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Submission to House of Lords Economic Affairs Committee Inquiry into private finance projects and off-balance sheet debt

November 2009

Prof Allyson Pollock

Mark Hellowell

David Price

Moritz Liebe


1. Could you provide a brief overview of what you see as the main problems of private finance projects in the health sector and what benefits, if any, private finance projects have brought?

1.1 Since 1992, PFI has been the dominant form of procurement for large NHS projects. Of the £11.6 billion of capital expenditure contracted to take place under England’s hospital-building programme, more than 90% has come through PFI (Department of Health, 2009). As of April 2009, 149 PFI hospital contracts were signed in the UK, with the NHS England being the biggest procurer in terms of numbers (68%) and capital value of assets (89%) (See Figure 2, overleaf, and Annex Table 1). In England, of the 133 new hospitals which were built between 1997 and 2008 or are currently under construction, 101 were financed under PFI. This accounts for around 90% of the £12.1 billion capital committed (Department of Health, 2008).

1.2 Off-balance sheet accounting:

For most NHS organisations, PFI has been, in the words of former health secretary Alan Milburn, the “only game in town”. This is largely due to anomalies in financial reporting standards. For most of the last 17 years, PFI has been “off-balance sheet” for NHS Trusts and other NHS organisations (though this is no longer the case). PFI has also been outwith the capital budgets of the Department of Health (thereby easing the constraints on that budget); and invisible to the calculation of public sector net debt (which of course has been important – and remains important to the Treasury). It still retains these advantages to both the Department and the Treasury.

PFI has provided successive UK governments with an opportunity to keep public sector net debt artificially low – nearly 96% of all UK hospital schemes were off-balance sheet; that is, excluded from public debt figures (HM Treasury 2009b) While most will now be on balance sheet, they will still be invisible from the perspective of departmental capital budgets and public sector net debt. PricewaterhouseCoopers (2008) have observed that current accounting standards[1] are used as “accounting driver for implementing projects through PFI” (p.1.) and that these rules have provide an adverse incentive to allocate risks to the project company inappropriately, simply to preserve the off-balance sheet status of (some) PFI projects (ibid).

1.3 Economic appraisal: value for money

Accounting anomalies distort decision-making at each level of government. The evaluation procedure involves a comparison of the proposed PFI solution with an entirely theoretical – and usually non-fundable – public sector comparator, which may differ significantly from the PFI in terms of output specification. Despite systematic bias (for example, the exclusion of financing costs from the comparison, and the completely unrealistic assumption of zero risk-transfer in the PSC – a contractual structure that would fail to proceed through the Office of Government Commerce Gateway process), these appraisals very often find in favour of the PFI option by just fractions of 1%. PFI is proceeded with on this basis, despite significant uncertainty about the cost estimates of the PSC, the values associated with risk transfer to the private sector and the appropriateness of the discount rate being used in calculating net present values. This process has been widely discredited in the academic literature (e.g. Gaffney et al 1999). In addition, Jeremy Colman, a former Deputy Comptroller of the National Audit Office, described a tendency for these appraisals to be based on “spurious precision” and “pseudo-scientific mumbo jumbo”.

1.4 Financing costs

Contrary to the Treasury’s stated position (HM Treasury 2003), it is not simply that the higher cost of private finance relative to public finance is due to risk – the private sector is charging premiums well above this. Research into 64 PFI consortia commissioned by the Office of Government Commerce in 2001 has also shown returns to PFI shareholders at around 2.4 percentage points above what would be expected[2] (PricewaterhouseCoopers, 2002). Rates of return to the consortia may be even higher after ‘refinancing’[3]. In this case, the debt maturity is often extended, representing a significant increase in risk for the public sector. This device has the potential to increase returns, because the public sector continues to pay back the debt at the old rate of interest. The increase in IRR is due to the nature of the IRR formula and the way it favours returns earned in the short term – refinancing turns back-ended cash-flow profiles into front-ended profiles. For example, investors of the Norfolk and Norwich PFI hospital increased their rate of return from 16% to 60% through refinancing. This outcome was described as “the unacceptable face of capitalism” by Edward Leigh, the chairman of the House of Commons Public Accounts Committee (Macalister and Carvel, 2006). The evidence of ‘excess returns’ to private finance investors contradicts the claim that the higher cost of private finance is simply a function of the risks taken on by private shareholders, and represents a significant element of bad value for the public sector (Hellowell and Pollock, 2009). The evidence of earlier returns to shareholders also contradicts claims about efficiency incentives.

1.5 Risk transfer: cost and time over run

The public sector is paying the private sector an excessive rate of return. The theory of PFI – as stated by the Treasury (2003)—is that whole-life costs will be lower than in, say, a fixed-price design and build contract. As the PFI contractor is responsible for both construction and long-term operation, there are said to be incentives to balance construction and operational costs in order to provide the lowest-cost solution overall – incentives that are strengthened by the inclusion of private finance. But there is no conclusive evidence of this.

Instead, in recent years, government attempts to justify the dominance of PFI in large-scale capital investment have focused on the model’s ability to deliver projects “on time and to budget”. For example, the Treasury (2003) states: “Treasury research into completed [PPP] projects showed 88% coming in on time or early, and with no cost overruns on construction borne by the public sector. Previous research has shown that 70% of non-PFI projects were delivered late and 73% ran over budget” (p.43). This conclusion has had a major impact on regulations governing the way in which public authorities carry out their PSC appraisals, in particular the calculation of risk transfer.

However, requests for the Treasury’s work on cost and time overruns indicate that NO research report exists. Indeed, Treasury officials have stated this in a correspondence with the Centre.

Meanwhile, the “previous research” noted above refers to two reports from the National Audit Office, Modernizing Construction (2001) and PFI Construction Performance (2003). But neither of these studies compares performance under different procurement routes. The first is based on interviews with industry about the scope for improved construction.

The second is a census of 38 project managers. Neither study examines the relative performance of PPP and conventional procurement. Indeed, the authors of PFI Construction Performance conclude: “it is not possible to judge whether these projects could have achieved these results using a different procurement route” (National Audit Office 2003).

A major problem with Treasury and government evaluations is that comparing PPP and non-PPP projects are based on post-contractual price increases (what the Treasury appears to mean by “time and cost overruns”). This is not a valid method for testing value for money. Under a PPP, the risk of cost and time overruns is transferred to the private sector, so it has little flexibility to increase its price during capital works unless major problems emerge.

Under PPP, the private sector increases its price before contracts are signed. It is assisted in doing so by the preferred bidder stage - a post-competitive phase of PPP procurement in which the public authority enters into a long and exclusive negotiation process with a single consortium.[4]

During this period, the private sector can ‘hold-up’ the public sector, pushing up prices and reducing the extent of risk transfer (Lonsdale 2005). Meanwhile, the scope for public authorities pulling out of such negotiations is limited by the unavailability of other procurement routes. In proposing that post-contractual price certainty can be taken as an arbiter of overall efficiency, the Treasury is setting up a comparison which is bound to favour the PFI method.

A project that is delivered to time and to budget (in post-contractual terms) may represent poor value for money if the price paid for the risk transfer that led to that outcome was too high.

1.6 Planning and affordability

Given the weakness of the economic case for PFI, the cost it imposes on a healthcare system—and the potential impact of this cost on services —is a significant public interest concern. Under PFI, payments to the private consortia have to be met from the budgets of public authorities and in the case of the UK’s NHS, from local hospital trusts’ annual financial allocations. Depending on the service element, the contracts cover between 60 and 75% of total payments of the £70.5 billion (£62.65 billion in the NHS England; Figure 3) made to the private sector for providing and maintaining the assets (the “availability fee” [5]). This availability fee can have a significant impact on the revenue streams of a hospital.

Research has shown that an ‘affordability gap’ emerges for NHS organisations during the PFI procurement process, and strategies to bridge this gap are identified in planning documents. Examples of bridging strategies are: increasing patient throughput; selling NHS land; and reducing beds and staff across health economies. (Gaffney et al 1999b). With many schemes now in the operational phase, it has become possible to examine empirically the impact of these strategies on capacity.

In a recent examination of the first 18 operational PFI hospitals, official auditors found that 13 had bed occupancy rates higher than the NHS average (National Audit Office 2007b). Almost all the trusts involved (17 of 18) had higher bed occupancy rates under PFI than in their former buildings. The NAO comments that such levels “raise issues about capacity and patient care”, including the “adequacy of capacity to meet peaks in admissions” and “infection control” (p.18).

While cuts and closures planned for in PFI planning documents have clearly had an impact on health care delivery, it is evident from more recent research (e.g. Hellowell and Pollock 2007) that an affordability gap remains.

Earlier published work (Pollock et al 2000) showed how the planning of the replacement Worcestershire Acute Hospital led to affordability problems which triggered the downgrading of Kidderminster hospital and bed reductions of 30% across the trust estate. Despite these measures, written evidence from the trust to the House of Commons Health Select Committee shows that affordability problems remain, such that the combined overspend for the trust in 2005/06 was £4.9 million, with an underlying deficit of £20 million (House of Commons 2006).

The trust attributed £7 million of this deficit to the “additional costs” of their PFI hospital, which it has said are “not reflected equitably in the national tariff and for which the trust does not receive sufficient income” (p.152).

This was despite £1.5 million of subsidy provided that year by the DH and the NHS Bank. In response, the trust has developed a recovery plan, which involves a reduction of staff numbers by 675. It has also warned that achieving recurrent financial balance will not be achieved without “even more radical action”, involving “a comprehensive review of services” across its three hospitals, amid “serious questions about their sustainability” (p.153).

In South East London, the outcomes are similar. According to a paper from the South East London and Maudsley Strategic Health Authority (SHA), the area’s four district general hospitals had a combined deficit of £66 million in 2005/06, with the largest losses at the Queen Elizabeth and Bromley trusts (South London and Maudsley SHA 2007).

Both Queen Elizabeth and Bromley have operational PFI schemes with capital values in excess of £50 million. Bromley’s PFI scheme is on-balance sheet, with the effect that both availability and capital charges are paid on the asset; and both trusts received DH subsidies in 2005/06 (£1.1 million and £4.9 million, respectively).

Nonetheless, according to an SHA document, the deficits of both trusts arise “because the cash costs of the PFI availability charge exceed funding for capital charges in tariffs” (p.5). Both trusts had capital cost/income ratios of over 10%, against the 5.8% funded in the tariff. The SHA explains that these trusts “incur recurrent [income/ expenditure] and cash flow deficits even if they operate as efficiently as the average hospital trust in England” (p.7). It suggests that achieving financial balance in the area cannot be achieved without significantly reducing “controllable costs”, including “further substantial reductions in staff costs and staff numbers” (p.10).

1.7 Quality and innovation

The NAO commissioned the Building Research Establishment to compare design quality between a group of PFI and a group of non-PFI hospitals. It found (2007c) that there were “no meaningful differences” in build quality between the two groups. However, it also noted that the average age of the non-PFI hospitals was much older.

We also know from the work of the Healthcare Commission that in terms of operational services in hospitals – cleaning, catering, portering and laundry – the quality in PFI hospitals tends to be lower than in non-PFI hospitals, and the costs are higher.

In other words, the evidence from government auditors and other specialists tells us that the cost of construction on hospitals built under the PFI is the same as under conventional procurement, but that the quality is somewhat lower. At the same time, the cost of services provided under PFI is higher than under conventional procurement, and the quality is lower.

The component of the PFI package that we know the least about is the maintenance – there is not sufficient data to say whether quality and cost are higher or lower in PFI, and this is something that future audits of value for money should consider.