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PRIVATE FINANCE INITIATIVE Public Services in Private Buildings
Contents
In the early 1990s the Conservative government in the UK began to openly promote the principle of using private money to fund all or part of the public services. The message from the centre was the Private Finance Initiative (PFI) would:
By 1994 my own service, the NHS, was obliged to test all capital investment proposals for their appropriateness for funding through PFI. Although this obligation was clear, how it was to be achieved was not. There was little guidance and even less experience available to undertake what is a very complex process. At the beginning we were advised by HM Treasury to 'leave things open' do not be prescriptive about what you want, otherwise you'll stifle the potential for the private sector to innovate and devalue the competitive element of the tendering process. From the private sector the message was quite different, they said 'tell us what you want, how big it should be and what it needs to contain. Their concern was one of cost. They were not willing to risk the significant sums of money required to tender for a capital project under PFI without understanding fully what the public sector wanted. During 1995 and 1996 some common ground was found and matters started to settle down, but many unknowns and untested issues remained. It was not until the Bates review of 1997, the publication of detail guidance in 1999 and development of practical experience that a mature market was able to start growing. We now understand what we have to and how it has to be done, but one question remains unanswered. Will PFI solve the problem of under investment and poor quality services in the public sector, or will it just create massive financial commitments that are poor value in the long run and future generations will not be able to afford. In this brief paper I take a look at the Ideology of PFI, why the private sector wants to invest in the public sector and whether innovation is only possible through the PFI process.
Ours is the age of substitutes: instead of language, we have jargon; instead of principles, slogans; and, instead of genuine ideas, Bright Ideas. Eric Bentley, 1916 New Republic, 29 December 1952
Having worked in the public sector since 1975 and been involved in PFI since the early 1990s, I have mixed views on the ideology behind PFI. The public sector has certainly suffered from under investment for many decades. The overly bureaucratic systems and a culture based on command and control has stifled innovation. Therefore the question we must try to answer is whether PFI can contribute to solving these problems. To do this we need to consider the three reasons why PFI was introduced:
The Private Sector Ethos The premise is the private sector can provide and operate services at a much higher quality and lower cost than the public sector. If they do not, they fail and go out of business. Of course a public sector service cannot 'go out of business'. It either carries on providing poor services or gets bailed out with more cash. Occasionally a few heads will roll, but generally little changes. This does assume that the whole of the private sector is efficient and provides good services and the whole of the public sector is costly and ineffective. Such generalisation is clearly wrong. Private sector companies go bust all the time, often because of poor management and under investment. There are also elements of the public services that are well run and cost effective in comparison to the private sector. My conclusion is that, correctly targeted, PFI can bring benefits in the form of better and more cost effective services, but targeting is the operative word. There are plenty of public services with similar counterparts in the private sector that would benefit from private sector ideas and involvement. There are also many public sector services that are unique and do not have private sector equivalents. How applicable is PFI to them? Perhaps the answer is for these parts of the public sector to be more like the private sector, without being or becoming the private sector, a cultural change rather than a structural one. To achieve this you need to encourage private sector managers to move into a public sector that is perceived, by the private sector, as being bad for one's career and bad for one's pay packet. A career in the public sector is seen as being partly vocational and the public riles against the thought of public servants being paid salaries similar to those in the private sector. Until this changes private sector innovation and practice will have to be bought in the market place at market prices.
Risk Transfer and VFM For PFI to work we must demonstrate that the service will cost less, including any capital investment, when provided by the private sector. If you exclude risk from the equation, the private sector service will always cost more. The HM Treasury interest rate on capital is less than that available to the private sector from banks and venture capitalists, the public sector does not have to make a profit for its investors and management costs in the public sector tend to be less. However if you include the cost of risk in the equation the situation becomes reversed. In the majority of schemes the private sector version costs less than the public sector version. It is the principle of risk transfer that makes PFI work and is how we determine if a scheme is value for money (VFM). This is one of the hardest areas of PFI to understand and, as you would expect, one of the most disputed by its proponents and opponents. Read through a PFI contract or review the financial model and it is easy to identify what risks are being transferred and how. But is it the private sector that really pays if the risk occurs? This is the question that must be answered if we are to determine if PFI is or can provide value for money. The answer can be found in how the private sector offsets risk. Pick up any textbook on risk management and you'll find the same four ways in which risk is managed:
Risk combination is only available to large organisations that can spread the consequential cost of a risk occurring across the whole organisation. In effect the organisation determines the average expected loss and budgets accordingly. The larger the organisation the more certain the cost becomes. The cost of covering the risk is treated as an operating overhead and is thus charged on to the customer. Risk avoidance is generally adopted at the planning stage. The potential risks are identified, and a decision taken on which risks will be avoided by eliminating the associated activity or product. This may involve not doing something, or substituting an alternative that has a lower risk. Often risk avoidance means changing to a higher cost product or method, a cost that is ultimately passed on to the customer. Risk reduction involves determining what the potential risks are and how some or all can be reduced or eliminated. Reduction mechanisms usually involve additional cost in the form of safety systems, monitoring equipment, various forms of physical protection and security systems. These costs form part of the operating costs of the organisation and are therefore charged to the customer through the cost of the product or service. Risk loss financing is often used where the cost of risk reduction becomes uneconomic. This approach involves planning for the cost of the loss through contingency funds or by risk transfer. The former will be priced into the organisation's budget over a period of time until a suitable sinking fund has been established. As with the previous risk management methods the cost of the sinking fund is built into the cost charged to the customer. The latter method, risk transfer, can take two forms. Transfer the activity that creates the risk to a third party and let them decide on the subsequent management method, or transfer the financial consequence of the risk occurring to a third party through an insurance policy. Inevitably the cost of these two options will flow through to the customer through higher overheads or operating costs. From this brief analysis it would seem that the cost of risk is not being transferred to the private sector as it will be reflected in the price charged to the public sector. What is transferred is the responsibility for the management of risk. If it is assumed the private sector can manage risk in a more cost-effective way than the public sector, then there is a net gain to the public sector from the private finance initiative. Whether this represents good value for money is very hard to determine. Only time and experience in operating PFI projects will provide the answer.
Increased Investment The final benefit from PFI is the ability to increase capital investment in public services without the need for governments to increase public spending or their PSBR in the short term. This is where the political dimension arises, although this apparently capitalist approach to funding public services has been enthusiastically embraced by socialist governments. How much a government can afford to invest in public services will depend on the wealth and prosperity of the country and their fiscal policies. The private finance initiative avoids the need for a significant level of public spending in the short term. It spreads the cost of the investment over the life of the PFI contract, perhaps 20 or 30 years. What becomes important to the country is not short-term prosperity but long-term stability. Some economists have expressed concern at the way in which PFI commits the country to long-term expenditure. If the country was to find itself in a period of sustained economic decline the PFI spending commitment could become a restraint to prudent economic policy and the ability to cut public spending. Only time will tell whether PFI proves to be a sound economic policy or millstone around a future chancellor's neck.
In a community where public services have failed to keep abreast of private consumption things are very different. Here, in an atmosphere of private opulence and public squalor, the private goods have full sway. J. K. Galbraith, 1908, American economist The Affluent Society (1958) ch. 18.
For PFI to work, the private sector must consider the public sector a worthwhile investment with a good prospect of generating a profit for their owners and investors. Without these qualities, private money would not be available to the public sector. Initially there was a lot of reticence from the private sector, particularly at the over enthusiastic views from the centre as to how much risk could be transferred and costs reduced. Some early schemes have failed to achieve the cost savings that were predicted and do not represent good value for money. Operational problems and public mishaps have troubled other projects. Such situations are not unexpected in the early days of a new initiative and could be attributed to the failure to pilot the process before adopting it as policy. With the introduction of compulsory PFI testing of capital schemes, major suppliers and construction companies have had little choice. They take part in the process or are denied access to a significant market. A few major contractors have taken the decision not to bid for PFI schemes. Whether their position is sustainable in the long-run only time will tell. At present there are plenty of contractors, banks and equity partners willing to get involved in PFI projects. Having resolved the legal issues and developed a good understanding of the process the market has begun to mature. Investment in public services is seen as being relatively safe and having the potential to generate good profits. The banks have total security over their investment (they only loose out in the most extreme circumstances). Public services tend not to be in competition with each other, they fulfil a need that will be constant in the long run and come with a significant degree of security over their income stream. It would seem that PFI is one of those rare win win situations. The public sector benefits from better quality services at a lower cost, and the private sector makes a health profit. Or are we missing something somewhere?
He that will not apply new remedies must expect new evils; for time is the greatest innovator. Francis Bacon (1st Baron Verulam and Viscount St Albans), 1561-1626, English lawyer, courtier, philosopher, and essayist Essays (1625) Of Innovations
During the early days of the Private Finance Initiative the introduction of innovative private sector practices to public services was proffered as one of its strengths. The design of buildings would be far removed from the institutional traditions of the past, services would be responsive to the needs of the public and quality would be the watchword for every aspect of the public service. The cynics wondered why these improvements could only be made through the private finance initiative. The public sector has access to the same architects and planners as the private sector. Services can be redesigned to meet the needs of the users and review and assessment systems adopted to ensure quality is improved and maintained. However this misses the one fundamental difference between the public and the private sector. Business succeeds by determining what the customer wants and supplying it a cost effective way that adds value to the product or service. The value added in excess of the cost represents the profit. Without profit business and commerce would not exist. In the public sector adding value has no benefit, the cost of the product or service cannot be increased and therefore no profit can be earned. The service is paid for, by the government, through fixed budgetary allocations. The incentive in the public sector is to get the best value from the money that is provided and often means low quality at low cost. PFI is seen as one way in which this dichotomy can be solved. Use private sector innovation and ideas in those parts of the public services that can benefit most, while leaving the public sector to fulfil its core purpose. How much of the public service can be provided by the private sector depends on the type of service involved. Other than the support of the emergency services, roads can be entirely privately funded and maintained. In contrast, hospitals have a significant element in which private sector involvement is not seen as appropriate. PFI schemes in health are limited to the provision and maintenance of the buildings and a few support services. Where the PFI involvement is limited to a small part of the service the cynics' view may well have some logic. Unfortunately the public services have a record of procuring buildings which tend to cost more than originally planned, take longer to build and are often out-of-date before they open. Combining the procurement of the building with its long-term upkeep under a PFI contract shifts all the construction time and cost risks, and maintenance cost risks to the private sector. In response the private sector will seek innovative ways to design a building that meets the needs of the public sector, is easy to maintain and has lower whole life cost, including the risks the private sector is required to manage. Whatever the degree on involvement the private sector has, it will bring benefits that may not be directly available to the public sector.
Summarising each section above, PFI provides:
These are the reasons PFI was introduced, and one might conclude, therefore, PFI is a beneficial ideology. The problem is the real proof will not be available until we have many years' experience in operating public services in private buildings. PFI contracts can be 20, 30 even 60 years long. If we have got it wrong, we will have to live with the problem for a long time.
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