many).

Although there are definite theoretical benefits of PFI, the unique disadvantage of PFI is described in the report as follows: "The use of PFI has the effect of increasing the costs of finance for public investments relative to what would be available to the government if it borrowed on its own account."

In other words, the case for PFI rests on its ability to allocate risks more effectively and to ensure that the public sector gains from the resulting savings. The report concludes that, unfortunately, this has not always been borne out in practice.

Artificial incentives

The report highlights one of the key flaws of PFI, which is not so much a flaw in the model itself but rather in the justification for its continued use – the existence of incentives to use PFI which are completely unrelated to value for money.

There is a two-pronged criticism. Firstly, PFI debt does not appear in government debt or deficit figures, providing a strong reason for the public sector to proceed with PFI rather than conventional procurement routes. Secondly, government can use PFI to leverage up their budgets without using their allotted capital budget, ensuring that capital investment can be accessed without unduly affecting budgets.

The report recommends that these accounting and budgetary incentives be removed and stricter rules and guidelines introduced. The figures are startling – according to the report, debt would increase by £35bn, i.e. 2.5% of GDP (although this is somewhat dwarfed by the £1 trillion pension liability). Nevertheless, this would provide much needed transparency over the true cost of PFI, as well as removing artificial incentives for turning to PFI.

Value for money

The Treasury has consistently said that PFI should only be used if it is the best value for money route. The report considers various factors and concludes that the price of finance is significantly higher with a PFI with no clear evidence of savings and benefits in other areas to offset this.

Value for money factors considered by the report and its conclusions

Risk allocation

• Some risks have been inappropriately transferred to the private sector, including for example energy tariff risk and insurance risks
• Construction risk is the only risk which has successfully been transferred, but other solutions can achieve this
• Inappropriate risk transfer has led to higher prices and deterioration in value for money

Whole life cost and innovation

• PFI ought to encourage the use of innovative designs and incentivise better maintenance of buildings
• Evidence exists that PFI performs less well in the areas of design and innovation and building quality than traditionally procured building

Delivery to time and budget

• PFI ought to provide more certainty regarding time and price
• There is no evidence to suggest that PFI delivers projects more quickly and at a lower cost than conventional procurement methods

Flexibility

• PFI contracts are inherently inflexible.
• There is little incentive for equity and debt holders to agree to any changes unless profitability is increased
• The lack of flexibility has had serious disadvantages, particularly in NHS contracts

Competition

• The barriers to entering the PFI market are too high
• Long, complex and costly procurement processes limit potential bidders
• There is evidence that PFI projects are receiving fewer developer bids than previously

Assessment bias

• The Public Sector Comparator, the value for money appraisal system used to assess whether to use PFI, is biased
• Public bodies are incentivised to use PFI as the best value for money option as it is often the only game in town

The conclusion is that PFI cannot therefore be relied upon to provide good value for money without substantial reform. What is not entirely clear is what the reform ought to be.

The future

The most interesting aspect of the report is its recommendations for future infrastructure investment – and perhaps more so, what is not said:

The report concludes that:

• There are serious doubts about the widespread use of PFI;
• More robust criteria are required for the use of PFI – the Treasury should seek to ensure that all assumptions that future PFI are based on objective and high quality evidence;
• There is recognition that this may over time sharply reduce the aggregate value of remaining PFI projects;
• The Treasury should consider using more direct government borrowing to replace PFI – there may also be merit in making more use of the design and build model.

In terms of current contracts, it is suggested that the most straightforward solution is for the Government to buy up the debt once the construction period is completed. Public finances would not be any less sustainable because it will be more affordable to service the visible government debt rather than the hidden PFI debt. This would not necessarily mean a higher financial liability for the Government but rather a more transparent debt.

There is also a call for an appraisal of data to ensure that the public sector gets a good second price on deals currently being negotiated. Quite how this will be achieved without significant delay is unclear.

The much heard plea to improve procurement and project management skills in the public sector is of course mentioned. Although there is a recognition that PFI has perhaps exacerbated this skill deficit (by focusing attention on unique PFI issues), no real solution as to how this should be tackled is given.

Anything new?

Only towards the end of the report does some new thinking start to become apparent. The report considers (but does not particularly advocate) the need for a national balance sheet and an infrastructure fund or bank.

More interestingly, the report recommends that the Treasury consults on the possibility of using other financing models, including the regulatory asset base and local asset-backed vehicles, as alternatives or replacements to PFI.

A regulatory asset base is where an asset earns a regulated return for the investor through the public sector (perhaps through an infrastructure bank) buying completed projects and putting a regulatory asset base wrap around them. Local asset-backed vehicles, a model increasingly seen in local government regeneration schemes, allow the public sector to use their assets to attract investment. Neither is explored in detail but at least there is recognition of a need to look at alternative models. The only other solution mentioned (use of fixed-price design and build contracts) is uninspiring.

The report signals a step towards the post-PFI world, a world in which PFI may survive but is unlikely to be dominant.

Stephen Matthew is a partner and Janet Lewis is a senior associate at Nabarro. Stephen can be contacted on 020 7524 6301 or by email at This email address is being protected from spambots. You need JavaScript enabled to view it.. Janet can be reached at 020 7524 6067 or by email at This email address is being protected from spambots. You need JavaScript enabled to view it..